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QUESTION: I’m considering opening or investing in a cannabis business. Do I get a Section 199A deduction for it? Did tax reform affect the cannabis industry in any other ways?
ANSWER: You won’t get a Section 199A tax deduction for your cannabis business. But some of the other tax reform changes may make the C corporation a more attractive choice of entity.
History of 280E
Congress enacted Section 280E in 1982 at the beginning of the Reagan administration’s “War on Drugs” in response to a Tax Court decision that upheld deductions claimed by a drug dealer for both cost of goods sold and other business expenses.6 The IRS has never issued any regulations or other interpretations of Section 280E. The only guidance on what it means includes a few Tax Court cases (which constitute authority) and a Chief Counsel Advice issued in 2015 (which does not constitute authority).
How does Section 280E hurt state-legal cannabis businesses?
Federal income taxes are calculated using a seemingly simple formula: You take your gross income, deduct business expenses to figure your taxable income, and then pay taxes on this amount. Owners of businesses that don’t involve the sale of Schedule 1 drugs use ordinary general and administrative deductions to maximize their profits, but Cannabis business owners have to pay taxes on gross income.
What types of business expenses are scrutinized under 280E?
• Employee salaries
• Utility costs such as electricity, internet and telephone service
• Health insurance premiums
• Marketing and advertising costs
• Repairs and maintenance
• Rental fees for facilities
• Routine repair and maintenance
• Payments to contractors
EXAMPLE: Let’s say your marijuana dispensary grosses $500,000 per year, with a cost of goods sold of $325,000 and other deductible business expenses of $100,000. If you were a business that sold non schedule 1 products, you would only pay taxes on $75,000. However, as a cannabis business, you will pay taxes on $175,00 because you aren't allowed to deduct general and administrative expenses.
If the business is an S corporation and you are in the 32 percent federal income tax bracket: You’ll pay $56,000 in federal income tax on the taxable net income (32 percent of $175,000). You’ll need to distribute 75 percent of the $75,000 net cash income just to cover the federal income tax bill! Your adjusted gross income increases by $175,000, not only causing you to lose various tax benefits but also subjecting you to additional taxes (such as the net investment income tax).
If the business is a C corporation: Your corporation pays $36,750 in federal income tax on the net income (21 percent of $175,000). Your after-tax profit is $38,250, which you can retain in the C corporation or distribute as a dividend. For every $1,000 you distribute as a dividend, you take a $150 tax hit on your individual tax return.
If the business is a C corporation (continued) If you distribute the entire $38,250, your tax on the dividends would be $5,737 and your total tax would be $42,487 (significantly less than the $56,000 as an S corporation owner).
Your personal Form 1040 adjusted gross income is unaffected by the C corporation’s net income (unless you distribute dividends). The key is that the “phantom” income created by Section 280E doesn’t impact your individual tax return—only the corporation’s.
TIPS TO MAXIMIZE COST OF GOODS SOLD: Consider the following to maximize your cost of goods sold in a marijuana dispensary:
SPACE: If you enlarge the space dedicated to inventory storage, then you will create a larger prorated expense for that space (rent, utilities, etc.) that can be allocated into cost of goods sold.
LABOR: Labor is always a large business expense. With clearly defined job descriptions and detailed hours tracking, you can maximize the amount of employee wages allocated to inventory management (and, thus, deductible as cost of goods sold).
This material is for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. Use of these materials do not create an attorney-client relationship between Howard Tax Prep LLC and the user/reader. The opinions expressed in this document are the opinions of the individual author.
When the IRS audits your tax return, you can either pay the amount due, or you can formally disagree with the findings by filing a petition with the Tax Court. When most people hear the word "court" they typically think of a court with 1 judge and a jury of 12; however, in tax court there is no jury, and 19 judges!
Once your trial ends in Tax Court, it can take up to 2 years for you to receive a decision. In cases where the disputed amount is more than $50,000 if you disagree with the decision of the Tax Court, you can appeal the case with your district U.S. court of appeals. Listed below are several court cases that cannabis business owners can use as guidance for cannabis business operations. For more information regarding the tax court cases below, please search the United States Tax Court website by using the link here: https://www.ustaxcourt.gov/
HIGH DESERT RELIEF: In High Desert Relief, the Tenth Circuit affirmed district courts’ denials of the taxpayer’s motions to quash summons issued to third-party banks. High Desert Relief (“HDR”) is a cannabis company that had refused to comply with IRS’s Information Document Requests (“IDRs”) unless the IRS assured HDR that it would not use that information in a subsequent criminal investigation. The IRS refused and it issued summons to third-party banks. In several district courts, HDR sought to quash the summons, which the courts rejected.
HARBOSIDE: Patients Mutual Assistance Collective Corp. (d.b.a. Harborside Health Center) v. Commissioner, 151 T.C. 11 (2018). Harborside is a medical cannabis dispensary operating legally under California law, and it is treated as a C-corporation for federal income tax purposes. On November 29, 2018, the Tax Court analyzed the application of IRC § 280E, which generally disallows business expense deductions for cannabis companies, to a cannabis community health organization in California.
Harborside argued that it had several lines of business and that it should be allowed to deduct expenses from the non-cannabis businesses.
The Tax Court ruled against Harborside on all issues, ruling that:
CHAMPS: Californians Helping to Alleviate Med. Problems, Inc. In Californians Helping to Alleviate Medical Problems (CHAMP), 128 T.C. 14, (2007) -- the taxpayer achieved a partial victory against the IRS. In CHAMP, the court acknowledged that a marijuana facility can have multiple lines of businesses, only one of which is "trafficking in a controlled substance," with Section 280E applied only to the offending line of businesses. The taxpayers in CHAMP were able to effectively argue that it operated a separate business focusing on non-cannabis related caregiving services, as a result, they were able to salvage the deductions attributable to the counseling business.
ALTERMAN: LAUREL ALTERMAN AND WILLIAM A. GIBSON, Petitioners v. COMMISSIONER OF INTERNAL REVENUE. Respondent Laurel Alterman and William Gibson operated a Colorado medical marijuana grow and dispensary. These taxpayers also sold cannabis paraphernalia, hats and shirts. The Court held that the sale of paraphernalia, hats and shirts was not a separate trade or business primarily due to the lack of records. Accordingly, costs associated with these activities were not deductible under IRC §280E.
In addition, the Court determined that certain costs were not allowable as COGS because of insufficient records, which should be a lesson to any cannabis business owner: It’s not enough to have potentially deductible costs, if you don’t keep records!