The cannabis industry has experienced significant growth over the past decade, with increasing numbers of states legalizing both medical and recreational use. Currently, cannabis is legal for adults in 24 states and the District of Columbia, and medical cannabis is legal in 38 states and the District of Columbia. However, despite the industry’s rapid expansion, it faces a unique and significant challenge in the form of Internal Revenue Code Section 280E (IRC §280E).[1] This federal tax code provision has a profound negative impact on the profitability of cannabis businesses and causes those businesses to constantly evaluate their operational strategies. In addition to IRC §280E and other federal tax challenges, the industry also faces significant state tax burdens.
Understanding IRC §280E
IRC §280E was enacted in 1982 to prevent drug traffickers from deducting business expenses related to the sale of Schedule I or II substances under the Controlled Substances Act.[2] The enactment of IRC §280E was in response to a Tax Court case, Edmondson v. Commissioner.[3]
In Edmondson, the Tax Court allowed the taxpayer to take business deductions for expenses incurred in an illicit drug business, including amphetamines, cocaine, and cannabis.[4]
In response, Congress quickly passed IRC §280E, which provides:
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
Despite the legalization of cannabis in many states, it remains a Schedule I substance at the federal level.[5] The Tax Court has assigned “trafficking” to mean “to engage in commercial activity: buy and sell regularly.”[6] As a result, nearly anything connected to the cannabis industry will meet the definition of “trafficking.” Accordingly, cannabis businesses are unable to deduct most business expenses that are typically deductible for other industries.
Importantly, IRC §280E does not prevent the taxpayer from deducting costs of goods sold (COGS) from gross income. The legislative intent to retain the COGS deduction was explained in the Senate Report that accompanied the enactment of the provision:
“All deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.”[7]
Therefore, taxpayers in the cannabis industry may deduct their COGS from gross income. Pursuant to Chief Counsel Advice 201504011, taxpayers trafficking in Schedule I or II drugs must determine COGS by using the applicable inventory-costing regulations under IRC §471, and appropriate Treasury Regulations as they existed when IRC §280E was enacted.
Impact on Profitability
Obviously, the inability to deduct ordinary business expenses significantly impacts the profitability of cannabis businesses. While they can deduct the COGS, other common deductions like rent, utilities, advertising, furniture, IT equipment, and employee salaries are disallowed. This leads to effective tax rates that can exceed 70%, far higher than the corporate tax rate of 21%.
Mitigation Possibilities
Segregate Activities
The Tax Court has drawn a distinction between “trafficking” and other business activities that are separate and apart from the trafficking, and in doing so, permits the deduction of business expenses related to the separate activity.[8]
Therefore, opportunities exist for segregating activities that are separate and distinct from the cultivation, production, distribution, or sale of cannabis. These businesses handle the cannabis plant itself in their operations and would be restrained by IRC §280E. These activities include growers who cultivate the plants, processors who extract compounds from the plant, and dispensaries that sell the product to consumers.
On the other hand, activities that do not “touch the plant” are those that operate in the cannabis industry but do not directly handle the plant. These can include businesses that provide ancillary services or products to the cannabis industry, such as equipment suppliers or IT providers. Another good example is provided in the Californians Helping to Alleviate Medical Problems, Inc. case where the Tax Court drew a distinction between the provision of medical cannabis and the provision of counseling and care-giving services.[9] The use of such distinctions will require diligent attention to documentation and accounting practices.
IRC §471(c) Small Business Opportunity
The Tax Cuts and Jobs Act of 2017 introduced a new provision, IRC 471(c)[10], that may provide some relief for certain cannabis businesses. The provision was designed to simplify accounting for inventory and COGS for businesses with less than $25 million in gross income. The new provision provides alternative methods for calculating COGS not previously available, as long as the methods are based on appropriate books and records of the company. An example of a business’s flexibility would be its ability to choose to include 100% of its facility costs in its inventory calculation. If the calculation was based on the books and records of the business, it would be permissible. Simplifying, in the cannabis business context, the argument is that the business could include the expenses of renting a warehouse as part of its COGS calculation.
There is much debate whether this IRC §471(c) COGS approach would pass judicial muster in light of IRC §280E, although anecdotal evidence suggests that the IRS is not challenging the use if appropriate books and records are kept. To those ends, businesses should use care to appropriately value inventory, make sure not to include indirect costs such as overhead in the calculation, maintain detailed records and documentation, and remain consistent in accounting methods.
Can Disallowed Costs Be Capitalized?
Recently, the Tax Court has seen a case where the taxpayer argued what a state tax press described as a “long shot theory”[11]that deductions denied by IRC §280E are not permanently lost; rather, they accumulate to the owner’s basis in an impacted business to be taken into account upon disposition of that business.[12] While that case recently settled, the taxpayer’s argument was based on constitutional grounds, likening the increase in basis to the protected COGS concept. At the core, the taxpayer argued that to ensure the tax applies only to the constitutionally permissible “gain,” a basis adjustment is needed to account for the unused deductions. This argument faces significant headwinds given the intent behind IRC §280E; however, the argument does draw upon the rationale for permitting the COGS deduction. To date, the Tax Court has not made a determination on this argument.
State-Level Remedies and Challenges
Many states tie their corporate tax schemes to the IRC. In other words, the determination of taxable income is largely dependent on federal law. In light of IRC §280E, this would also result in ordinary business deductions being denied at the state-level as well. Fortunately, many states that have legalized recreational or medical cannabis, or both, have recognized this issue and have “decoupled” from the federal IRC §280E restriction.
As of the date of this writing, at least 20 states (including California, New York, New Jersey, and Massachusetts) have decoupled from the federal law, allowing cannabis businesses to deduct expenses as any other business. While this does nothing to alleviate the federal impact, it does provide relief for state taxes. It is likely that more states will follow the decoupling route.
The decoupling relief is welcome in light of the significant taxes that states impose on the industry. The Tax Foundation estimates that states collected nearly $3 billion in excise-type taxes from medical and recreational use in 2022, and estimates that this amount could reach $8 billion if cannabis is legalized nationwide.[13]
These taxes take two basic forms: (1) ad valorem rates applied at the wholesale and retail levels; and (2) ad quantum taxes levied separately on cannabis seeds, flower (mature and immature), leaves, trim, clones, whole plants, concentrates, and edibles. These rates can vary by THC content in the product. Currently, with cannabis operations largely operating in the intrastate realm, these differences do not pose much of an issue. If, however, nationwide legalization occurs and interstate activities are permitted, these variances will pose significant problems for businesses and will create substantial opportunities for tax arbitrage, like those that currently exist in the tobacco industry. Nationwide legalization will create an immediate need for states and the federal government to examine state tax approaches. Until then, businesses will deal with state taxes, which is not necessarily the best method from a tax policy standpoint.
The relative infancy of the industry has also resulted in evolving concepts of state taxation of cannabis products. Cannabis taxation presents unique policy challenges because of the nature and variety of cannabis products, much more so than in the areas of alcohol and tobacco taxation. Currently, states tax cannabis in a variety of ways, including imposing tax on price, weight, potency, or a hybrid of these methods. It is no secret that a main impetus behind legalization of both medical and recreational cannabis was the opportunity for states to raise revenues. As we have seen, substantial sums are now being raised by states from cannabis sales, with an even greater potential as legalization efforts continue. While states enjoy these revenues, they must remain vigilant, keeping in mind possibly the most important overarching policy goal in the area of cannabis taxation — maintaining the imposition of taxes at a level that does not create an incentive for users to retreat to the illicit market for lower-cost products.
What Is The Outlook?
As seen in the discussion above, there is no doubt that federal and state taxation, particularly IRC §280E is financially limiting the cannabis industry in the U.S. Despite periodic efforts to reform or repeal IRC §280E (a total of 19 bipartisan efforts between 2013 and 2022), it looks like it is here to stay, at least for the time being. Despite that gloomy prognosis, there are some bright spots.
First, in response to a statement from President Biden, in August 2023, the U.S. Department of Health and Human Services recommended that the Drug Enforcement Agency (DEA) reclassify cannabis as a Schedule III substance. Obviously, as we have learned above, IRC §280E only applies to the trafficking of Schedule I and II drugs; therefore, reclassifying cannabis as a Schedule III substance, without any other change, would allow cannabis businesses to begin deducting their ordinary business expenses, just like other businesses. Thus far, the DEA has not indicated whether it will accept the recommendation.
Second, legalization and reform legislation has been introduced by both parties in Congress. Even in light of public opinion polls showing the support of legalization, and the momentum of more states moving to legalize (the most recent example being Ohio), it is unlikely there will be any meaningful federal reform or change in 2024, given the general political acrimony and the fact that we are now in a presidential election year.
[1] 26 U.S.C. §280E.
[2] 21 U.S.C. §801-971.
[3] Edmondson v. C.I.R., 42 T.C.M. (CCH) 1533 (T.C. 1981).
[4] Id.
[5] 21 U.S.C. 812.
[6] Californians Helping to Alleviate Medical Problems, Inc. v. C.I.R. (T.C. 2007).
[7] REP. NO. 97-494 (Vol. 1), at 309 (1982).
[8] See Californians Helping to Alleviate Medical Problems, Inc., supra (company that provided medical cannabis to patients along with non-cannabis related services could deduct business expenses attributable to the non-cannabis services).
[9] Id.
[10] 26 U.S.C. §471(c).
[11] Where do Pot Deductions Go When They Die?, State Tax Notes, (March 28, 2022).
[12] SIRA Naturals, Inc. v. Commissioner, No. 14771-22 (T.C. 2023).
[13] See Cannabis Tax Revenue & Nationwide Cannabis Tax Policy Blueprint (taxfoundation.org) https://taxfoundation.org/research/all/state/cannabis-tax-revenue-reform/ (December 14, 2023).
