Although a marijuana business is illegal under federal law, it remains obligated to pay federal income tax on its taxable income because the law does not differentiate between income derived from legal sources and income derived from illegal sources
Everyone in the space knows at least a little about the unfair burden that cannabis entities are faced with, but what really is Internal Revenue Code 280E?
The law created in 1982 reads as follows: “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.”
Translation: this means that cannabis touching entities are not allowed to deduct any expenses or take any credits.
Subsequent to this, there was a Senate Report reads as follows: “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.”
Translation: this means that cannabis touching entities are entitled to certain deductions, specifically, Cost of Goods Sold.
Cost of Goods Sold represents the portion of a business’ net income attributable to goods that are purchased or manufactured as inventory and later sold to customers. These items include direct and allocable indirect costs. In order to use this, the cannabis business must use GAAP accrual Cost Accounting pursuant to IRC 471.
Translation: this means that cannabis touching entities must utilize a specialized accounting and inventory system, or else they risk all deductions being disallowed.
By forcing businesses, or individuals in sole proprietorships and partnerships to pay taxes not only on their net profits, but also on a significant portion of their disallowed business expenses, the effective tax rate on these companies can be exorbitant.
Translation: this means that cannabis businesses will always pay higher taxes and have a higher effective tax rate.
Unfortunately, cannabis touching entities that complete the arduous state licensing process, comply with strict state regulations, and pay a myriad of taxes imposed at each level of government. Ironically these cannabis touching entities are economically disadvantaged when compared to the criminal market operators, for whom i280E was truly intended.
If you have questions regarding IRC 280E, call a cannabis CPA at the Canna CPAs at:
833-CPA-CANA, or email us @ firstname.lastname@example.org.