280E Tax & How It Impacts Different Cannabis Verticals [UPDATE]

Section 280E of the tax code presents unique financial challenges for cannabis businesses; here’s what you need to know.

What is Section 280E?

280E refers to Section 280E of the Internal Revenue Service (IRS) Tax Code, a clause introduced in the early 1980s to target illegal drug activities. It states that businesses involved in illegally “trafficking controlled substances” (either Schedule I controlled substances or Schedule II controlled substances in the Controlled Substances Act) are not allowed to deduct ordinary business expenses in their taxes. 

While cannabis is legal in many states, it remains against federal law, which means that all legal cannabis businesses fall under this clause and cannot deduct daily expenses from their gross income and federal taxes. Businesses use expenses to lower their gross income, and without being able to do so, reported taxable income is higher.

Cannabis businesses still need “ordinary business expenses,” and not being able to deduct this cost can feel like paying for expenses twice. Internal Revenue Code Section 280E is a huge financial burden on all plant-touching businesses in the United States, and if it feels personal, well, it is. 

Allowable Deductions

The only deduction allowed for cannabis businesses under 280E is COGS: cost of goods sold. The IRS defines COGS as “inventory at the beginning of the year; purchases less cost of items withdrawn for personal use; labor costs (generally applies to manufacturing and mining operations); materials and supplies (generally a manufacturing cost); other costs (generally applies to manufacturing and mining operations); and inventory at the end of the year.”

This is understood to mean that cannabis companies can deduct the direct costs of labor and materials necessary for doing business. 

Non-Allowable Deductions

Unfortunately, this means that the list of “ordinary business expenses” that cannabis businesses cannot deduct is quite long and includes things like:

• Rent 
• Salaries outside of direct labor costs 
• Marketing and advertising costs 
• Monthly utilities 
• Administrative expenses 

That cost for your inventory software? Not deductible. How much you spent on a billboard? Not deductible. Monthly rent at your office or store? Not deductible. Non-deductible expenses add up quickly and sadly, cost cannabis businesses a lot of money (and profit) every year in increased tax rates.

Impact on Taxable Income

In most industries, ordinary expenses are subtracted from profit. A business spends $500 to bring in $1500, but once expenses are deducted, only $1,000 is taxable. Without being able to deduct expenses, however, that entire $1,500 is taxable. For cannabis companies, this means that the federal government sees more profits than they actually brought in, because they can’t subtract the cost of doing business. Higher profits lead to higher taxable income, which increases the amount businesses may pay annually and increases your tax liability. It’s a vicious cycle.

The strict impositions of 280E affect all plant-touching verticals in the industry. There is also a lot of uncertainty around what qualifies as “COGS” for each vertical, leading to confusion in tax preparation and increased scrutiny from the IRS. 

Cultivation

While the cost directly associated with cannabis production can often be written off (including the cost of seeds, genetics, and fertilizers), expenses like labor, rent, and marketing are not. Whether utilities like electricity fall under COGS and “directly associated with growing” or “ordinary expenses that cannot be deducted” is up for debate. 

Processing/Manufacturing

Defining costs directly associated with the production and manufacturing of cannabis products is tricky. Common expenses like expensive equipment, packaging, salaries, and quality testing do not count as deductible expenses for cannabis businesses. So what expenses, exactly, count as “cost of goods sold” in this vertical? It can be hard to say, and should be discussed with a licensed tax professional who has cannabis experience. 

Retail/Dispensaries

280E was designed with “illegally trafficking” in mind, which means it hit places that sell marijuana, like dispensaries, the hardest. Almost none of the expenses related to running a retail business count as deductible, including rent, salaries, advertising, security, technology, and overhead costs. There are very few deductions for “cost of goods sold” that dispensaries can actually take to reduce their gross income.

Delivery Services

Delivery services also fall under “trafficking” by definition of Internal Revenue Code Section 280E, and are also short for deductible expenses. Salaries, vehicle maintenance, marketing, and advertising are not deductible, but the cost of holding inventory may be. This increase in taxable income may necessitate delivery services raising rates, charging higher delivery fees, or even limiting the areas where their service is available.

It can feel daunting when the federal government seems to be against your business. To protect your time and financial investment, you need robust risk management strategies to keep your business (and bottom line) safe in the marijuana industry.

Accurate Cost Accounting

The best defense is a good offense. Meticulous cost accounting helps you ensure that your I’s are dotted and your T’s are crossed. Keeping incredibly accurate records of your expenses and gross receipts allows you to maximize whatever cost-of-goods deductions you are able to get, even if it’s just on the state level. 

This is not something you have to manage alone in an Excel spreadsheet — there are specialized accounting software programs built to deal with the intricacy and nuances of the cannabis industry that can help you make the most of your money. Consulting with tax professionals on a quarterly or bi-annual basis, as well as professionally filing your taxes, are also best practices to keep your finances tidy; finding the properly calculated cost and maximizing your claim deductions.

Structure Optimization for Cannabis Companies

How your business is built has a major impact on your annual tax liability. For larger companies, it’s worth considering structuring your business in such a way that the plant-touching activities are separate from the cannabis-centric activities. This is not a simple or easy solution, and should be considered with legal and financial experts before you decide to do this. But, depending on the scope and scale of your operation, keeping departments like marketing or assets like real estate separate from the cannabis plant may help you reduce tax liability and potential payments, keeping more of your money in your pocket. 

However your business is structured, rely on the knowledge of cannabis-specific software and operating systems to help you support your business in the face of the complex regulations and many tax intricacies. Automation is a key piece of success for cannabis companies because no one can be everywhere and remember everything. 

Advocacy and Reform

Laws and regulations change. As a member of the cannabis industry, if you don’t like a federal policy or regulation like 280E, you can make your voice heard. It doesn’t change anything to grumble about financial burdens at networking events — it takes active participation in industry associations and lobbying efforts like the National Cannabis Industry Association’s Annual Lobby Day or your state’s NORML chapter to make real change. When cannabis businesses get together to amplify their voices in the formal rulemaking process, politicians take notice.

What could be possible in this industry if Code Section 280E weren’t a reality? What doors would open if decriminalizing or rescheduling marijuana could happen? Let the excitement of these possibilities drive you to speak up.

Insurance policies that mitigate tax risks? It’s not crazy — it’s using tried and true business practices to control what you can control; to cover exposures and protect your bottom line as much as possible, to better weather changes brought about by forces outside of your control. 

The needs of each cannabis company are unique, and your necessary umbrella of coverage may look different than another company in your town, state, or vertical. Still, in addition to the always-necessary policies like general liability and workers’ comp, here are a few more insurance policies you may not have considered. 

Aside from the usual umbrella of coverage (i.e, general liability, workers’ comp, etc.), here are policies that offer protection:

Tax Liability Insurance

Not only does 280E actively hamper the cannabis industry, but it’s also used to keep a very close eye on plant-touching businesses. Internal Revenue Code Section 280E actually increases tax liability, making it incredibly important that cannabis companies have accurate tax prep. In the face of an unexpected audit, a misinterpretation of 280E, or another challenge issued by a tax authority in tax court, Tax Liability insurance shoulders the burden. 

This policy can be a lifesaver, offering protection against unexpected tax assessments, covering legal defense during the audit in tax court, and keeping your bottom line secure in the face of a tax challenge.

Just because the IRS uses 280E to keep cannabis businesses from writing off expenses doesn’t mean they don’t also keep a scrutinizing eye on plant-touching businesses as well. If someone in a position of tax authority issues a challenge against your company, Tax Liability insurance can help.

Directors & Officers (D&O) Insurance

On the surface, Directors and Officers insurance may not have much to do with the IRS or 280E. Still, the financial challenges levied by this federal policy can be felt across your business, and financial stress is often a catalyst for problems, including shareholder lawsuits alleging company or financial mismanagement, and claims of breach of fiduciary duty. 

D&O Insurance gives your company’s leadership a layer of protection and keeps them from directly shouldering any burden, should a lawsuit or claim of breach arise. D&O Insurance acts as a safety net for the leadership team, an attractive proposition in an industry where financial problems can cause in-fighting and rash actions. Knowing that their personal assets are protected may help attract and retain qualified management.

Crime Insurance

What does 280E have to do with crime insurance? Again, it comes back to financial strain. 280E is one of several federal policies that make it challenging for cannabis businesses to operate — the Schedule I designation of the plant and its federal illegality make banks wary of working with plant-touching businesses, leading to cash-intensive business practices. Cash businesses are more vulnerable to external theft and internal embezzlement, particularly if a business is already feeling the pinch of not being able to write off normal operational expenses.

Crime insurance provides coverage for losses due to theft or employee dishonesty, a financial safety net to protect your cash and other assets. 

Dealing with 280E tax is one of the most frustrating parts of operating in the cannabis industry. It doesn’t matter what state you’re licensed in or what vertical of cannabis — to the federal government, it’s all an opportunity to unfairly take an extra-large slice of the pie. Focusing on what you can control is the key to success and setting your business up for long-term success in the marijuana industry. 

Protecting your cannabis company can seem confusing; however, we’re a full-service insurance brokerage working with carriers worldwide to offer you the best coverage possible. We’re here to help! Please reach out to us today by email [email protected] or calling 646-854-1093 for a customized letter or learning more about your cannabis insurance options.