Why Cannabis Businesses Are Paying 70% Taxes—And How to Bring That Number Down

The Internal Revenue Code 280E came about in the 1980s, when a tax code loophole was thrust into the spotlight in 1981, after a tax court ruled a drug dealer could deduct “ordinary” business expenses from his profits, even though his business was in violation of the Controlled Substances Act. Congress closed the loophole to disallow  “illicit drug dealers to unfairly use the tax code to utilize business tax benefits.” The result was 280E, which clearly states that “No deduction or credit shall be allowed for any amount paid or incurred… if such trade or business… consists of trafficking in controlled substances…”

In the decades since then, cannabis has been made legal for over half of Americans—but federal law has not changed. This means that plant-touching cannabis businesses cannot take normal business expense deductions and end up paying astronomically higher tax rates. There is no difference between medical marijuana and recreational marijuana businesses.

Necessary business expenses that cannabis companies cannot deduct include:

• Payroll for retail and admin staff
• Marketing and advertising costs
• Utilities and rent for dispensary and office spaces
• Legal and professional fees (with exceptions)
• Insurance premiums outside of inventory coverage

This rule disproportionately impacts dispensaries and retail sales, whose primary business is to sell marijuana, considered “trafficking” by federal law. Cannabis businesses in other niches have some workaround options, while dispensaries and retailers are left to empty their wallets year after year.

There is one major exception to Section 280E, which prohibits tax deductions—COGS, cost of goods sold, is the only allowed offset. This is not quite the same as a tax deduction, but it is an adjustment to your taxable income.

Under the Uniform Capitalization Rules (UNICAP), even businesses engaged in “drug trafficking” can capitalize expenses into inventory and inventory management. Sometimes referred to as IRC §263A or IRC §471, this rule is key to circumventing Section 280E as much as legally possible.

Here’s how it works: expenses related to your COGs can be offset from your gross income. An easy example of this is the raw materials your business buys, the cost of direct production labor, and how much you spend on packaging materials. (Unfortunately, raw materials do not include the cannabis plant in any form.)

The key to success with minimizing the impact of 280E are your expenses indirectly related to COGS. This gets tricky, because indirect costs cannot be fully offset—they must be split between deductible expenses (related to COGS) and non-deductible expenses (such as retail sales and admin costs).

Examples of How to Maximize Deductible Production Costs

• Payroll: Time sheets can help you split the cost of wages for employees who spend their time in production (which is COGS) and relation (which is not). While you can’t offset the salaries of all employees, you can divide their time into deductible and non-deductible buckets.
• Facility Costs: Cannabis businesses with multi-use spaces can divide up expenses based on square footage allocation. Space dedicated to inventory, like grow rooms, storage, and packaging areas, can be associated with COGS and thus offset, while spaces for retail and offices cannot.
• Depreciation: While cannabis brands can’t use machine depreciation the same way other industries can, it can still work in your favor. Your business can capitalize on the depreciation of equipment that is used directly in production for COGS. This includes extraction machines, grow lights, HVAC for grow rooms, and packaging machines. It does not include things like computers and security systems.

It takes a little creative accounting to maximize your COGS deduction, and cannabis businesses must be careful not to attempt to offset costs associated with selling cannabis. But understanding the federal tax code and working with a cannabis accounting professional can help you make the most of tax season and reduce your taxable income so you aren’t paying the government 70%.

The best way to maximize your business deductions is to separate your “non-trafficking” activities into a new entity—but this won’t work for all businesses.

Harborside, one of the original medical marijuana dispensaries in California, was audited by the IRS for six years of tax returns. The IRS fined the company millions of dollars for inaccurate deductions, and the case went to tax court. The tax court ruled that Harborside was still on the hook for millions of dollars. One of the key findings of the court was that cannabis made up 99% of the company’s revenue, and no separate entity could be claimed for the sale of merchandise.

This set an important precedent; cannabis companies can hold separate business entities for “non-trafficking” activities—but they must be a legitimate business, separate from the plant-touching side.

This opens up two avenues for cannabis companies that want to take advantage of this: A PropCo and a ManCo business structure.

The Real Estate (PropCo) Structure

A property company is one created to own and hold the real estate assets of a business. With this structure, the PropCo rents the real estate to the cannabis company (also called the Operating Company, or OpCo) and is able to deduct all ordinary business expenses against the rental income. This includes local taxes, interest, maintenance, and depreciation.

This is a common business structure across many industries, but cannabis companies must adhere to all rental rules and regulations (such as market-rate rent and a solid lease) to survive IRS scrutiny.

The Management/Ancillary Service Company (ManCo)

Under this structure, a management company (ManCo) is created to handle all of the administrative functions of the OpCo, such as human resources, accounting and finances, security, branding, and intellectual property. The ManCo is not a plant-touching business, and can take all ordinary business deductions while charging the OpCo a management fee for running these services.

The ManCo structure does not change the business write-offs the OpCo can take (the management fee, for example, would still fall under IRC 280E), but it shifts services and the deduction capability to the ManCo. When structured properly, this business framework can save substantial tax dollars.

However, as the Harborside case highlighted, the entity separation must be real, which means separate bank accounts, separate employees, and real contracts between the two entities. The IRS is both aggressive with cannabis companies and highly sensitive to this industry attempting to reduce its taxable income.

If you decide to separate your businesses, do it the right way, or you could find yourself facing an even bigger headache down the road. Consult with a cannabis tax expert to ensure your PropCo or ManCo is set up correctly.

Dealing with the IRS isn’t easy for any business, but particularly for cannabis businesses, which are still considered drug traffickers under federal law. So every cannabis business must have iron-clad financial documentation and strict financial processes to ensure that its books are clean and audit-ready.

Meticulous Record-Keeping

Financial documents are hardly the most fun part of doing business, but in the cannabis industry, it is absolutely vital that business owners keep the books neat and clean. Every allocation decision must be accounted for in a paper (or digital) trail. From employee time sheets to facility floor plans, you cannot be too careful when it comes to keeping cannabis financial records of retail sales, taxable income, and gross receipts.

Check Your State Laws

Several states with established cannabis industries, including California, Colorado, and New York, have decoupled their tax codes from IRS Section 280 to attempt to ease the burden on cannabis companies. By doing this, the state allows businesses to take full deductions on its state taxes, which provides critical cash flow relief. Check your state’s and local tax laws, or consult with a professional cannabis financial planner to ensure your business is taking full advantage of local tax regulations.

Plan for Your Reality

While federal rescheduling—either Schedule III or complete descheduling—would be a divine lightning rod for the cannabis industry, taking away a multitude of burdens, including Section 280E, it does no good to plan for a future that may not come to fruition. Cannabis business owners must take a practical look at the reality they currently operate in—not a hopeful future one that is continually dangled like a carrot and taken away. A pragmatic risk management plan with robust and conservative financial planning is the best way forward, no matter what happens (or doesn’t happen) with cannabis on the federal level.

IRS Section 280 is a massive and unfair burden on the cannabis industry, particularly when coupled with the financial burdens of state excise taxes, retail taxes, and general sales tax. But it’s not an inherent death sentence. Forward-thinking operators understand that this is one of many unfair burdens our industry faces, and it takes strategy, transparent accounting, and entity separation to reduce the federal tax burden into something manageable. It has been done, and it will continue to be done, for as long as the cannabis industry faces the wrath of the IRS and federal prohibition.

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 info@alpharoot.com or calling 646-854-1093 for a customized letter or learning more about your cannabis insurance options.