State-legal marijuana businesses operate in a twilight zone: Legal for state purposes, but illegal for federal. In this gray zone, many tax traps hide, waiting for the unwary. This article will help make you a little more wary.
Let’s begin by looking at marijuana businesses from the perspective of the federal income tax system. The feds see marijuana businesses as illegal operations, and, generally, the feds income-tax illegal businesses just like legal businesses. However, a closer look into this general rule reveals numerous exceptions. For example, businesses cannot take deductions for bribes and certain other illegal payments. Nor can businesses take losses when authorities seize their illegal property or income. And so on.
For marijuana businesses, chief among these exceptions is Internal Revenue Code §280E. Under §280E, businesses that traffic in controlled substances cannot deduct their expenses. As marijuana is a controlled substance under federal law, marijuana }dispensaries and growers, even those legal under state law, are subject to §280E’s limits on deductibility.
§280E causes dramatic consequences. Thanks to it, money-losing marijuana businesses may still have to pay income taxes! Fortunately for marijuana businesses, there are some techniques to reduce the pain of §280E. Unfortunately, they’re not the simplest of techniques.
First, the marijuana business can attempt to capitalize as many costs into the cost of goods sold. (“Cost of goods sold” refersto the costs capitalized into inventory, which are not recovered until the inventory isdisposed of.) This works because, per legislative history and because of potential Constitutional issues, §280E does not disallow reductions in incomefor the cost of goods sold.
This causes marijuana businesses to have unusual preferences. While other businesses prefer the instant hit of deductions over the slower cost recovery of capitalization methods, marijuana businesses prefer packing all of their costs into cost of goods sold, then slowly burning through their cost recovery as they make sales.
At first, marijuana businesses appear to have lucky preferences, and other businesses unlucky ones. This is because §280E increased the type of costs to be capitalized into the cost of goods sold. However, it really seems that only the government has lucky preferences: while non-marijuana businesses must suffer the higher capitalization rules of the post-§280E years, recent IRS guidance determined that the post-§280E changes should not apply for purposes of determining cost of goods sold under §280E. Effectively,the IRS’s stance is that marijuana businesses must dig up the tax laws as they existed when §280E passed, and use them to determine the cost of goods sold. Whether the IRS’s guidance is legally correct is an interesting question (for tax lawyers). Yet, marijuana businesses won’t want to take on the IRS to find out.
Besides using cost of goods sold, a marijuana “business” may find itself trying to escape §280E by in fact consisting of multiple distinct businesses. The idea is this: Only businesses trafficking in controlled substances are subject to §280E. If taxpayers successfully segregate their other businesses from their marijuana business, the other businesses will avoid being dragged into §280E’s deduction-denying vortex by the marijuana business.
This is not a simple strategy to pursue, however. Courts carefully apply a number of factors to determine whether activities truly constitute separate trades or businesses. For example, medical marijuana dispensaries that also provide caregiving services and lounges have attempted to treat those services as businesses separate from their dispensary. In these cases, courtshave found the businesses to be separate only where the service business had many dedicated staff, actually took separate fees for these other businesses, and had other indicia that the other services were not simply incidental to helping the business sell marijuana.
Let’s begin with the payroll tax. For the payroll tax, the IRS penalizes most taxpayers who fail to electronically pay their employee withholding taxes. Unfortunately for marijuana businesses, few providers of electronic payments want to touch the semi-legal money of marijuana businesses. Thus, cannabis businesses often trade primarily in cash. Marijuana businesses thus have had difficulty meeting the IRS’s electronic payment requirements. The IRS has previously abated these penalties for marijuana businesses, but more challengesawait while this is sorted out.
Again, as with the broader income tax, this isn’t great treatment. Perhaps states will be more favorable than the feds, you may think; many states consider marijuana legal, after all.
But in fact, states that legalize marijuana often levy heavy excise taxes on marijuana products. These rules vary by state, and have changed over time, and thus are not summarized here. (A consolation prize is that state excise taxes generally may reduce income taxes despite §280E. The ideais that, for income tax purposes, such state excise taxes may add to cost of goods sold, or may reduce the amount realized. In either case, such taxes are not deductions which §280E would block.)
Across the board, then, taxes offer many serious hurdles for marijuana businesses. Perhaps this willchange; states might alter their own tax codes to treat marijuana businesses more like other businesses. Perhaps the federal government will amend or change its enforcement of §280E. But until such changes come, marijuana businesses will need to engage in careful tax planning to avoid turning to ash alongside their product.