As of April 2022, there are only four states in the U.S. where cannabis is not decriminalized in some capacity. Despite this fact, the federal government still treats it as a criminal enterprise.
While it is common knowledge that cannabis is regulated by a punitive tax structure, what is less understood is how difficult it is to actually run a legitimate business, be a good corporate citizen, pay your taxes, and be profitable in state-legal cannabis. The cannabis economy is built backward and upside-down from a business perspective, with the largest impact rooted in how it is taxed.
To begin to wrap your head around taxes for the cannabis industry, you first have to understand IRC 280E.
The federal government enacted 280E to punish drug dealers; it was never intended as a viable tax option for legitimate businesses. The goal of 280E is to disincentivize businesses from selling cannabis by disallowing all credits and deductions. In plain English, the government enacted 280E to take the profit out of trafficking illegal narcotics, but the byproduct of that is that state-legal cannabis businesses are being taxed to death. This is because under 280E, these businesses are only allowed to deduct the costs related to their inventory—and even that is uncertain.
280E states that, “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,” as seen in Pub. L. 97–248, title III, § 351(a), Sept. 3, 1982, 96 Stat. 640.
Consider a hypothetical C corp with income of $3 million, cost of goods sold of $1.6 million, and expenses of $1.3 million. This business has a gross profit of $1.4 million and net income of $100,000. A normally taxed C corp will pay $21,000 in federal taxes, or 21% on $100,000 net income. However, that same business in the cannabis industry will pay $294,000 in federal taxes, or 21% on $1.4 million gross profit. Cannabis is taxed on 100% of the expenses a “normal” business could write off. It goes without saying that a tax bill greater than real net income will create cash flow issues, and being taxed on gross profit also creates fictitious taxable income—and thus fictitious profit.
This scenario repeats itself year after year, with the cannabis business falling deeper and deeper into tax debt, creating a difficult choice: Stay open or pay federal taxes. Meanwhile, state-legal cannabis is competing with an illicit market that is thriving, stealing market share, and not paying taxes. 280E continually puts state-legal business owners in the position of thinking of ways to “get around” the current bureaucratic hurdles in order to keep their businesses open, and it effectively disincentivizes doing business aboveboard.
Selling, General, and Administrative (SG&A) expenses substantially affect the bottom line and contribute to good corporate citizenry. Deductible corporate donations to nonprofits, additional testing for product safety, product liability insurance, installing additional security and safety measures, providing living wages, paying payroll taxes, and additional benefits to employees are considered routine SG&A expenses, as well as best practice. Cannabis businesses are not only unable to deduct those expenses but also are taxed on those dollars.
This makes the expenses economically unfeasible, even when the business is required to provide them. Consumer safety also may take a back seat when the cost of quality product testing or child-safe packaging is not deductible and not required. Payroll taxes, health benefits, and retirement matching are not feasible for companies marginalized by laws that tax them on those costs. All this affects businesses who lack access to low-cost bank accounts and most sources of capital.
How do they survive? We advise them to use alternative business strategies, such as:
- Not expanding for the sake of expansion alone. There are few economies of scale available to cannabis businesses because they cannot transact across state lines.
- Seeking investment or capital from people who want to see the industry succeed in the long term rather than short-term, high-interest rate loans.
- Brand building by focusing locally. Finding other like-minded businesses and joining forces to find synergy.
- Finding local growers or producers that are Sun + Earth certified or using biodynamic and regenerative farming practices for quality product.
- Educating customers and vendors about financial realities. Only illicit-market cannabis can be $10 a gram, an unsustainable price for tax-paying businesses. People need to understand why paying more supports local, quality shops and farms doing the right thing.
- Ruthlessly controlling expenses. If a nondeductible expense is not absolutely needed, don’t do it. Stop expensive advertising, providing free meals, giveaways, or travel.
- Working with ethical, cannabis-specific CPAs and attorneys.
- Ensuring your advisers have previous experience with 280E filings in similar markets and know your tax challenges. Find an adviser willing to work with you and educate you on how to make good spending choices.
Society benefits from good corporate citizenry. Laws should not prevent or punish businesses from doing right by their employees, their communities, and the environment. Federal law lags behind state legalization and society’s changing views of cannabis. This creates a hostile environment making it nearly impossible to sustain the legal industry. Without sensible policy reform at the federal level, 280E will continue to block economic viability for legal cannabis. Regardless of the federal viewpoint, the legal cannabis industry is here to stay, and punitive tax rules have not deterred bad actors in the market to quit; rather, they punish the quality innovators we want anchoring this emerging industry. As legal markets mature—and if they are to flourish—they deserve equality, and the right to leave the trappings of federal prohibition behind.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Katye Maxson-Landis, CPA, owns and operates Moxy Accounting LLC in Portland, Ore. She has provided tax preparation, advocacy and advisory services to state-legal cannabis businesses since 2012 and trains tax professionals on 280E compliant tax work through The Moxy Accountant Cohort, a NASBA certified CPE provider.
Katie Scates, CPA, J.D., supports Moxy Accounting LLC in tax preparation, advocacy outreach and advisory services. She co-teaches and provides training through The Moxy Accountant Cohort.
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