More than half of the states in the US legally allow some form of medicinal and/or recreational marijuana. Although Michigan has legalized both medical and recreational marijuana, marijuana is still classified as a Schedule 1 drug at the federal level. IRC Section 280E is an IRS law that denies businesses dealing with Schedule 1 or Schedule II controlled substances the ability to deduct business expenses. While the law intends to target illegal drug dealers, it creates problems for legally operating cannabis companies from taking advantage of these, sometimes, substantial deductions. As a result, these legally operating Michigan businesses may have effective tax rates upwards of 70% because they are prohibited from reducing their taxable income with deductions other businesses regularly use. So, what can a cannabis business do to minimize the impact of IRC Section 280E?
3 Ways to reduce taxable income:
- Choose the best corporate structure. The tax rate applicable to the income from a cannabis business will change depending on if the corporate entity chosen is a sole proprietorship, partnership, S or C corporation or an LLC. And, the use of a corporate entity form may provide some protection from personal exposure in the event of an IRS audit. In addition, some tax savings may be realized by separating out non-cannabis functions and costs into a different entity.
- Maximize cost of goods sold (COGS). The tax codes permit marijuana growers, producers, wholesalers or retailers to deduct the cost of goods sold (COGS) from their gross receipts, regardless of the language in Section 280E. For marijuana growers, COGS includes expenses directly related to production of the plants, such as the seeds, electricity, and labor that went into growing and preparing the buds for sale. For marijuana dispensaries, COGS is much more restrictive and generally includes only the amount they paid for the cannabis products they sell plus a few additional allocations.
- Hire experienced professionals. Hire an experienced cannabis lawyer and CPA and get them talking. The IRS has won every 280E case that has gone to court, is actively enforcing IRC 280E, and audits of cannabis businesses in the future will likely continue to increase. And, each cannabis case that goes to court and in which a decision is issued, sets new precedents in case law, higher legal hurdles to overcome and further tightening of 280E. Hiring professionals who are experienced in this specific industry will go a long way to minimize the expense and risk long-term.