Cannabis Businesses, Investors Can Reap Tax Savings when they Plan Right by Joshua P. Heberling, CPA
Even as New York prepares to join a growing number of U.S. states to legalize the sales of marijuana for recreational purposes, cannabis continues to be treated on the federal level as an illegal Schedule I substance. As a result, taxpayers involved in the cannabis industry, either as investors or business operators, face a landmine of financial and legal challenges. The good news is that cannabis companies and their investors do have opportunities to enjoy both profits and tax savings without breaking federal tax laws.
The Contradictions of Federal and State Laws for Cannabis
Under federal law, taxpayers may not claim tax credits or deductions for amounts paid or incurred involving sales, trafficking or any other business activities related to Schedule I and II substances, even if those activities are conducted in a state that has legalized the sale of cannabis for medical or for recreational purposes. Consequently, U.S. cannabis businesses that generated approximately $17.5 billion in sales in 2020 must report and pay federal income taxes on this income, but they are prohibited from deducting from their taxable income any of the ordinary or necessary expenses they incur to operate their companies, including costs for rent, repairs, interest, depreciation, and employee compensation and benefits. This can result in an onerous tax rate on profits and impediment to cash flow, regardless of whether or not cannabis is legal in a particular state.
As of March 28, 2021, 48 U.S. states and the District of Columbia have legalized some form of medical marijuana use with 17 of those state also legalizing sales for recreational use. This green wave of legalization is bringing significant greenbacks to these jurisdictions through the imposition of state-level taxes on growers and sellers. In fact, tax revenue from the sale of marijuana in some states exceeds those collected through the sales of liquor or cigarettes. However, with decriminalization and new state tax obligations come increased costs of operations that complicate an already complex business landscape marked by disparate state and federal laws that make it difficult, at best, for cannabis companies to yield a profit and gain legal and affordable access to the banking system.
Working Around Federal Tax Laws
Section 280E was first introduced into the federal tax code in the 1980s to ensure that businesses growing, manufacturing and/or selling illegal controlled substances pay their fair share of taxes of gross income without benefiting from the same tax breaks available to “legal” entities. In essence, the law makes it less profitable for businesses to engage in these activities.
Without the benefit of the deduction for business expenses, cannabis companies will generally pay more taxes than a similar business that sells widgets or other “legal” products or services. That is unless they qualify for an exception to the disallowance of expense deductions.
Section 280E allows cannabis businesses to subtract from gross income the “costs of goods sold” (COGS) to create and/or resell a particular product to customers, including costs associated with manufacturing, labor and maintenance. For example, producers may deduct costs for soil, seeds, water, lighting and other expenses related to growing and cultivating cannabis as well as direct labor costs for planting, harvesting and sorting product, and indirect production costs, such as rent, repairs, utilities and employee wages. The deductible amount depends upon the company’s inventory costing system. Typically, indirect costs are allocated based on methodologies that include a standard amount based on a fixed formula.
Although this is not considered a tax deduction, per se, it represents a significant adjustment to taxable income and potential tax savings, especially for resellers that buy products to sell to customers and producers that control the production of products.
To calculate costs of goods sold, taxpayers must first add the cost of product (inventory) on hand at the beginning of the year with the cost of product that was produced or purchased since the beginning of the year, and their direct and indirect production costs. They must then subtract the cost of inventory on hand at the end of the year. However, taxpayers must capitalize the cost of an item in the year that it is acquired or produced and either amortized those costs or wait until they sell the item to make an adjustment to their gross income.
While the COGS exception eases the tax burden for many cannabis businesses, it is not a panacea.
Positive Change on the Horizon
Historically, the tax court has sided against cannabis businesses that challenged Section 280E of the federal tax code. In 2019, the U.S. Supreme Court declined to review a medical marijuana business’s petition challenging the authority of the Internal Revenue Service. However, as deregulation of cannabis and more relaxed regulations on the state level continue to gain momentum, there is a glimmer of hope that federal tax laws will fall in line and become less onerous for businesses in the cannabis industry.
As the legal landscape for cannabis continues to evolve, businesses that grow, produce and sell cannabis products should seek the counsel of experienced tax advisors to help them uncover planning opportunities that allow them to maintain tax efficiency and compliance on the state and federal levels.
About the Author: Joshua P. Heberling, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he focuses on tax planning and compliance services for high-net-worth individuals and businesses in the commercial real estate, land development and office market industries. He can be reached at the firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at email@example.com.