Marijuana is currently legal in some form in 30 States, Washington DC, Guam and Puerto Rico. It is quickly becoming a major economic driver in many states as reflected in Colorado. Through September, the Cannabis industry in Colorado alone has surpassed the one-billion-dollar mark. Despite the overwhelming support of legalized cannabis, the federal government continues to enforce tax policy that will, if not change, tax the industry out of business.
The simple solution would be for Congress to pass legislation that would remove Marijuana from the list of Schedule 1 drugs. There are currently a host of bills that attempt to do just that. The most promising and straight forward is H.R. 1810 – Small Business Tax Equity Act of 2017. H.R. 1810, introduced by Carlos Curbelo (R- FL), is co-sponsored by 38 other members of the House from both sides of the isle. H.R. 1810 simply states that Section 280E of the Internal Revenue Code would not be applicable to “marijuana sales conducted in compliance with State law”.
Unfortunately, nothing seems that simple for our elected officials. Few members of Congress, even those members whose states have legalized cannabis, are willing to take a stand against those who are against Marijuana reform- namely big pharmaceutical and big alcohol companies.
Courts continue to strictly interpret code Section 280E by disallowing all deductions for trade or business expenses in connection with listed Schedule I & II drugs. Deductions from gross income are allowed for costs of goods sold (COGS). The IRS has taken the position that the definition of COGS is defined by code Section 471. Those businesses that both produce and distribute marijuana can take guidance from the Regulations found in section 1.471 of the code. Under these Regulations, includable costs consist of production facility: rent, maintenance, utilities, direct materials, tools, supplies, testing, production wages and production overhead. Specifically excluded costs include: general and administrative, marketing, selling, advertising, distribution, and other expenses not associated with production.
So how can cannabis companies afford to stay in business?
Let’s look to a few critical cases to better understand the constraints of Section 280E.
Review of the 2007 CHAMPS v Commissioner., 128 TC 173 case is critical in helping us to better understand that only those trade or business expenses related to marijuana trafficking should be disallowed under Section 280E. CHAMPS established that businesses can have multiple activities and that those not involving “trafficking” are not precluded by Section 280E. CHAMPS charged a fee for extensive caregiving services and provided a set amount of medical marijuana. The court concluded that the taxpayer had not one but two businesses and therefore, those business expenses not related to “trafficking” of a controlled substance were deductible. The court allowed the proration of costs between the two “businesses”
The second direction giving case is the 2012 Martin Olive v Comm., 139 TC 19, also known as the Vapor Room case. Quite the opposite from the facts presented in the CHAMPS case, Mr. Oliver kept inadequate records and was not able to establish that he conducted more than one business. The court concluded that in order for a taxpayer to establish multiple businesses, it must be engaged in these other activities with a profit motive. Simply giving away free munchies, coffee and advice did not escalate to a spate business unit. The case did, however, give guidance to an acceptable cost of goods sold percentage of roughly 75%.
In the most recent cannabis case decision released on October 23, 2017(Feinberg v. Comm., TC Memo 2017-211), the US Tax Court decided in favor of the IRS with respect to costs disallowed under Section 280E. The IRS victory in this case hinged mainly on the taxpayers’ inability to support its deduction as it related to cost of goods sold. The court concluded that the taxpayers did not “maintain sufficient reliable records to allow the Commissioner to verify the taxpayer’s income and expenditures.” The court did not rely on post audit reclassification of cost of goods sold items. Alas, there is no substitute for good record keeping.
As a Certified Public Accountant (CPA) who specializes in the industry and has represented clients through multiple IRS audits, my take away is simple: It is foolhardy for one to believe that by some magical process, Section 280E will go away or will be retroactively repealed. Until legalized cannabis is exempt from Section 280E provisions, industry businesses should make every effort to direct the predominance of their expenses into production. CEO’s, CFO’s and specialists should concentrate their time and resources on production, manufacturing and inventory controls. Multiple business units should be established, each with its own written plan for profitability. Job descriptions should indicate which positions have inventory production, control or monitoring responsibilities. CPAs familiar with cannabis can play an important role in helping business owners set up a chart of accounts, identify business units and develop strong internal controls needed for success.
It is clear to me that IRS audits in this industry will not go away any time soon. Every company should prepare themselves for this eventuality. For now, good accounting records and well thought out business units will reduce the strain of Section 280E and allow all involved to keep their heads above water. To survive the long term, however, the industry must get Congress to remove marijuana from the grips of Section 280E. It will be beneficial if all involved give their representatives in Washington, DC a heads up that H.R. 1810 – Small Business Tax Equity Act of 2017 is the simplest solution.