Understanding Section 280E: The Tax Hurdle for Cannabis Businesses

The cannabis industry has seen remarkable growth in recent years, driven by increased legalization and a shift in public perception. However, while the business of selling cannabis products is thriving, cannabis companies are faced with a significant challenge in the form of Section 280E of the Internal Revenue Code. This tax provision has created a financial burden for legal cannabis businesses in the United States, and understanding its impact is crucial for those involved in the industry.

Call Turner Business Solutions at (316) 285-0125 if you need a cannabis tax expert to assist you. You can also schedule a free consultation online.

What is Section 280E?

Section 280E of the Internal Revenue Code was enacted in 1982 to prevent illegal drug dealers from deducting business expenses related to trafficking controlled substances. At the time, Congress was reacting to a case where a convicted drug dealer was allowed to deduct ordinary business expenses. Section 280E explicitly prohibits businesses that sell controlled substances, as defined by the Controlled Substances Act, from deducting expenses related to the sale of those substances.

Despite the growing trend of state-level legalization, cannabis remains classified as a Schedule I controlled substance under federal law. This classification means that cannabis businesses—whether recreational or medical—are still subject to Section 280E, significantly increasing their tax liabilities.

How Does Section 280E Affect Cannabis Businesses?

Normally, businesses are able to deduct "ordinary and necessary" expenses, such as rent, utilities, employee salaries, and advertising, from their gross income to determine taxable income. However, cannabis businesses subject to Section 280E are only allowed to deduct their cost of goods sold (COGS), which typically includes the direct costs of producing the cannabis product, such as seeds, soil, and labor related to cultivation.

This limitation leaves cannabis businesses unable to deduct other critical operating expenses, which often leads to an effective tax rate far higher than that of traditional businesses. In some cases, cannabis companies have been reported to face tax rates as high as 70%, which dramatically cuts into their profitability and ability to reinvest in their operations.

Workarounds and Compliance Strategies

While Section 280E is an undeniable burden, cannabis businesses have developed strategies to mitigate its impact (among others):

1. Proper Cost Allocation: One of the most effective ways to reduce tax liability under 280E is to properly allocate expenses to the cost of goods sold. This includes ensuring that all direct costs associated with the production of cannabis are accurately accounted for. Working closely with a tax professional can help cannabis companies ensure they maximize their COGS deductions.

   
   

2. Segmenting Businesses: Some cannabis businesses have found success by separating their business operations into different entities. For example, a company may divide its operations into a cannabis cultivation business and a separate non-cannabis-related business, such as consulting or real estate. While the cannabis operation is still subject to 280E, the non-cannabis business can take full advantage of tax deductions.

   
   

3. Investing in Tax Compliance: Given the complexity of the tax code, especially under Section 280E, it is essential for cannabis businesses to invest in professional tax services. Accountants who specialize in the cannabis industry can help businesses navigate the intricate web of tax laws and ensure compliance, reducing the risk of costly audits or penalties.

   
   

The Future of Section 280E

There have been multiple calls for reform to Section 280E, particularly as more states legalize cannabis and the industry becomes an increasingly legitimate part of the U.S. economy. Various bills have been introduced in Congress to either exempt state-legal cannabis businesses from 280E or to reclassify cannabis as a Schedule II substance, which would lift the 280E restrictions.

However, as long as cannabis remains federally illegal, Section 280E will continue to pose a major financial hurdle for cannabis businesses.

Conclusion

Section 280E is a significant challenge for the legal cannabis industry, creating a situation where these businesses face exorbitantly high tax rates compared to other industries. While there are some strategies to mitigate the impact of this provision, the full resolution of the issue lies in federal reform. Until then, cannabis businesses must remain vigilant in their tax planning and compliance to ensure they can thrive in this rapidly growing market.

Call Turner Business Solutions at (316) 285-0125 if you need assistance with your cannabis taxes. You can also schedule a free consultation online.