If you are in the cannabis business you are probably familiar with IRS 280E tax code. This tax code punishes you for selling a controlled substance by prohibiting most business expense deductions, increasing your income tax by 20x in some cases! Your strategic business forecasting must include proper considerations for section 280E – this is essential to planning cash flow and avoiding catastrophic tax bills at year-end.
What is IRS section 280E?
IRS 280E tax code states that no deductions for common business expenses shall be allowed for a business that conducts the trafficking of a controlled substance listed as Schedule I (cannabis) or schedule II. In simple terms, that means the cannabis industry taxable income is closer to its revenue rather than profit. That is technically unconstitutional according to the 16th amendment, so the IRS has danced around the constitutional challenges by allowing deductions for cost of goods sold.
The difference between cost of goods sold and ordinary business expenses is well defined in Generally Accepted Accounting Principles (GAAP) but routinely ignored by small business bookkeeping services. Even worse, an IRS income tax return does not follow the same rules as GAAP. Pile in section 280e provisions and the result is a big mess for the cannabis industry.
This increased tax burden is the same for medical marijuana and recreational marijuana.
What cannabis expenses are deductible under section 280E?
According to IRS memorandum no. 201504011, the following costs are tax deductible business expenses:
- For marijuana retailers:
- Price of marijuana purchased, less trade or other discounts
- Transportation costs
- For marijuana growers, extractors, and producers:
- Direct material costs such as seeds or plants
- Direct labor costs used for planting, cultivating, harvesting, etc.
- Category 1 indirect costs including:
- Repair expense
- Utilities such as heat, power, and light
- Indirect labor and production supervisory wages (including overtime, vacation and holiday pay, sick leave pay, and payroll taxes.)
- Indirect materials and supplies (such as???)
- Tools and equipment not capitalized (e.g. trimming shears)
- Costs of quality control and inspection, such as third-party testing or in-house QC labor.
Proper cannabis accounting must recognize these costs on regular financial statements to comply with 280E tax code.
What cannabis expenses are not tax deductible under section 280E?
Whether you are growing, extracting, or retailing; none of the following expenses are ever permitted to be tax deductible:
- Marketing and advertising expense
- Selling expenses, such as wages for salespeople and budtenders
- Other distribution expenses, such as rent.
- Interest expense
- R&D expenses
- Losses under section 165 (fire, storm, theft, etc.)
- Depreciation and amortization reported for tax purposes in excess of that reported in financial reports
- Income taxes attributable to the sale of inventory (e.g. state income tax)
- Pension contributions representative of past services cost
- G&A expense incident to and necessary for the taxpayer’s activities as a whole
- Salaries to officers.
Businesses often have expenses that do not fit squarely into one category or another. For example, is interest expense paid to a vendor on a late bill a COGS or a non-deductible expense? IRS guidance ultimately defers to how you keep your financial reports so long as those reports follow GAAP. Hence you need good cannabis accounting to defend yourself in audit.
How do I maximize tax deductions under section 280E?
In order to deduct ordinary business expenses they must be considered “inventoriable costs” aka costs of goods sold. Therefore, you should work with your accounting service to ensure all permissible deductible expenses are reported properly. Here’s some common areas of opportunity we see clients miss:
- Prorate building rent for grow/production areas.
- Clearly define job titles and descriptions for anyone working in production.
- Segregate management responsibility to exclusively supervise production areas.
- Hire contractors who exclusively work on and bill in production areas (e.g. janitorial services.)
In general a marijuana growing operation will have much more complex tax deduction compliance than a retail operation.
How do I forecast for the 280E tax code?
Once you understand what counts as cost of goods sold in the cannabis industry, you are ready to forecast your section 280E tax. Here’s how:
- Build a strategic business forecasting model that reliably predicts your revenues, expenses, and working capital.
- Determine your effective tax rate. Most cannabis businesses are pass-through entities, meaning your federal + state income tax rate will be anywhere from 10% to 47.9% depending on business income and other personal considerations. Consult your CPA or fractional CFO if you are unsure of your effective tax rate.
- Multiply your tax rate to your forecasted Gross Profit. This is your projected income tax.
The last step is a departure from traditional forecasting where income taxes are a function of Earnings Before Profit (EBT).
Financial planning for cannabis companies.
Tax strategy is just one component of business financial planning. Best in class cannabis companies do not stop at taxes – they gain insightful strategies by routinely performing business growth analysis, build systems to identify red flags of fraud, and consider macroeconomic such as inflation strategies.
If your cannabis business is ready to take planning to the next level, schedule a call with a fractional CFO to see how financial professionals can help you grow profits as well as marijuana.