Accounting for Internal Revenue Code Section 280E When Drafting Operating, Joint Venture, Employment, and Licensing Agreements for Marijuana & Cannabis Businesses
INTERNAL REVENUE CODE SECTION 280E
Under Federal law, marijuana remains illegal, classified as a Schedule 1 controlled substance under the Controlled Substances Act (CSA). Nonetheless, and regardless of whether or not marijuana is illegal under a particular state’s law, marijuana businesses are subject to federal income tax.
If marijuana was not federally illegal, you could deduct certain expenses (that are “ordinary and necessary” to the business)—such as vehicle expenses, rent, wages, and costs of promotion—and the remaining amount after those deductions is the amount you pay tax on.
26 U.S.C. § 162(a) states:
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business . . . .
An expense is considered “necessary” if it is “appropriate and helpful” for the development of the taxpayer’s trade or business and “ordinary” if it is “common and accepted” in the taxpayer’s line of trade or business. Welch v. Helvering, 290 U.S. 111, 113–14 (1933); See, also, Alpenglow Botanicals, 894 F.3d at 1200 (“The Supreme Court has defined ‘ordinary and necessary expenses’ as those expenses that are ‘appropriate and helpful to the development of the (taxpayer’s) business,’ and ‘normal in the particular business.’”
For a marijuana business, Internal Revenue Code (“IRC”) section 280E prohibits the deduction of:
- ordinary and necessary expenses under IRC Section 162(a) (above)
- state and local taxes under IRC Section 164
- losses under IRC Section 165
- depreciation under IRC Section 167
- charitable contributions
But, you can deduct the cost of goods sold (COGS) from your gross receipts. See, IRC section 471; see, also, Alterman v. Comm’r, T.C. Memo 2018-83, 115 T.C.M. (CCH) 1452 (2018), 2018 WL 2980049, at *11; Beck v. Comm’r, T.C. Memo. 2015-149, 110 T.C.M. (CCH) 141 (2015), 2015 WL 4720041, at *6.
COGS are not considered a deduction from gross income, but rather, a part of calculating gross income. Calculation of COGS is generally done by evaluating the inventory at the beginning of the year, adding the year’s purchase and production costs, and subtracting the year-end inventories. Costs of flower, distillate, and other products used for the production of the final product being sold may deducted from gross receipts if properly substantiated.
TAX DEDUCTIONS WHEN RUNNING MULTIPLE BUSINESSES
If a business owner operates more than one trade or business, they may be able to make deductions of day-to-day expenses for a non-marijuana related business if is a separate trade. For example, the U.S. Tax Court found a community center for members with debilitating diseases to be a separate trade from the trade of selling marijuana. However, the Tax Court has also found a caregiving operation not separate from the trade of selling marijuana where the sole source of income was the marijuana sales.
The above regulations should be carefully considered before structuring any marijuana business deal. Do you want a joint venture/partnership structure? Or contractor/employee? Which party has the license? Who will buy the goods? Who will pay the wages? What products are being sold—is it marijuana or a marijuana derivative? Or is it fully legal product that is simple related to “cannabis culture”? The answer to each of these questions, and others, should be analyzed to structure a deal that reduces liability, tax and otherwise, from the outset of your operation, rather than simply hoping an accountant can magically change the facts at tax time.