Earlier this year, Illinois became the 11th state to legalize recreational marijuana. Beyond that, a continuously growing number of states do offer legal medicinal marijuana. However, the drug remains illegal on all accounts at the federal level; thus, creating a number of issues for businesses legally engaged in the cannabis industry. Not only is banking an incredibly touch-and-go endeavor, but there are obstacles in place preventing companies from taking advantage of notable tax deductions.
Chief among these hurdles is Internal Revenue Code (IRC) Section 280E.
What’s in this article?
- What is Section 280E?
- How does Section 280E affect legal cannabis businesses?
- What are the exceptions to Section 280E?
- Have there been any recent legal challenges to Section 280E?
- What is happening on the national political landscape?
- What is the state of California’s response to Section 280E?
- What can I do with my business in the meantime?
What is Section 280E?
Section 280E reads only a few lines, but carries significant impact for the cannabis industry. The law reads as such:
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I or II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
More simply, the law denies businesses affiliated with Schedule I or II controlled substances the right to deduct business expenses. U.S. Congress enacted the law in the 1980s following a court case which disallowed a convicted cocaine trafficker from claiming deductions from ordinary business expenses under federal tax law. While the law intends to target illegal drug dealers, it simultaneously generates considerable problems for cannabis companies legally operating in their respective states because cannabis is a Schedule I substance.
What is a Schedule I controlled substance?
In 1970, President Richard Nixon signed the Controlled Substances Act (CSA). The CSA is part of the Comprehensive Drug Abuse Prevention and Control Act, a federal drug policy to regulate the manufacturing, importation, possession, use and distribution of certain narcotics, stimulants, depressants, hallucinogens, anabolic steroids and other chemicals. Under the CSA, there are five schedules at the federal level used to classify drugs based on their abuse potential, accepted medical applications in the U.S., and safety and potential for addiction.
The DEA defines Schedule I drugs, substances or chemicals as those drugs with “no currently accepted medical use and a high potential for abuse.” Examples of Schedule I drugs include:
How does Section 280E affect legal cannabis businesses?
Typically, the ability to deduct ordinary business expenses provides significant tax savings. However, the definition of Section 280E and the classification of cannabis as a Schedule I substance severely hinder legal cannabis companies from taking advantage of those tax savings. In fact, businesses within the cannabis industry are left with tax liabilities of up to 70% of their income.
What are the exceptions to Section 280E?
While Section 280E greatly restricts the tax deductions of state-legal cannabis businesses, there is still a small bit of reprieve. Section 61(a) allows the Internal Revenue Service (IRS) to collect taxes from “all income from whatever source derived.”
This includes income from federally illegal activities. The 16th Amendment to the Constitution explains in the context of a reseller or producer, income entails gross income, not gross receipts. Further explanations under the Section 61 regulations explicitly list gross income as total sales, less the cost of goods sold (COGS), plus any income from investments and from incidental or outside operations or sources. Later in Memo. 2009-22, the Tax Court clearly explains that the cost of goods sold is merely an adjustment to gross income and not a deduction.
Understanding these regulations is critical for any cannabis-related business. The tax codes, as outlined above, permit marijuana growers, producers, wholesalers or retailers to deduct cost of goods sold from their gross receipts, regardless of the language in Section 280E. This was upheld through Olive, 139 T.C. 19 (2012) as well as through Chief Counsel Advice (CCA).
The costs of goods sold generally entails inventory costs, including the cost of the product itself, shipping the product and any other directly related expenses.
As of October 2019, the IRS does not allow any other amount as a deduction or credit for amounts paid or incurred with respect to the cannabis business.
Have there been any recent legal challenges to Section 280E?
More than half of the states in the U.S. legally allow some form of marijuana, whether that be medicinal or both medicinal and recreational. As such, there is a considerable amount of legal businesses dealing with the excessive tax burden of Section 280E. In response, companies are turning to the courts to challenge the status quo.
Alpenglow Botanicals and the U.S. Supreme Court
Alpenglow Botanicals LLC is a medical marijuana dispensary in Colorado – a state where medical and recreational marijuana is legal. The business elected to deduct ordinary business expenses on their federal tax returns. However, following an audit of Alpenglow’s tax returns between 2010 and 2012, the IRS denied the deductions and charged the company over $50,000 for those taxes not paid. Alpenglow argued that the IRS exceeded its authority because rejecting the deductions due to Section 280E regulations implicitly determined that Alpenglow trafficked in an illegal drug. Remember, though, that marijuana is legal both recreationally and medicinally in Colorado.
Subsequently, they sued for a refund in district court and lost. Then in 2018, the Tenth Circuit also sided with the IRS. Alpenglow did not give up. They pushed the case all the way to the highest court in the land with a February 2019 Petition for Writ of Certiorari.
Yet again, Alpenglow did not achieve the desired results. Instead, the U.S. Supreme Court issued a denial of certiorari. The Court offered no explanation for denial; however, by denying the cert the Court seems to agree with the Tenth Circuit judgment that the IRS was simply enforcing the law.
As such, Section 280E remains a thorn in the side of cannabis-related businesses.
The Harborside Case
Before the Alpenglow pushback against the 280E enforcement, there was the case featuring Harborside Health Center, one of the nation’s largest state-licensed marijuana suppliers.
Similarly to Alpenglow, the case originated from an IRS audit of Harborside’s federal tax returns for 2007-2012. Despite paying federal taxes for those specified years, the IRS claimed that the company’s tax payments were severely deficient by tens of millions of dollars. The IRS defended their findings with two reasons. First, the IRS determined that Section 280E applied to Harborside and therefore the company was not eligible for the millions of dollars in business expense deductions. Second, the IRS explained that Harborside implemented the incorrect calculation method for cost of goods sold, thereby resulting in a lowered federal tax liability.
The case, formally known as Patients Mutual Assistance Collective Corporation, dba Harborside Health Center v. I.R.S., reached the United States Tax Court where the court ultimately sided with the IRS on both issues. First, in regards to the Section 280E concern, Harborside argued that it did sell marijuana, but that it also sold other items like t-shirts and yoga classes. According to them, these other activities and products pushed the company outside the restrictions of Section 280E. However, the court rejected this narrow scope of the tax code. The court further rejected the argument, deeming the non-marijuana products and services as merely “incidental.” Finally, the court considered whether or not Harborside was a producer or reseller for purposes of calculating COGS and ruled against in that regard as well.
The case, while unsuccessful for the company, did provide some clarity for cannabis-related businesses. For instance, the case confirmed that a disallowance such as under Section 280E may apply to all the credits and deductions of activities that constitute a single trade or business although the business engages in activities not subject to disallowance.
What is happening on the national political landscape?
In what is considered by some to be the most pro-marijuana Congress in U.S. history, there is finally some push for cannabis industry legislation. For example, the bill with the greatest likelihood of passage, the SAFE Banking Act, passed certain House committee votes and the overarching House of Representatives vote. However, it remains to be seen when or if it will be addressed in the Senate. But, the SAFE Banking Act focuses on the banking woes hampering the cannabis industry, not necessarily the burdensome Section 280E. In that regard, we have the Strengthening the Tenth Amendment Through Entrusting States (STATES) Act.
Originally introduced in April 2018 by Sen. Cory Gardner (R-CO) and Sen. Elizabeth Warren (D-MA), the STATES Act amends the CSA of 1970 to exempt individuals and corporations in states who are in compliance with U.S. state, U.S. territory and the District of Columbia laws from federal enforcement. The original banking ordinances from the STATES Act were later added to the SAFE Banking Act. After initial failure to move forward, Sen. Warren in the Senate and Rep. David Joyce (R-OH) and Rep. Earl Blumenauer (D-OR) in the House of Representatives again introduced the STATES Act in April 2019.
As of the time this article is being written, there is no movement within Congress on the bill despite considerable support from members of Congress and industry groups.
What is the state of California’s response to Section 280e?
California is one of the hotbeds for the cannabis industry. Accordingly, electing a pro-marijuana governor to lead the state means that marijuana-friendly legislation is making its way to his desk. In October 2019, California Governor Gavin Newsom signed several marijuana-related bills into law. Among the new legislation is AB 37, which permits the state to depart from the IRS policy regarding IRC Section 280E. Therefore, under the new bill, the state tax code now allows licensed state cannabis companies to claim deductions like any other business.
What can I do with my business in the meantime?
Cannabis is a hot topic in the United States and there appears to be considerable acknowledgement from both political parties that something needs to be done to help the fledgling industry overcome considerable challenges. However, lack of progress on the federal side means that cannabis-related companies are still affected by Section 280E. This is where Squar Milner comes in. We offer dedicated professionals with unique expertise in working with clients in the cannabis industry. Our cannabis practice is here to help your business with cost-effective tax strategies.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.