This is How to Navigate the Dreaded 280e Tax Code
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Although we continue to see rapid growth and hear about financial success stories in the cannabis industry, business owners are still facing massive challenges. One such hurdle is being taxed at an extremely high rate due to section 280e of the IRS tax code. Unfortunately, the IRS deems state-compliant cannabis business as federally illegal and this archaic code bans businesses that traffic Schedule I or Schedule II substances from deducting business expenses besides the cost of goods sold.
As a cannapreneur, that means you’re likely paying an effective tax rate 3.5 times higher than your neighboring business -- just because you cannot take normal deductions associated with selling cannabis, including employee wages, technology, accounting, rent, and more. Examples of costs that are deductible are those that are attached to the production of cannabis, such as soil, water, lights, electric, nutrients and additional expenses related to the cultivation of cannabis.
But state-legal, compliant cannabis businesses can take steps to reduce their 280e tax burden and keep your operation safe and profitable.
Set Yourself Up As a Corporation
Businesses generally seek to lessen their tax burden and protect themselves from litigation by selecting the right company structure from which to operate -- S Corporations and Limited Liability Corporations (LLC) are typical choices for small businesses. With the addition of Section 280e, however, the traditional taxes and liability considerations take on additional wrinkles and traditional C-Corporations become attractive. This is because Section 280e disallows deductions and creates “phantom income” which, in the case of an LLC or S-Corp, flows through to owners and creates personal income tax. This results in owners getting taxed on income they never received.
“Understanding and managing phantom income is essential in any cannabis business,” says, Tax Attorney, Nick Richards who advises cannabis companies and handles 280e audits and litigation. Different from a flow thru entity, a C-corp protects business owners from phantom income tax because it is a separate taxable entity. It is also important to know, says Richards, that C-Corps are subject to “double tax” when they pay dividends to their owners. However, with the reduction in corporate tax rates to 21 percent, the increase in tax may be minimal compared to the alternative of personal owner liability. It is important to consult a tax professional in determining the proper entity from which to operate your cannabis business.
It’s no secret that operating in the cannabis industry requires acute attention to detail, transparency, tracking, and documentation in order to meet strict compliance regulations. When it comes to 280e, every expense you have from cultivation to business administration to marketing and operations must be documented. When you are audited, the IRS will ask for documentation that outlines your cost of goods sold. You’ll stand the risk of being fined for an inaccurate tax return if you cannot prove how you identified your deductions. Be aware that your cannabis business is subject to more frequent IRS audits than other businesses so it’s important to keep all documentation up-to-date and accessible.
Categorize Your Employee Positions
Assigning each employee with a specific position in your production or retail operation not only allows for better internal processes, it also allows you to more accurately report on wages to avoid penalties. For example, if one of your employees works part-time as a budtender in your dispensary and the rest of the time at the cultivation, you’ll need to clearly record and track that time. Even further, tracking each employee task can provide specific clarity into the actions that are deductible and non-deductible.
Consult with Experts
It cannot be stressed enough how important it is to work with seasoned experts when seeking guidance on tax, accounting, and compliance. There are several tax attorneys who focus on cannabis tax law and know the requirements inside and out.
Additionally, aligning your business with ancillary providers that specifically service the cannabis industry ensures you’re using the proper tools to manage your operation while meeting compliance requirements. Often times, operators will try to implement generic technology solutions at their business and become frustrated with the lack of cannabis expertise and compliance support. This unique industry requires direct experience and custom solutions built for the highly regulated market.
Advocate for Change
The cannabis community must come together to support the change of stringent regulations so entrepreneurs can run their businesses fairly. Reforming 280e will result in a net increase in federal tax receipts over ten years, which is beneficial to everyone, including the federal government. For the industry to thrive, it’s vital for legal small business owners to contact members of Congress and ask for their support to address this antiquated code.
Big steps are being taken to improve the cannabis economy, including the bipartisan Strengthening the Tenth Amendment Through Entrusting States (STATES) Act introduced by U.S. Senators Cory Gardner (R-CO) and Elizabeth Warren (D-MA). From improving access to financial institutions to exempting states that have legalized cannabis from most federal enforcement to paving a path for hemp, this bill offers basic safeguards for the heavily-regulated industry. Although cannabis will still be considered a Schedule 1, illegal substance, this act successfully offers long-overdue solutions.
With the right partners, a dedication to compliant practices and patience, the effects of 280e can be less severe. It’s critical to remain aware of regulatory updates and support the efforts of your local cannabis organizations that advocate for change on your behalf. The future is bright, yet there’s still a lot of work to be done to get there.