Federal Income Tax Rules for Cannabis Businesses

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters. Today's episode is an overview of the tax rules and the cannabis industry. We'll take a big-picture look at the industry and specifically discuss the impact of IRC Section 280E.

HOST: A quick note at the beginning: we acknowledge that marijuana is a Schedule I controlled substance under the Controlled Substances Act of 1970. Any trade or business activity related to this may be considered illegal trafficking in controlled substances. That said, there is a clear trend toward legalization, and this is an increasingly important issue to address.

HOST: Joining today's conversation is Barry Weins, director in our firm's National Tax Group and a key resource for cannabis clients. Barry, how are you doing today?


BARRY WEINS: Doing fine. I'm here in Tampa, Florida. It's a little overcast, but it'll be sunny tomorrow.


HOST: And as always, Sarah McGregor.


SARAH MCGREGOR: Hello again from Greenville, South Carolina. Barry, I think your Tampa Bay Lightning just pulled one out at the last second last night, 3.8 seconds to be exact.


BARRY WEINS: Very exciting.


BROOKS NELSON: I'm Brooks Nelson, a partner in Richmond, Virginia. It is hot and steamy here today.


HOST: Sarah, how's life treating you right now?


SARAH MCGREGOR: It's good. It feels like we're on the cusp of the summer vacation period. Up in Richmond and down here in Greenville, it jumped from spring to August almost overnight. It's Friday afternoon, and I'm looking forward to the weekend.


HOST: All right. Let's jump into today's discussion.

HOST: A little background. In 1996, California was the first state to legalize medical use of marijuana. Close to 40 states have since followed. Washington and Colorado were the first states to legalize recreational use, beginning in 2012, and about 16 states plus the District of Columbia have followed.

HOST: There's been rapid growth in this industry, lots of private equity activity, and IPOs connected with Canadian entities. It's generated significant cash flow and interesting tax issues. Even the National Taxpayer Advocate blogged about tax rules for cannabis earlier this month.

HOST: Sarah, let's set the groundwork. Give us definitions of cannabis, key points in the timeline, and how this all relates to tax.


SARAH MCGREGOR: To be clear, marijuana comes from a cannabis plant that contains 0.3% or more of THC, the delta-9-tetrahydrocannabinol compound. In the industry, high-THC products are generally referred to as cannabis. The term "marijuana" carries baggage, so the industry is moving toward "cannabis" for high-THC products.

SARAH MCGREGOR: The other product is hemp, which is also a cannabis plant but contains less than 0.3% THC. Hemp is regulated by the Department of Agriculture, which issues licenses through the states for farmers to grow hemp. CBD oils and other cannabidiol products are extracted from hemp and have been broadly used across the country.

SARAH MCGREGOR: Cannabis and hemp have been cultivated for thousands of years. In 1911, recreational use of cannabis became prohibited in the United States, though it remained available for medical use. In 1970, the Controlled Substances Act placed marijuana on Schedule I, making it an illegal drug under federal law.

SARAH MCGREGOR: From a tax perspective, the story picks up in 1981 with Edmondson v. Commissioner. That case involved a drug trafficker who reported income and deducted business expenses. In response to the resulting controversy, Congress enacted Section 280E in 1982, which disallows deductions for businesses trafficking in controlled substances.

SARAH MCGREGOR: California's 1996 law and later recreational legalization in 2012 began changing state law, but federal law still classifies cannabis as a controlled substance. The Agricultural Improvement Act of 2018 descheduled low-THC cannabis products, so hemp was no longer a Schedule I product. That change enabled the growth of CBD and other hemp-derived products.


BROOKS NELSON: You said all of that very well, Sarah. I have practiced a lot to say those words.

BROOKS NELSON: All right, Barry. We've talked about Section 280E. Give us more background on it and its implications for cannabis businesses.


BARRY WEINS: From a basic tax perspective, you pay tax on net taxable income, which is gross receipts minus allowable deductions. Section 280E disallows deductions and credits for any trade or business trafficking in a controlled substance defined under Schedule I or II.

BARRY WEINS: The statutory language says no deduction or credit shall be allowed, which is all-encompassing. Because cannabis remains a Schedule I drug under federal law, businesses operating in states that have decriminalized or legalized cannabis still face 280E at the federal level.

BARRY WEINS: One important nuance is that cost of goods sold, or COGS, is not treated as a deduction; it is a reduction in gross income. COGS is governed by Section 471 and related regulations, our inventory rules, which apply to all companies but carry special significance in the cannabis industry.


HOST: Sarah, Barry said this is simple. Which types of businesses and which segments are most impacted by Section 280E?


SARAH MCGREGOR: The retail level, dispensaries, is probably hardest hit. A dispensary's taxable income is its gross revenues less COGS. For a dispensary, COGS is limited to what it paid to acquire the product and transportation costs to get it to the location. Rents, salaries, utilities, advertising, and insurance are not deductible.

SARAH MCGREGOR: Depending on margins, a dispensary could face a much higher effective tax burden than a neighboring retail store selling non-cannabis products.


BROOKS NELSON: Quick question. If a dispensary also sells non-cannabis items like T-shirts or hemp-derived CBD oil, are those sales and the associated deductions still disallowed?


SARAH MCGREGOR: It depends on facts and circumstances. Courts have looked at whether there are separate trades or businesses. If a non-cannabis line is incidental to the cannabis business, say less than 5% or 10%, courts have treated it as a single trade or business, making deductions unavailable. If the non-cannabis business is a distinct trade or business and properly separated, it may be treated separately, but the bar is high.


BROOKS NELSON: What about growers and producers?


SARAH MCGREGOR: Growers and processors generally can use COGS and typically use the accrual method with full absorption costing for production. Direct costs, seeds, fertilizer, soil, water, are included in COGS. Indirect costs, some wages, rent, repairs, and equipment used in production, may be included to the extent they qualify as production costs.

SARAH MCGREGOR: However, costs such as security are not production costs and are subject to Section 280E disallowance. Depreciation can be taken up to tax basis limits but not in excess. Many typical tax-accelerating strategies do not work in this industry.

SARAH MCGREGOR: A key complication is vertical integration. If a company grows, processes, and retails, it becomes difficult to draw a clear line between production and retail. Determining when growing and processing stop and retailing begins is a major challenge and raises transfer-pricing-like issues for intercompany transactions.


BROOKS NELSON: What about Section 263A, the UNICAP rules? Can they be used to mitigate 280E?


BARRY WEINS: No. Courts have interpreted Section 263A so that UNICAP rules cannot be used to capitalize costs that would otherwise be non-deductible. Costs disallowed under Section 280E cannot be capitalized into inventory under 263A to circumvent the disallowance. So while taxpayers generally dislike UNICAP, the cannabis industry cannot use it to avoid 280E.


SARAH MCGREGOR: It's essentially heads they win, tails you lose. UNICAP hurts manufacturers in many industries, and here it does not provide relief from 280E.


BROOKS NELSON: Have taxpayers challenged 280E in court or pursued other workarounds?


BARRY WEINS: There have been numerous attacks. One argument is constitutional, that the disallowance is unconstitutional, but courts have generally held that deductions are a legislative grace and can be limited if there is a rational basis. Another approach is to argue separate trades or businesses, which requires clear separation and documentation.

BARRY WEINS: Some have tried paying wages through S corporations, but that hasn't been successful. Poor recordkeeping, common in cash-heavy industries, creates problems. Setting up separate entities for management services typically fails if the management company only serves the cannabis business; courts will aggregate the entities and treat them as one trade or business.

BARRY WEINS: If the non-cannabis business truly has independent revenue and functions, it may be treated separately. But simply shifting expenses to another related entity without independent commerce does not solve the 280E problem and can make things worse.


SARAH MCGREGOR: In practice, if your cannabis business pays management fees to a separate entity that has independent revenue, that other entity may have taxable income and pay tax. But the cannabis entity's payment of management fees remains nondeductible under 280E, so you haven't avoided tax at the consolidated level.


BROOKS NELSON: Sarah, what other trends do you see in the cannabis industry?


SARAH MCGREGOR: Despite onerous tax rules, there's significant activity. Multi-state operators, or MSOs, are becoming the large players, while there is room for niche processors similar to craft breweries. We're also seeing specialization: companies developing grow houses to lease to cultivators, specialty labs, and other service providers.

SARAH MCGREGOR: Social equity initiatives are important, especially on the East Coast, as states legalize adult use. These initiatives aim to help communities disproportionately affected by past enforcement benefit from legalization.

SARAH MCGREGOR: States and municipalities have varying rules and regulations. There are opportunities in Congress that could lead to descheduling high-THC cannabis in the future, but for now federal classification drives the tax treatment.


BROOKS NELSON: Barry, any final thoughts on tax rules and cannabis?


BARRY WEINS: It's a complex area. If you're entering the industry, you must understand the impact of 280E. Until Congress changes federal classification, generating significant after-tax profits will be difficult because the tax burden is so high.


SARAH MCGREGOR: For tax professionals and those entering the space, understanding inventory rules is critical, and good recordkeeping is essential.


BROOKS NELSON: I'll add that there's a lot of cash in this business. Be careful with the application of tax rules. Bad records and ignoring the broad disallowance of deductions under Section 280E create substantial risk.


HOST: That concludes this podcast on an overview of tax rules and cannabis. A quick disclaimer: we are not providing tax advice on this podcast. Please consult your tax advisor, hopefully at Cherry Bekaert, about your specific tax issues or to discuss information from today's episode.

HOST: Check out the firm's website at cbh.com for the latest guidance and materials on this and other tax and business topics. Thank you, Barry, for joining us, and thank you to our listeners for spending your time with us. Let's call it a day and go forth in peace. Peace.