In March 2021, the Marijuana Regulation and Taxation Act (MRTA) was signed by Governor Andrew Cuomo. This act legalized cannabis (marijuana) sales in New York State (NYS), although with checks. The 280E tax is one of those checks.
Section 280E, enacted in 1982 during the “War on Drugs” period, has become progressively pertinent for Cannabis enterprises. The marijuana business has witnessed a significant increase lately. It is estimated to reach a yearly market figure of $43 billion by 2025.
As a participant in this promising line of business, it is necessary to know what the 280E tax is. Additionally, you should know how it can affect your cannabis business.
What is Section 280E?
Section 280E conveys weighty laws that have a critical impact on marijuana-related businesses, particularly their taxable income. 280E denies citizens concerned with specific controlled substances, including marijuana, from deducting average operational expenses related to its activities.
Practically, the law deprives cannabis businesses of the right to deductions in income tax both for standard and basic costs of doing business, although properly authorized as a lawful business. Congress approved the law during the 1980s while observing a legal dispute. This dispute denied a sentenced cocaine dealer from claiming rights to deductions from standard operational expenses under the U.S tax law.
While the law targets illicit drug dealers, it simultaneously creates extensive issues for cannabis businesses lawfully working in their different states, including New York, since cannabis is a Schedule I substance.
Elements of Section 280E
Three elements make up the Section 280E tax concerning Cannabusinesses. According to the Section 280E definition, they include:
- Controlled substance
- Trade or business
Where these three appear, Section 280E becomes applicable.
Trade or Business
The federal law considers cannabis an illegal business. However, the law still expects related parties to pay income tax on the earnings obtained from the trade of cannabis. In other words, the law does not distinguish between taxable income earned through legal or illegal means.
For cannabis, activities to be considered a business depend on a good number of case precedence, degree of consistency, and the extent of activities the participant has engaged in over a certain period.
Segment 280E deprives deductions and credits for costs incurred or paid during a trade or such that deals with controlled substances, disregarding the federal government or state law. Notwithstanding legitimization in 36 states, including NYS, the U.S law still considers cannabis a “controlled substance” under plan I of the CSA. Section 280E. Thus, it disallows otherwise allowable deductions and credits related to the business of cannabis.
The Tax Court, taking its definition from Webster’s Third New International Dictionary, considered “trafficking” to mean “to take part in business action: trade regularly.”
This implies the law also considers the act of buying and selling cannabis as trafficking, even though NYS law permits it.
Impact of Section 280E on Cannabis Businesses
The Internal Revenue Code (IRC) will not accept any credit or deductions incurred or paid within a tax year associated with the trafficking of controlled substances. Federal law denies Cannabis dealers the right to an income tax deduction for their standard and basic operational expense. This is despite the legal acceptance and licensing of Cannabis businesses in NYS operation.
On a norm, the imposition of deduction on a business’s operational expense implies that the business’s net income is subject to federal tax. However, according to the 280E tax classification of cannabis as a Schedule I (controlled) substance, cannabis businesses are disadvantaged.
The tax code deprives legal Cannabis businesses the advantage of tax deduction. This limits economic benefits enjoyed by other companies, thereby incurring more expense for cannabusiness owners. Instead of a moderate tax rate, the IRS charges a higher rate.
What are the Exceptions to Section 280E?
Amid the harshness toward Cannabis businesses brought by the 280E tax, there is a ray of hope.
Recent IRC provisions made it possible for Cannabusinesses to deduct their cost of Goods Sold while computing their taxable income. This includes (subtracting the Cost of Goods Sold while calculating their federal taxable income, notwithstanding Section 280E):
Cost of goods sold (depending on the line of Cannabis business involved, i.e., reselling or producing) includes:
- Directly related expenses
- Cost distributing the goods
- Cost of the goods itself
At present, the IRS does not permit some other charge as a credit or deduction for costs incurred or paid concerning marijuana business.
To put it plainly, Section 280E denies a citizen concerned with any dealings related to a Schedule I or II controlled substance from access to credits or deductions. This includes cannabis, which is recorded as ‘marihuana’ on Schedule I. The gross income is calculated except for the adjustments of the cost of goods sold (COGS), which offsets the business’s gross profit.
However, Section 280E forbids deductions for costs like the following that are not illicit:
- Phone costs
Marijuana businesses would most likely be charged higher tax rates. This is due to their ineligibility for specific tax deductions and credits accessible to other lines of business.
About Bowers & Company CPAs
Bowers & Company CPAs has formed a Cannabis and Hemp branch to help new and existing businesses understand this complicated, growing industry. Our professionals can help business owners navigate tax implications, industry regulations, and operating procedures. Our team members will counsel and support existing cannabis businesses and start-ups in tax planning, licensing, operating procedures, general business consulting, and more.
Since the sale of cannabis is still illegal at the federal level, a business cannot take certain deductions or credits when filing taxes. That means cannabis entrepreneurs must pay taxes on their gross margin and cannot deduct other common business expenses such as sales payroll and rent to reduce their liability. Bowers & Company CPAs can help business owners maximize after-tax cash through careful planning.
Bowers & Company CPAs aims to offer helpful information to our clients and friends. Learn more about how we can help should your business need Cannabis and Hemp Services.
Disclaimer: To ensure compliance with requirements imposed by the Department of Treasury, we inform you any U.S. federal tax advice contained in this document or video is not intended for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.