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Tax Challenges in the Cannabis Industry

Posted by Nick McCrillis, Esq. | Feb 21, 2023

With individual and business tax deadlines coming up, cannabis companies continue to face many challenges with tax compliance, both at the federal level and the state level. Although cannabis is still illegal at a federal level, the IRS, according to IRC §61 requires all income to be reported regardless of whether the income comes from a legal or illegal source.

Because illegal sources of business income are still taxed, it would lead most people to think that business expenses from that illegal business would also be deductible to offset that income. Unfortunately, in 1982, the tax code added a provision, §280E, that prohibits deductions related to businesses that traffic in controlled substances. With cannabis continuing to be listed as a Schedule I drug, cannabis businesses are unable to deduct ordinary and necessary business expenses. This often includes significant expenses like rent, utilities, legal and accounting fees, security costs, some labor costs, and many other types of expenses. This means that regulated cannabis companies pay much more in federal taxes than any other businesses as they are unable to offset their revenue with these expenses. A sample P&L Statement is illustrated below for fictional companies to detail how this tax treatment affects cannabis vs. non-cannabis companies with identical financial performance. The expenses highlighted in orange are deductible for normal businesses, but not for cannabis-related businesses under §280E, resulting in a significant difference in taxable income (thus significantly increasing the federal tax liability).

This sample P&L shows that although both companies made an operating profit of $400,000, because the cannabis company was unable to deduct the ordinary and necessary business expenses, the cannabis company paid $126,000 more in federal taxes. Although these are sample figures and your business expenses may vary, this example shows how significant the impact of deductions can be on a company's bottom line.

While §280E disallows ordinary and necessary business expense deductions, costs of goods sold may still be deducted. This exception seems relatively mundane; however, it can provide significant tax advantages based on the business structure, type of cannabis business, and the classification of expenses. Typically, cannabis growers will benefit more significantly from this strategy, but retailers can also see significant impacts to their tax liability by properly using this exception. Expenses falling under costs of goods sold for growers may be items like seeds, clones, or fertilizers. For retailers, this may include invoice pricing of cannabis and transportation costs.

The already complex tax code is made even more complicated with a constantly evolving cannabis industry and bifurcated legality between state and federal laws. Business purchases or sales, business structure, accounting methodology, investments, and expense management in cannabis companies can all have massive tax implications for the company, owners, and investors. In addition to accurate and complete reporting and accounting practices, every cannabis company should have comprehensive tax planning and tax strategies for business operations and growth goals.

Make sure to involve your cannabis tax attorney and CPA with any significant business decisions. We help with optimizing your business structure, tax planning for transactions, tax opinions, tax disputes, and audits.

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Nick McCrillis is an attorney admitted to the United States Tax Court and advises and assists the firm's clients in a variety of industries on various intellectual property matters throughout the United States. In addition, Mr. McCrillis advises and represents the firm's clients throughout Maine's Medical and Adult Use cannabis programs on state and federal related tax matters and banking laws.  Learn more about Nick McCrillis by clicking here.

Caseiro Burke is a boutique law firm that specializes in intellectual property law and cannabis compliance and licensing in the State of Maine. We offer clients creative, cost-effective and reliable legal solutions in all intellectual property and Maine cannabis law matters.

About the Author

Nick McCrillis, Esq.

Nicholas A. McCrillis is a licensed attorney practicing in intellectual property law, corporate law, and commercial finance law. Nick is a Maine native with an undergraduate degree from the University of Maine at Orono and a law degree from the University of Maine School of Law. Nick handles matt...