U.S. Code § 280E is a (huge) thorn in the sides of all direct participants in the state-legal cannabis industry, refusing tax deductions or credit for any business involved in “trafficking in controlled substances.” But fortunately for cultivators, with the right tax planning and foresight, a business’s negative impacts from the tax code can be manageable.
Section 280E permits the deduction of cost of goods sold (COGS), but disallows selling, general and administrative expenses unless other lines of business have been established unrelated to cannabis “trafficking.” Several cases have been heard in U.S. Tax Court, including:
- Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner of Internal Revenue, May 15, 2007.
- Olive v. Commissioner of Internal Revenue, Aug. 2, 2012.
These cases have clarified what constitutes “trafficking” (supplying marijuana products) and has enabled accountants to better help their clients identify those costs within their businesses, as well as identify other expenses that clearly are necessary to the business and not related to “trafficking.” The cases also stressed the grave importance of having accurate books and records, and being in compliance with 280E, at the risk of penalties and fines.
The first step in tax planning for any business is choosing the best entity type to establish. This step alone can be one of the most important in the process, but it is often ill-advised. For cannabis-industry professionals, LLCs are a preferred entity type due to their less-restrictive operating formalities and flexibility through customized operating agreements. In an environment where outside investment is frequently sought, LLCs are attractive in that the business manager/owners can maintain control and establish ownership percentages irrespective of contribution values by investors.
Another important consideration for the grower is regarding land and real estate. With the risk of federal asset forfeiture, it makes sense to separate the cannabis-touching entity from the land being cultivated. For a grower who currently owns the land being cultivated, the first entity structuring plan is to place the land in a limited liability company (LLC) that will act as a property management holding company. The next step is to form a second LLC for the purpose of cultivating the land and leasing the property from the holding company.
Why Are LLCs Optimal?
An LLC is a flow-through entity such that net profits (and losses) pass through to member owners based on the allocation percentage that is specified in the operating agreement. With 280E, growers can deduct a majority of their expenses as cost of goods sold (COGs). For a grower, the point at which 280E applies is when the product has been harvested, bagged, sealed, and activities are being performed to “traffic” the product to customers. The “trafficking” costs disallowed under 280E include, but are not limited to: advertising, website, telephone and communications, delivery and sales force.
An LLC is a “flow-through” business entity — so it passes income/profits on to the member owners. In other words, LLC member owners are personally responsible for their taxable flow-through income from the partnership. Due to this “flow-through” nature, it may be best to elect to be taxed as a corporation instead of an LLC. If you choose to be taxed as a corporation, the operating formalities of the LLC will remain intact, and 280E exposure transfers from the shareholders to the entity. Therefore, the shareholders are not held personally responsible for their partnership’s tax liabilities.
The Accrual Method of Accounting
The accrual method of accounting is the best choice for all cannabis-touching businesses — particularly growers. Since COGS is an allowable expense under 280E, the accrual method of accounting is the only viable method that allows for absorption costing — the process of identifying indirect production costs and allocating them to inventory. Advertising is certainly not an inventory cost. However, trimmers and the area where they are used are.
This tax-planning technique must be addressed up front, as the accrual method needs to be elected on the first tax return filed by the entity. If it’s not, then the business will need to apply for special permission from the IRS commissioner to make the change.
As COGS is the only deductible expense on the federal tax return, it’s imperative to take these planning considerations seriously from the outset. Always consult your tax and legal professionals for the best guidance for your business.