How to Prepare Your 2020 Business Taxes with Section 280E of the Internal Revenue Code in Mind

If you ask any cannabis-related business of the biggest challenges they face in the industry, the first answer will be banking relations quickly followed by section 280E of the Internal Revenue Service (IRS). 

While strained banking relation is top of the list, it is the least of their worries. The Internal Revenue Service Code Section 280E means that most cannabis businesses pay up to 3.5 times more in taxes than other companies

What is Section 280E? 

Section 280E was created in 1982 after a convicted cocaine trafficker asserted his right under federal tax laws to deduct ordinary business expenses like rent, employee salaries, and advertising.  

The law states that deductions and credits are not allowed for any expenses paid during the tax year for business activities that involve the sale of controlled substances.

While cannabis is legal in some states, federally, it’s classified as a Schedule I substance alongside heroin and ecstasy falling squarely in the net of section 280E. 

Ideally, the law was created to prevent drug dealers from claiming a tax deduction for their business expenses. It was later interpreted to include state-legal cannabis businesses that are building compliant operations intending to provide medical marijuana access.

As a result of code 280E, cannabis businesses face higher federal tax rates of between 40 and 80% compared to 21% for corporate tax. 

How Section 280E Impacts the Cannabis Business 

Non-cannabis businesses start with the gross income, subtract direct costs (cost of goods sold), and then deduct indirect costs to calculate taxable income. The final income amount is what is taxable.  

Because of code 280E, cannabis businesses pay taxes on gross income without subtracting any deductions. As a result, the taxable amount that a cannabis business pays is nearly double that of regular businesses. 

As with other tax laws, there are a few exceptions to the no deductions rule. For instance, cannabis businesses can deduct the cost of goods sold (COGS). These are all the costs involved in selling the product. They include: 

  • Packaging 
  • Labeling
  • Marketing 

There are a few other productions costs that may be considered as COGS for cannabis producers like: 

  • Repair expenses 
  • Utilities 
  • Rent
  • Maintenance 
  • Indirect labor
  • Production supervisory wages like basic compensation and overtime pay
  • Indirect materials and supplies cost of quality control and inspection. 

Of all cannabis dealers, the hardest hit by code 280E are the resellers whose only deductible is the invoice price of the purchased cannabis less transportation and other costs required to acquire the inventory. 

What Happened to the Cannabis Industry in 2019? 

The beginning of 2019 shore a bright light on a buzzing industry filled with promise. Canada was the first G-7 country to legalize cannabis in October 2018, and most analysts believed 2019 would be the year to drive sales.

Unfortunately, around July of 2019, Pot Stocks dived the worst. This was after CannTrust, Canada’s biggest cannabis dealer, was involved in regulatory scandals.

The Domino effect of the findings led to the FDA issuing a warning letter to Curaleaf for promoting unapproved CBD-based products. 

2019 is also the year most Cannabis businesses changed leadership. CannTrust fired its CEO because of the scandals, and Canopy Growth followed suit while Hexo’s CFO resigned. Such significant changes to the management of the businesses resulted in the plummeting of stocks. 

However, the biggest undoing in 2019 for cannabis businesses had to be the slow regulation process. For instance, Canada suffered from an increase in black market sales because legal stores were taking too long to open, not to mention that the illegal market offered lower prices, and California’s black market sales are also increasing

How Your Cannabis Business Can Better Prepare for Taxes This Year 

Cannabis businesses will continue to struggle with the effects of code 280E. Unfortunately, there’s no better solution than paying up and doing so in time. 

Most of the cannabis businesses that go to court with the IRS have lost. As a result, the IRS has continually tightened the section 280E noose. 

With a few tips, you can prepare your cannabis business for this year’s taxes and avoid the legal tussles and fees of dealing with the IRS.

Determine the right corporate structure 

It’s best to start by determining if you have the right corporate structure. There are three entities: C-corporation, Limited Liability Corporation (LLC), and an S-Corporation. The business has to determine which entity works best for them to minimize the tax burden. At times, this calls for outside consultation. 

Each of the three entities has upsides and downsides for cannabis businesses in different fields. It’s up to you to choose which entity works best for your field.  

Keep a sound accounting system

One of the ways to maximize your deductibles is to keep a good accounting system. For cannabis growers, a vast majority of the expenses that go into the product are direct expenses and go directly into COGS. Under 280E, these are allowable deductions. 

By keeping lean and neat records, you can easily track every expense and capitalize on all the deductibles. 

Be honest

It’s vital to track all your inventory. Even more important, be mindful of the potential penalties. If you fail to report income by 20% or more, there’s a fair chance you will get a substantial understatement penalty. 

Ensure you’re recording your income correctly to avoid massive penalties and further investigation.

Seek expert advice 

Section 280E can be confusing. A single misstep or loophole could have your business facing serious ramifications and fines. Consider working with compliance, accounting experts, and even bookkeepers to help you keep a tidy and well-documented enterprise.

These experts can give you invaluable information into the ins-and-outs of this highly regulated industry and take most of the burden of compliance off your shoulders. 

Be audit-ready

Your cannabis business is likely to be audited more often than any other business since you’re handling a federally illegal substance. 

Document all expenses and revenue from seeding to cultivation, marketing, and sales. Have receipts for every transaction no matter how small, and always keep detailed documentation of your COGS in case the IRS asks for it to prevent fines if you can’t show how you came up with the deductions. 

Final Thoughts 

With the high-regulation, the most practical decision for cannabis businesses is to remain compliant. Section 280E might hurt revenue and profit, but trying to fight the IRS in court could subject the business to stiff legal costs, fines, and scrutiny that the business might not recover from.