Decoding Section 280E
Impact on the legal landscape of cannabis businesses
Calvin P. Shannon CPA, CVA | October/November 2023 Footnote
This article is provided by BGM, the MNCPA's partner in developing cannabis resources for MNCPA members.
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As the cannabis industry flourishes, a complex set of regulations and tax codes has emerged, shaping the financial landscape for businesses operating in this dynamic sector.
Among these regulations is Section 280E of the Internal Revenue Code, which plays a pivotal role in the world of cannabis operators by significantly affecting their ability to claim business expense deductions.
This article delves into the intricacies of Section 280E, its implications for cannabis businesses, the existing exceptions and the legal battles that have defined its interpretation.
The roots of Section 280E
Section 280E was introduced as a component of the Tax Equity and Fiscal Responsibility Act (TEFRA) in 1982. This provision explicitly targets the deduction of expenses for businesses dealing in controlled substances listed under Schedule I of the Controlled Substances Act (CSA). While deductions serve as a crucial tool for reducing taxable income for most businesses, Section 280E places stringent limitations on these deductions for enterprises engaged in the sale of Schedule I controlled substances, such as cannabis.
To grasp the impact of Section 280E, a clear understanding of what constitutes a Schedule I controlled substance is vital. Schedule I is the most restrictive classification under the CSA, reserved for substances deemed to possess a high potential for abuse and lack any accepted medical application. Cannabis, despite its increasing acceptance for medicinal and adult use in certain states, remains classified as a Schedule
I controlled substance at the federal level, largely due to historical precedent.
Guiding principles for regulation
The Cole Memorandum was released Aug. 29, 2013, by then-Deputy Attorney General James M. Cole. It provided a framework for federal enforcement of cannabis-related activities in states with legal cannabis. While not directly related to income taxes, this document marked a significant shift in the federal attitude towards state-regulated cannabis industries. It emphasized areas of focus for law enforcement and offered guidance on regulatory priorities, contributing to the evolving landscape of the cannabis industry. It's important to note in 2018, then-Attorney General Jeff Sessions rescinded the Cole Memorandum, creating uncertainty around federal enforcement priorities in states with legalized cannabis.
Navigating the hurdles
For cannabis operators, Section 280E presents a significant financial challenge. This provision bars the deduction
of regular business expenses related to the trafficking of Schedule I controlled substances. This implies legitimate business expenditures — like employee wages, rent, utilities and marketing costs — cannot be deducted when calculating taxable income. Consequently, cannabis businesses frequently encounter substantially higher effective tax rates compared to other industries.
Exceptions to Section 280E
While Section 280E creates a substantial obstacle for cannabis operators, there are exceptions in place that allow for specific deductions. One such exception pertains to the deduction of cost of goods sold (COGS). Cannabis businesses are permitted to deduct costs directly linked to the production or acquisition of the products they sell.
This means expenses directly associated with producing or purchasing inventory can be offset against revenue. However, this exception is still subject to limitations and intricacies that demand meticulous accounting and accurate financial statements.
Pivotal court cases for defining scope of Section 280E
The legal arena surrounding Section 280E has evolved through key court cases scrutinizing its application and boundaries. Five notable cases include:
- Minneapolis, Minnesota: Jeffrey Edmondson v. Commissioner (1981). The Tax Court allowed an illegal business to recover the cost of the controlled substances obtained on consignment and to claim certain business deductions. In 1982, Congress enacted IRC 280E, which reverses the holding in Edmonson.
- Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP 2002). In the CHAMP case, the court disallowed trade or business deductions related to the sale of medical marijuana. This case underscored the conflict between state laws legalizing medical cannabis and federal tax regulations.
- Harborside Health Center v. Commissioner (2018). Harborside, a prominent medical cannabis dispensary, challenged the IRS's interpretation of Section 280E. The Tax Court ruled against Harborside on all issues and upheld the IRS's stance, confirming deductions beyond COGS are prohibited. The key takeaways: You need a separate trade or business that can stand on its own and uniform capitalization under Section 263A (UNICAP) is not available to increase COGS.
- Alternative Health Care Advocates v. Commissioner (2018): This case reinforced the IRS's authority to deny deductions for businesses engaged in the trafficking of controlled substances. Alternative Health Care Advocates used a cannabis management company to provide HR services. The court ruled this management company violated the 280E, even though it didn't deal directly with the sale of cannabis.
- Northern California Small Business Assistants, Inc. v. Commissioner (2019). This case emphasized the significance of the meticulous allocation of expenses among different business activities. The company claimed $1.5 million in ordinary and necessary trade or business expenses allowed under IRC Section 162. The IRS disallowed the company's tax deductions under Section 280E because the business was trafficking a Schedule I controlled substance, which the court affirmed. The company appealed, arguing the Eighth Amendment applied to corporations and Section 280E operates as a penalty and the penalty was excessive. The court concluded the 280E does not violate the Constitution or Eighth Amendment because it is not a penalty position.
Section 471(c) as an alternative
Within the context of cannabis operators seeking ways to navigate Section 280E, Section 471(c) emerges as a potential alternative. Section 471(c) offers qualifying small taxpayers the option to account for inventory using applicable financial statements or actual books and records. This could potentially allow for the categorization of more expenses as inventoriable costs, thereby potentially mitigating the impact of Section 280E.
Essential first steps for newcomers
For entrepreneurs contemplating entry into the cannabis industry, proactive steps are essential. Here are three crucial actions to undertake before investing:
- Comprehensive research. Dive into the legal and regulatory landscape of cannabis in your intended state of operation. It is crucial to understand both state and federal regulations.
- Holistic financial planning. Develop a comprehensive financial plan that incorporates the implications of Section 280E and the maturing of the cannabis industry markets. Devise and implement strategies to minimize tax liability while adhering to regulations.
- Expert consultation. Seek guidance from professionals with years of experience in the cannabis industry.
Their insights and experiences will guide you through complexities and optimize your chances of success.
Embracing challenges for informed progress
The path into the cannabis industry offers challenges and the prospect of success. By delving into income tax complexities, understanding Section 280E, exploring license types, conducting comparative analyses, comprehending key court cases and following essential steps, you can confidently navigate the income tax complexities. With knowledge, readiness and a commitment to informed decisions, you are poised to embrace the challenges and embark on a journey toward a thriving future in the ever-changing cannabis landscape.
Calvin P. Shannon CPA, CVA, is a principal of BGM. With more than 20 years of experience, Calvin provides tax, advisory, and business valuation services and specializes in serving cannabis operators. You may reach him at cshannon@bgm-cpa.com or 651-287-6347.
