It’s tax time for everyone, but for entrepreneurs in the rapidly growing cannabis business, it’s a particular challenge. That’s because they are confronted with the issue of filing taxes for a federally illegal market, even though it’s perfectly legal in the state in which they do business.
Section 280E of the Internal Revenue Code prohibits the deduction of otherwise ordinary business expenses from gross income associated with the trafficking of Schedule I or Schedule II substances as defined by the Controlled Substances Act.
Specifically, the statute states: “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedules I and II of the Controlled Substances Act) which is prohibited by federal law or the law of any state in which such trade or business is conducted.”
Entrepreneurs who engage in the cannabis business face the prospect of paying the same expenses as other businesses without the ability to take advantage of the normal deductions or credits available to other businesses, since cannabis falls under the definition of a Schedule I substance. In other words, they must pay tax on their gross income.
“Section 280E was added to the code back in the 1980s as a result of a case involving a drug cartel,” said Jessica Billingsley, CEO of MJ Freeway, a cannabis technology company and consulting service that serves businesses and governments in 29 states, the District of Columbia, and 10 countries. “What it means is that a state-licensed business that pays and all associated state taxes in a legal cannabis business is still, at the federal level, prohibited from deducting payroll and regular business expenses.”
The lack of deductibility can cause taxes to jump from 30 percent to as high as 80 percent, according to Billingsley. “This is a reality for all our retail clients. They are all impacted by the inability to take tax breaks on normal deductions that other shops can take to support their businesses. They have the exact same overhead, but cannabis retailers have higher taxes.”
And it also provides an incentive to cut corners to minimize gross profit. Moreover, cannabis businesses are often underbanked because banks are leery of providing accounts to businesses that do not comply with federal law. Taken together, this makes them a target for audit on their federal returns.
What to do? “Obviously, they want to work within legal means to optimize the cost of goods sold,” said Billingsley. “It incentivizes operations to be vertically integrated. If they control their supply chain, they have a little more flexibility as to where their costs are. You can optimize cost of goods sold so you have more flexibility when you control your supply chain. What that means is that you have a cultivation business as well as a distribution and retail business. You grow, harvest and distribute as well as sell retail.”
But the ability to do this varies from state to state, she noted. “Some states require it, while others prohibit it. But to the extent you have the ability to control, it will be more tax advantageous.”
A typical MJ Freeway client has “multiple verticals — cultivation, manufacturing, distribution and retail — in multiple states or countries,” she said. “They are cannabis businesses that are scaling rapidly, and we built software to support them at this fast pace..”
