Understanding and Planning for Section 280E as a Medical Cannabis Business [Blog Post]
November 29, 2016 - By: SC&H Group
The following SC&H Group blog post discusses the limitations under Section 280E of the Internal Revenue Code, as well as how cannabis businesses can minimize its effects with proper planning and an understanding of indirect and direct costs.
For medical cannabis businesses, it can be challenging to minimize tax liability and manage expenses under the industry’s unique tax regulations. Such is the case with Section 280E of the Internal Revenue Code.
Section 280E, which relates to the taxation of income for businesses dealing in controlled substances, disallows indirect costs (i.e., ordinary and necessary expenses that are unrelated to production) from being deducted. These may include costs such as employees’ pay and benefits, rent, interest, taxes, and insurance.
With limited deductions, cannabis businesses face a higher effective tax rate—which can be as much as 90 percent more than that of a typical business.
The Implications of 280E: A Real-Life Example
Unlike a typical business, cannabusinesses cannot deduct most indirect costs. Moreover, they can face a tax rate in excess of 100% of pre-tax income as a result of the non-deductible expenses.
For example, a typical business and a cannabis business each make $1 million in revenue and have $300,000 in indirect costs. Both deduct $550,000 for cost of goods sold, a direct cost. That leaves each business with a gross profit of $450,000.
A typical business can then deduct the $300,000 in indirect costs. So, a typical business will have $150,000 in net income before taxes, and, after paying a blended tax rate of 36 percent, have $96,000 of cash left.
However, for a cannabusiness, that $300,000 deduction is disallowed under 280E. So, although they have the same costs, their taxable income is $450,000, giving them a 108 percent effective tax rate. That leaves them with a $162,000 tax liability—$12,000 more than their revenue less direct and indirect costs.
These otherwise identical businesses have two drastically different cash flow results. One produces $96,000 for possible owner distributions or future working capital needs; the other produces no available cash and requires owners to fund a $12,000 cash flow deficit.
Re-Evaluating Your Expenses
While this limitation may seem burdensome, cannabis businesses can diminish the effects of Section 280E by understanding the flow of costs, properly planning, and documenting intentions.
For instance, one of the ways Internal Revenue Code Section 61 defines income is “net gains derived from dealing in things in property,” or gross receipts less cost of goods sold. So, if a cannabis business can show the IRS that an expense is related to the cost of goods sold instead of an ordinary and necessary business expense, they can deduct it.
In essence, the more indirect costs that a cannabusiness can classify as direct costs and include in cost of goods sold, the less the burden will be. However, it is important to understand how to do this while remaining in compliance with the Internal Revenue Code, since the IRS will very likely question how the direct costs were figured.
In addition, though direct costs specifically relate to inventory, not all indirect costs do. Sometimes expenses can be split between cost categories. For instance, a cannabusiness could place 20 percent of an expense in direct cost and deduct it. Meanwhile, the other 80 percent may have to remain in indirect cost and be disallowed under 280E.
Ultimately, cannabis businesses should work with their tax advisor to best determine their direct and indirect costs, as well as how to most effectively plan and manage their expenses. That way, they can minimize the impact of 280E, allowing them to meet financial obligations and maximize their return on investment.
Want to learn more about how Section 280E affects your cannabis business, or get help in planning, managing, and categorizing your expenses? Contact SC&H Group’s Medical Cannabis Advisory practice here.