280E vs. Your Bottom Line: How to Minimize the Damage Legally

Every cannabis operator knows only too intimately the woes of IRC 280E. This tax rule prohibits legitimate cannabis businesses from deducting normal and customary business expenses like rent, utilities, payroll, marketing, and office equipment, or any business expense, unless it can be attributed to the cost of goods sold (COGS).

If it seems unfair, it’s only because the federal government has yet to reschedule marijuana from where it currently resides, as a Class I (illegal) substance.

The verbiage in the code goes something like this:

“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... consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act).” (source)

So, while it seems like an oxymoron—holding cannabis companies to the same restrictions as illicit drug traffickers—it’s where we’re at right now.

In the meantime, cannabis operators must bear the brunt of the pain, most especially dispensaries, as they have few costs that can be written off to COGS.

Bottom line, the marijuana industry is one of the most tightly controlled and regulated sectors, and the federal government is not going to miss an opportunity to collect what is inarguably the most significant tax-grab going.

Here’s an example:

Say you’re a non-cannabis retail business with $1 million in revenue and $800,000 in expenses. Taxable income is only $200,000, and that’s what’s used to calculate tax owing.

On the other side, we have a cannabis dispensary with the same revenue and expenses. They might only be able to deduct $250,000 in expenses, leaving them with a taxable income of $750,000. The tax rate can exceed 70%, sucking up all their cash flow and establishing insurmountable barriers to growth.

Dodging this reality is not an option. The only legal way to survive in this challenging tax climate is to plan well and structure your business to minimize taxes.

Tips and (Legal) Strategies to Mitigate the Damage of IRC 280E

Cannabis CPAs and tax advisors have a big job helping their clients stay on the right side of compliance. Certain strategies must be in place before launching any kind of cannabis enterprise, or it will be incredibly challenging to stay in the black.

Here are a few tips and recommendations to safely and legally minimize the impact of 280E.

1.      Maximize COGS allocations

COGS is the only thing you can legally deduct. Therefore, it pays to apply rigorous cost accounting principles and track all expenses related to inventory. Depending on the type of cannabis business you run, examples could include:

·       Seeds, growing medium, nutrients

·       Cultivation, processing, and manufacturing labor

·       Rent costs and utilities for production and storage spaces

·       Production equipment (which can be capitalized to leverage depreciation)

Understanding what expenses do and do not apply to COGS is essential. Work with a qualified cannabis CPA for expert guidance.

2.      Optimize payroll

Wages attributed to cultivation, production, and manufacturing can be at least partially attributed to COGS. However, administrative roles and sales staff can’t be. It’s critical to document payroll allocations in case your allocations are called into question. You must be able to substantiate your claims with detailed documentation, as auditors will want to see it and confirm its accuracy.

3.      Consider state-level relief

Operators don’t always have a choice of where they want to set up shop, but it’s worth considering that many states have decoupled from 280E. This does not exempt you from federal tax obligations, but it does provide some relief at the state level. State decoupling should always be a consideration if you are thinking about expanding, as a decoupled state can significantly ease the overall tax burden.

4.      Maintain impeccable records

Many 280E woes stem from poor documentation. Maintain meticulous records of all transactions, tax allocations, expense categorization, employee time tracking, and inventory management. Be sure to provide a detailed rationale for each decision, as you will be required to back them up. While this won’t prevent an audit, it will undoubtedly make them run smoothly and may result in fewer penalties for inadequate recordkeeping.

5.      Keep an eye on your cash flow

Tax flow planning is critical for cannabis operators. Cannabis is a cash-heavy industry due to a lack of banking options, and it’s easy to be overly optimistic when you see large amounts of cash coming through the door. But keep in mind, no matter how many greenbacks you’re counting, you’ll still have a massive tax bill to pay, and you can’t avoid it. You’ll need to plan ahead for monthly tax filings, license renewals, and other business expenses. We recommend using forecasting tools to predict cash flow and setting aside adequate reserves to ensure you have the funds you need to avoid coming up short.

280E Pitfalls You Must Avoid at All Costs

It may be tempting to get creative about 280E, over-allocate COGS, or file aggressively, but keep in mind, the IRS knows what’s usual and customary in the sector and your region.

Poor recordkeeping is another way to run afoul of the tax man; if you can’t prove it, the IRS won’t allow it, so apply that rule to every transaction and financial decision you make.

To avoid IRS red flags, keep your books clean and up to date, and work with a qualified cannabis tax professional to ensure you’re leveraging every opportunity to mitigate the impact of 280E.

Set up a call with the experts at Growise today, and let’s talk growth!