The green rush has caught the attention of a vast number of individuals and businesses looking to capitalize on this phenomenon. As of today, there are thirty-three (33) states with some form of legalization – whether it is medicinal or recreational – of marijuana, and this number is expected to grow in the upcoming years. This occurrence has led to the creation of both direct (cultivators, processors, distributors) and ancillary (software development, construction, legal, insurance, accounting, consulting) businesses related to the legal cannabis industry.
One of the main drawbacks is either the lack of information or misinformation about many issues in the industry. This also applies to one of the hottest topics, the IRC 280E tax code, which disallows flower touching cannabis companies from deducting any business expenses from their gross income except the cost of goods sold. I have personally seen, heard, and read some strategies for minimizing the effect of 280E that ranges from partially incorrect to straight garbage. The following are three commonly advised tactics for ‘combating’ 280E that were proven to be wrong:
1) The Multiple Entity Strategy –
As a marijuana business owner, having more than one entity can be advantageous for certain things. An owner can have a non-cannabis business entity to gain access to banking services, purchase fixed assets, purchase real estate, etc. Although this can increase the ease of access for certain services, there is a possibility that the non-cannabis business also becomes subject to the 280E tax code.
In the Alternative Health Care Advocates et al. v. Commissioner court case, the owner set up a separate management company, Wellness Management Company, to conduct the day to day affairs of its dispensary including, hiring employees, managing payroll, paying advertising expenses, and banking.
The Commissioner of Internal Revenue (IRC) determined that the sole purpose of both entities was the trafficking of a controlled substance and therefore both businesses were subject the 280E tax code. This was largely because the management company only managed the daily operations of the dispensary and no other business and in effect was a flow-through company for the dispensary. Alternative Health Care Advocates were, therefore, liable for 6662(a) accuracy penalties and ironically, the owner had to pay more taxes because of that strategy.
2) Use of 263A and UNICAP inventory method
As mentioned previously, the only expense that can be deducted under 280E is a company’s cost of goods sold. Therefore the more costs that a business can include in inventory costs, the greater the reduction in its tax liability. Because of this, some professionals have been advising owners to use the 263A Uniform Capitalization Code rules to increase the cost of goods sold. Section 263A expands the costs that could be capitalized and included in the inventory and would be a major factor in potentially reducing a company’s taxable income
However, the findings of the court case Harborside Health Center vs the Commissioner, the company’s cost of goods sold was adjusted and reduced since the inventoriable costs under 263A were denied. One of the main reasons was because of a timing provision. The 280E tax code was enacted in 1982 while the 263A code was implemented in 1986 and therefore cannot retroactively negate the effects of 280E.
2)Weak Non-Cannabis Segment Implementation
A very popular plan that is used by dispensaries is establishing a segment to the business which either sells or provides non-cannabis products (paraphernalia, apparel, etc.) and/or services (counseling, massages, movie nights, etc). The driving factor behind this plan is largely due to the positive results in the famous CHAMP v. Commissioner case.
Even though CHAMP was successful against the IRS, the company was very meticulous and strategic in the way their implemented non-cannabis segment and most importantly, had proper records and accounting to prove it. On the other hand, many businesses are not truly operating a separate non-cannabis business segment and just has this in place to beat 280E, which the IRS is very aware of. A key example of this is found in the court case Olive v. Commissioner. Some of the issues that resulted in a loss in the US Tax Court was their failure to show the sale of marijuana was inseparable from their other services, the inability of their non-cannabis services to act as a business on its own, and its lack of proper accounting records and financial reports.
These are just three samples of the misinformation that is going on in the cannabis industry. As more cases are settled and we observe the interpretation of the law by the Tax Court, the more precedence will be established for correct strategies to be put in place. The common theme, however, is having robust financial reports supported with detailed financial records for your cannabis business to survive and strive during this period of federal prohibition.