Dispensaries - What Can Be Deducted According to the 280E Tax Code?
Although cannabis has seen rapid legalization across the country, it is still categorized as a Schedule I controlled substance under the Controlled Substances Act. This implies that business owners may face several financial hurdles despite the plant's increasing acceptance.
One such challenge faced by cannabis companies is that they need to abide by 280E of the Internal Revenue Code (IRC). The IRC's section 280E states that any business selling cannabis (or any federally illegal controlled substance) cannot deduct expenses incurred during their product's production, distribution, or sale.
What is the 280E tax code?
The purpose of the 280E tax code is to disallow businesses that deal in federally illegal controlled substances from deducting ordinary business expenses from their gross revenue for tax purposes. This code was established in 1982 to prevent drug dealers from using these tax deductions to lower their tax liability.
A report from the Congressional Research Service states that under Section 280E of the Internal Revenue Code, deductions and credits cannot be claimed for expenses related to conducting any trade or business that involves selling controlled substances listed in Schedules I and II of the Controlled Substances Act in violation of the federal or state law.
Implications of the 280E tax
Although state-legal cannabis businesses may operate within the regulations of their respective states, they need to remember that it is still illegal under federal law. The application of 280E to these businesses is controversial, as it prevents them from deducting ordinary business expenses such as rent, employee salaries, and marketing expenses from their taxable income.
Cannabis businesses face a higher tax burden because they cannot deduct expenses, which results in taxes almost thrice compared to other businesses. This makes it difficult for them to earn substantial profits and reinvest in their operations, putting them at a disadvantage compared to industries that can deduct business expenses.
How Section 280E Affects Different Cannabis Verticals
The cannabis industry is affected by Section 280E in all areas related to the selling or distributing of cannabis products. The impact of 280E can differ based on the type of cannabis business involved in the entire process, from growing to selling.
Cultivation/Grow and Processing/Infusions/Extractions Verticals:
Even though cultivators, processors, and extraction companies do not sell cannabis products directly, they must comply with 280E regulations. These businesses can only deduct their direct costs of goods sold, such as labor, materials, and equipment. However, they are restricted in their capacity to deduct other business expenses.
Retail Dispensary Vertical:
Businesses that sell cannabis products, called retail dispensaries, are subject to 280E. Due to this, they cannot deduct expenses and have to face a higher tax rate than other types of businesses. This vertical is the most affected by 280E.
Vertically Integrated Vertical:
Cannabis businesses with licenses for every stage of the production process may also have to deal with 280E. These businesses must meticulously track their expenses and revenue to reduce tax liability. If they choose to sell their products to other vendors or retailers, it will be considered "trafficking" and subject to 280E.
What can cannabis businesses deduct?
Make sure to deduct COGS, as they are the only business expense that can be deducted under 280E. So, what is COGS? Cost of Goods Sold (COGS) is the expenses or costs of producing the goods. 280E states that cannabis retailers can subtract the cost of goods sold (COGS) from their taxable income.
Here are some deductions that cannabis retailers can claim.
- Invoice for the price of cannabis minus any discounts or trade
- Electricity bills for designated inventory areas (the sales are electricity bills that cannot be deducted)
- Transportation costs to purchase cannabis or legal shipping costs for it.
Salaries of employees in sales, marketing, or executive roles are not included in COGS. To ensure maximum deductions, it's crucial to identify any overlap in employee activities. Even if the CEO of a large retail facility spends minimal time working with plants, a portion of their salary could qualify for a deduction under 280E tax law.
To ensure that the activities of employees can be classified as COGS, you must carefully record and regularly review each employee's job time logs, tasks, duties, and descriptions. These descriptions may need updating if their duties change.
Due to Section 280E, cannabis businesses should adopt distinct accounting practices that tackle complicated claims and deductions. It is advisable to understand the best practices for tax deductions from your lawyer or CPA and how it applies to your cannabis business.
Prohibited Business Expenses for Cannabis Businesses Under 280E
Under IRC section 280E, cannabis businesses are prohibited from deducting most ordinary and necessary expenses, except for Cost of Goods Sold (COGS). This means that there are several expenses that cannabis businesses cannot deduct from their tax returns, including:
- Marketing and advertising expenses: Cannabis businesses cannot deduct expenses related to advertising or promoting their products, including social media advertising, billboards, and other forms of marketing.
- Employee training and wages for non-production employees: While cannabis businesses can deduct wages and salaries for employees directly involved in the production process, they cannot deduct wages or salaries for employees who are not involved in the production, such as sales staff, administrative employees, or security personnel.
- Rent and utilities for retail spaces or other areas where cannabis is sold: Cannabis businesses cannot deduct rent or utility expenses for areas where cannabis is sold, such as retail stores, dispensaries, or delivery vehicles.
- Business insurance for non-production risks: Expenses related to insuring the business against non-production risks, such as theft or liability, cannot be deducted under 280E.
Boosting Cannabis Business Despite the 280E Taxes
A great idea to work around the 280E Taxes is to increase non-marijuana-related sales and pay the regular tax on their sales. Yes, you can sell ancillary smoke shop items. Considering you are catering to a customer base that uses marijuana, you can offer supporting items to help them consume the same. Your customers will be interested in smoking equipment and accessories like pipes, lighters & torches, rolling papers, cones and wraps, bongs, bubblers, and dab rigs. Not only will this boost your sales, but the income from the sales won't also be taxed under the 280E.
This means you are expanding your offerings to your current customer base without the need to spend additionally on marketing etc. It would be best to buy smoke shop equipment, tools, and accessories at wholesale prices to register maximum profit from the sales. MJ Wholesale has the best smoking equipment and accessories collection from top brands that you can order at wholesale prices.
Tips on protecting yourself from audits.
- Get to Know the Local Tax Regulations
As taxes vary by state, it is essential to comprehend how these tax alterations will impact your business before automating the calculations. To guarantee accuracy, consulting with an accountant is recommended before making revisions.
- Keep Accurate Records
To remain compliant with the stringent regulations, it is essential to document each process step, from cultivation to marketing. For cannabis companies more likely to be audited by the IRS, having a concrete paper trail is critical for success. To comply with tax regulations, keep your fiscal documents, including returns, transaction receipts, communications with the IRS, and related work papers, for seven years.
- Do Employee Categorization
To stay compliant with wage laws and avoid costly penalties, it is vital to identify your employees' roles in detail. You can identify and specify any tax-deductible actions by keeping records of the time spent on each task. Tracking this information meticulously can save you money and trouble in the long run.
- Formulate a Tax Hierarchy of Priority
As a business owner in this field, you must adhere to your tax responsibilities. It can be overwhelming to process the complexities related to local taxes, state taxes, and surcharges on certain taxes. To ensure accuracy in your reports, create a procedure that outlines how you will apply these various taxes throughout every transaction.
- Seek Professional Advice
It is a great idea to seek help from a specialist with expertise and experience in the cannabis sector. This can help approach potential issues proactively instead of reacting when it may be too late. You can develop strategies that benefit your business by consulting with an accountant.
Dispensary owners must understand how current laws and regulations impact their business, despite changes over time. Audits are never easy; however, you can avoid complications by being prepared and seeking professional advice beforehand. To ensure compliance with all regulations, it is essential to have an experienced accountant review your books regularly and make the necessary modifications if needed. Ultimately, you must be aware of any modifications to local laws and stay on top of prospective audits about 280E and medicinal marijuana. This will help you save on taxes and ensure success in the long run.