As states across the nation continue to legalize marijuana there is a lot of excitement, but also a lot of unanswered questions. The cannabis industry is new, it’s federally illegal, and it’s risky. But, as the saying goes “with great risk comes great reward.”
Today we are going to focus on the tax risks of entering the industry. If you are in, or thinking about entering the cannabis industry, I am sure you have heard of this crazy thing in the Internal Revenue Code called Section 280E – Expenditures in connection with the illegal sale of drugs. A quick history lesson. 280E came about in 1982, the year after Nancy Reagan toured the country with her “Just Say No” campaign.
Even if cannabis is legal in your state it is federally illegal. Since you have to report taxes at a federal level, 280E applies to you.
Essentially 280E says, there is no tax deduction or credit allowed for any amount paid or incurred during the taxable year, if your business consists of, or participates in activities, associated with trafficking a controlled substance.
So what does this mean for cannabis businesses & those providing ancillary services to the cannabis marketplace? (i.e. leasing space to a cannabis company)
Basically, if you are operating a cannabis company, you are paying a tax rate of about 3.5 times that of other industries.
Cannabis Companies
Assume in the example below we are talking about a C-Corporation whose tax rate is 21%
| Legal | Illegal | |
|---|---|---|
| Revenue | $1,000,000 | $1,000,000 |
| Cost of Goods Sold (COGS) | (500,000) | (500,000) |
| Gross Margin | 500,000 | 500,000 |
| Selling, General & Administrative Expenses (SG&A) | ||
| Salaries | (250,000) | (250,000) |
| Rent | (100,000) | (100,000) |
| Professional & Legal | (100,000) | (100,000) |
| Total SG&A | (450,000) | (450,000) |
| Net Income | 50,000 | 50,000 |
| Taxable Income | 50,000 | 500,000 |
| Tax | 10,500 | 500,000 |
| After Tax Cash Flow | $39,500 | ($55,000) |
So why would anyone want to be $55,000 in the red? Oh, and not to mention, you may have to pay this out of your own pocket, because right now getting loans from banks if you are in the Cannabis industry is not super easy.
But, as the example below outlines, if your revenue increases, you have the potential to be very profitable.
| Legal | Illegal | |
|---|---|---|
| Revenue | $10,000,000 | $10,000,000 |
| Cost of Good Sold (COGS) | (5,000,000) | (5,000,000) |
| Gross Margin | 5,000,000 | 5,000,000 |
| Selling, General & Administrative Expenses (SG&A) | ||
| Salaries | (2,500,000) | (2,500,000) |
| Rent | (100,000) | (100,000) |
| Professional and Legal | (100,000) | (100,000) |
| Total SG&A | (2,700,000) | (2,700,000) |
| Net Income | 2,300,000 | 2,300,000 |
| Taxable Income | 2,300,000 | 5,000,000 |
| Tax | 483,000 | 1,050,000 |
| After Tax Cash Flow | $1,817,000 | $1,250,000 |
When choosing to operate in the cannabis space it is very important to have a plan in place that accounts for tax liabilities.
What are things to consider when tax planning?
- Direct vs. indirect cost. Take advantage of cost of goods sold when you can (the only deduction for a cannabis business).
- The ownership structure of your company – in most cases this should be a C-Corp (but, not all so consult with your tax advisor before making any decision).
- Possibility to create multiple entities, where one may not be subject to 280E.
- Document everything. This is crucial! When trying to put as much into cost of goods sold as possible, documentation is key. This gives you proof for the IRS so you are not penalized. Great documentation provides for great tax planning opportunities!
- Plan to be audited. Another reason why it is crucial to keep great records. 16% of cannabis small businesses are audited compared to 1% in other industries.
- Find an expert who know section 280E inside and out, or you could cost yourself A LOT of money now, and/or in the future.
Ancillary Service Providers
An ancillary service provider is someone like DKB, who is servicing the industry. This could mean you are a real estate professional leasing space to a cannabis company, or a security firm providing monitoring services. The range of possibilities is endless.
How are ancillary service providers treated with respect to 280E?
Hmmmm….good question! We have compiled a couple examples of how 280E could impact ancillary service providers.
- If you are a management company who has the ability to execute transactions on behalf of an entity which is subject to 280E, you will likely also be subject to 280E.
- If you lease space to a restaurant and part of your lease agreement is the share of profits, you may want to rethink this if the restaurant provides cannabis products like infused brownies, cookies, etc. Taking a share of the profit may subject you to 280E.
Will all ancillary service providers be impacted? No.
Will over half be impacted? Probably.
Whether you are a cannabis company or an ancillary service provider, it’s crucial that you are working with your tax advisor to prepare for possible ramifications of 280E.
