Both the federal tax code as well as the soon-to-be-effective New York State cannabis tax rates will have a large impact on the state’s cannabis industry.

New York State legalized adult-use cannabis on March 31, 2021, under the Marijuana Regulation and Taxation Act (MRTA). Along with legalization came Article 20-C of the New York State Tax Law. Article 20-C, effective April 1, 2022, imposes the first U.S. THC potency excise tax. The excise tax is in addition to a 13% sales tax, which replaces the standard state and local sales tax rates.

The MRTA’s excise tax varies depending on the products sold by the distributor. A retailer will pay to a distributor an excise tax of $0.005/mg of THC for cannabis flower, $0.008/mg of THC for concentrates, and $0.03/mg of THC for consumables.

The 13% retail sales tax, paid by retail consumers and collected by retailers, will be allocated to both state and local governments. Of this 13%, 9% will go to the state and 4% will remain local; of the 4% percent, assuming there is at least one city, town, or village in a county that has remained opted in for retail sales, 1% will go to the county in which the retail sales took place and 3% will be split between the opted in cities, towns, and villages within the county in proportion to the sales of cannabis products by the retail dispensaries in those cities, towns, and villages.

Below are estimated tax rates and final retail costs, assuming a wholesale flower cost of $8.05/gm, which comprises the average wholesale prices in Massachusetts and Illinois (as of 2020), and a 100% percent retail mark up. The vaporizer cartridge wholesale price and gummy wholesale price are taken from averages from California, Colorado, Illinois, Massachusetts, Nevada, Oregon, and Washington.

If retail prices are in line with the above chart, that would place them around twice the illicit market prices. The effective rate above is included to demonstrate the increase in cost to the consumer. From a business perspective, the effective rate is complicated by Internal Revenue Code Section 280E.

The MRTA did not change New York State’s 7% medical cannabis excise tax.

It’s crucial for businesses operating within the cannabis sector to understand two significant Internal Revenue Code sections that specifically govern what deductions are allowable from a federal income tax perspective.

IRC Section 280E: Expenditures in Connection with the Illegal Sale of Drugs

The rules surrounding IRC Section 280E are very specific. Internal Revenue Code Section 280E states that 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 (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) that are prohibited by federal law or the law of any state in which such trade or business is conducted. All expenses, other than inventory costs governed under Section 471, are nondeductible for tax purposes for any business involved with the illegal sale of a controlled substance, which includes businesses operating within the cannabis sector.

No credits of any kind are allowed for businesses subject to 280E, including but not limited to the R&D credit, work opportunity tax credit, or FICA tip credit.

Simply put, anyone involved with trafficking a controlled substance, from seed to sale, would be subject to the nuances of 280E. Ancillary businesses, businesses that are providing products or services to the cannabis industry but are not plant touching, typically are not subject to 280E. Because 280E is unavoidable, it’s imperative to have a solid understanding of how this impacts a cannabis business.

Additionally, many states follow the federal tax code, meaning they also apply their own version of 280E. However, several states have decoupled from 280E, lessening, however slight, the effects of 280E. As of writing this article, bills are pending in the New York State Senate and Assembly to decouple from 280E.

Section 471: General Rules for Inventories

Whereas 280E governs the expenses that are not allowed for Cannabis companies, Section 471 governs the rules around inventory, and which expenses are includable as cost of goods sold and inventoriable costs.

Section 471-3 applies to retailers and dispensaries, and this Internal Revenue Code Section provides rules for determining the cost of merchandise on hand, and specifically states that inventory must be valued at cost. Cost of goods sold for a retailer and dispensary is limited to the cost of the product (using the inventory price), transportation costs, and costs to acquire the goods. If production is done to a product, more costs may be allocable under Section 471-11; however, nearly everything else is subject to 280E.

Cost of goods sold for cultivators, processors, and manufacturers includes all direct and indirect costs. Accrual and absorption costing is required to calculate the cost of goods sold. Allowable indirect costs are specifically identified and governed under Section 471-11. It is necessary to have a strong understanding of the indirect costs that are allowable as inventoriable costs, as these expenses can significantly impact a Cannabis companies overall tax position.

• Treasury Regulation Section 1.471-11(C)(2)(i) provides that the following indirect expenses must be included in inventoriable costs for cultivators, processors and manufacturers: repairs and maintenance; utilities such as heat, power and light; rent; indirect labor and related payroll taxes and fringe benefits; tools and equipment not capitalized; materials and supplies; and costs of qualify control and inspection.

   

• Treasury Regulation Section 1.471-11(C)(2)(ii) provides that the following indirect expenses cannot be included in inventoriable costs for cultivators, processors and manufacturers: marketing expenses; advertising expenses; selling expenses; other distribution expenses; interest; research and experimental expenses; losses under Section 165; depreciation and amortization reported for Federal income tax purposes in excess of depreciation reported by the taxpayer in the financial reports; general and administrative expenses incident to and necessary for the taxpayer’s activities as a whole rather than to production or manufacturing operations or processes; and salaries paid to officers attributable to the performance of services which are incident to and necessary for the taxpayer’s activities taken as a whole rather than to production or manufacturing operations or processes.

   

• Lastly, Treasury Regulation Section 1.471-11(C)(2)(iii) provides that the following indirect expenses can be included in inventoriable costs for cultivators, processors and manufacturers, but only if these costs are includable in inventoriable costs in the taxpayer’s financial reports and are in accordance with GAAP: taxes; depreciation and depletion; employee benefits; costs attributable to strikes, rework labor, scrap, and spoilage; factory administrative expenses (but not including any cost of selling or any return on capital) incident to and necessary for production or manufacturing operations or processes; officer’s salaries; and insurance costs.

IRC 280E and IRC 471-11 play a critical role in the overall tax position of a cannabis company. In order to remain in compliance, it is essential to have good record keeping and a solid understanding of what expenses are allowable and the intricacies involved with calculating cost of goods sold.

The draconian nature of Section 280E has led to tax rates in the cannabis industry ranging from approximately 50% (cultivators and processors who can include more into cost of goods sold (COGS) to 90% (typically, retail establishments).

All of this adds up to a high likelihood of an IRS audit. In 2013, with solely medical cannabis legalized in a few states, the IRS determined that the average per hour recovery for IRS work in mainstream businesses was $493. For cannabis business, the average per hour recovery was $1,375.

The higher price of legal cannabis, combined with Section 280E, has led to various lawsuits, mostly alleging that Section 280E violates the U.S. Constitution. Cases have argued that 280E violates the Sixteenth Amendment insofar as certain “ordinary and necessary expenses” are actually exclusions that, like COGS, must be subtracted from gross income. Alpenglow Botanicals, LLC v. United States, 894 F.3d 1187 (10th Cir. 2018), cert. denied, 139 S. Ct. 2745 (June 24, 2019). Further, the taxpayer in Alpenglow argued that 280E violates the Eighth Amendment prohibition on excessive fines. The Tenth Circuit Court of Appeals rejected both arguments, holding that the deductions are a matter of legislative grace and that taxable income is calculated on gross income minus permitted deductions, and further, “the disallowance of a deduction is not an exaction imposed as punishment.” See also Patients Mut. Assistance Collective Corp. v. Comm’r, 995 F.3d 671 (9th Cir. 2021) (Sixteenth Amendment issue not considered on appeal); Standing Akimbo, LLC v. United States, 955 F.3d 1146 (10th Cir. 2020) (IRS did not exceed its summons powers and 280E did not violate the Sixteenth Amendment); Northern California Small Business Assistants Inc. v. C.I.R., 153 T.C. No. 4 (Oct. 23, 2019) (Sec. 280E does not violate the Eighth Amendment).

At the federal level, it appears the general sentiment is that until there is a legislative change or cannabis is not a Schedule I or II controlled substance, the tax impacts of 280E will continue to be felt by the cannabis industry. In New York State, the combination of 280E and complicated THC potency taxes, resulting in some of the highest cannabis tax rates in the nation, will continue to be an issue for industry participants that will make competition with the illicit market difficult.

Jason Klimek, Esq., is Barclay Damon’s cannabis team co-leader. His practice focuses on the nuanced processes of structuring, licensing, and maintaining compliant cannabis businesses at the federal, state, and local levels. He also has extensive experience advising clients on various complex federal and state tax compliance issues affecting cannabis-touching businesses.

Kara Cline, CPA, is a director in EFPR Group’s tax and business services department. She is a member of the firm’s multi-state taxation group, providing multi-state tax consulting and compliance services to clients. She is also a member of the firm’s international tax division, assisting individuals and businesses with U.S. tax issues.