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Speaker: Understanding IRS Sec. 280E Vital for Thriving in Cannabis Industry

Chris Gaetano
Published Date:
Dec 11, 2018

With cannabis businesses unable to take the kinds of deductions any other firm would take for granted, Peter Metz, a principal at Grassi & Co., speaking at the Foundation for Accounting Education's Cannabis Industry Conference on Dec. 11, said that firms must understand IRS Code Section 280E in order to avoid a massive tax bill. 

Despite cannabis being legalized in many states, the federal government still considers it a Schedule 1 controlled substance. Because of this designation, the law does not allow cannabis industry firms to claim business expense deductions, unlike nearly every other business. A cannabis company, for example, cannot deduct advertising, insurance, marketing, rent, repairs, salaries, state taxes, utilities and many other expenses. The only item that such businesses can deduct is cost of goods sold, which is governed by Section 280E. 

"Why do we care? If we don't, we will face a large tax burden if we don't maximize cost of goods sold," he said. 

Metz said that one should use IRS Code Section 471, which concerns inventories, in order to calculate cost of goods sold. However, he also stressed the importance of keeping up to date with tax court case law, which further refines what is and is not deductible. 

For example, in the case Olive v. Commissioner, a business sold both cannabis products as well as non-cannabis-related amenities. Because of this, the company claimed business deductions, arguing that its non-cannabis offerings meant that it was not solely dealing in controlled substances and so therefore was not subject to 280E for the non-cannabis products. This argument was not convincing to the judge, however. 

"The problem was the taxpayer provided those amenities for free. ... So the court ruled that both activities were combined as a single cannabis activity, subject to 280E," said Metz. 

This is in contrast to another case,  Californians Helping to Alleviate Medical Problems, Inc. (CHAMP) v. Commissioner. This case involved a caregiver organization that also happened to sell cannabis, which would be smoked in a special room away from other patients. In this case, the court sided with the organization, as the caregiving was ruled to be a separate business expense from the cannabis, since that was not considered the primary business. This ruling meant that the organization could indeed split its business into the part that deals in controlled substances, which cannot claim deductions, and the medical caregiving business, which can. 

However, a more recent case, Laurel Alterman and William A. Gibson v. Commissioner of Internal Revenue, showed that there are limits to what can be separated out. Much like the other cases, this one involved a business that sold cannabis as well as non-cannabis products, and wanted to separate out the latter half for tax purposes. The tax court, ruled against them, however, because the non-cannabis products being offered were drug paraphernalia such as pipes and bongs. 

"The result was [that] the sale of pipes and paraphernalia complemented the business of cannabis sales, and therefore was considered part of the cannabis business," said Metz. 

He added that the owners were also penalized for very sloppy bookkeeping. 

Finally, a case that was decided at the end of November added proportionality to factors in determining whether a company can separate out non-cannabis aspects of its business. The case, Patients Mutual Assistance Collective Corporation d.b.a Harborside Health Center v. Commissioner of Internal Revenue, involved what Metz said was one of the largest marijuana dispensaries in the country, with over $25 million in sales last year. He said the company decided to apply the more broadly-based Sec. 263A for calculating cost of goods sold instead of Sec. 471, as it also sold non-cannabis therapeutic products. The court ruled against the company, he said, as the non-cannabis components of the business were a small fraction of overall activity and so were considered incidental. The court said this meant, despite the non-cannabis-related products and services, it was functionally a cannabis company and therefore subject to Sec. 471. 

Metz said that, as time goes on and the industry gains more acceptance throughout the country, he expects that the Sec. 280E will eventually be overturned. He noted that a Schedule 1 drug is defined partially by not having any accepted medical use. Since New York and other states allow medical cannabis, this implies that these states do see the substance as having medical value, and so therefore do not consider it to be a Schedule 1 drug. Over time, he said, the FDA will likely approve its use on a federal level, which would then releases it from its Schedule 1 designation. 

"But in the meantime, we have to comply with 280E," he said. 

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