The cannabis industry’s boom is showing no signs of slowing down. As of 2022, more than three-quarters of the United States has legalized marijuana for either recreational or medicinal use – and among those who had previously only approved it for medical use, many are expanding into recreational sales – ultimately growing the sector into a $61 billion industry.
But many pitfalls still lay in the path of would-be cannabis entrepreneurs, not least of which is the federal government’s continued reluctance to follow states’ lead. There has been some promising movement on this front with the House of Representatives recently passing a bill to legalize cannabis – but until that bill becomes law, marijuana is still considered a Schedule 1 controlled substance by the federal government, which can create many hurdles for cannabis businesses.
Chief among those hurdles is a tax regime that leaves cannabis entrepreneurs at a distinct disadvantage. The Internal Revenue Code dictates how businesses can deduct expenses – and many deductions available to other businesses simply aren’t for the cannabis sector. As a result, it’s more important than ever for entrepreneurs to be smart about how they set up their cannabis business to minimize the loss of these key tax deductions and stay well within the bounds of both state and federal laws.
What you need to know about Section 280E
Section 280E of the Internal Revenue Code prevents cannabis businesses from deducting many common business expenses (or using applicable tax credits) when determining their taxable income. For example, a consumer-packaged goods company that hires an accounting firm to handle its taxes can deduct that expense when determining its net income for the year. Unfortunately, with marijuana remaining illegal at the federal level, cannabis businesses do not have this luxury; they are only allowed to subtract cost of goods sold (COGS) from their revenue when determining their federal tax liability. Thus, they have fewer business operational expenses at their disposal for reducing their tax burden than more traditional businesses.
That can lead to a crippling federal tax bill, and can even result in a cannabis business owing federal taxes despite having a net loss in a given tax year. How a business calculates COGS, then, can make all the difference between a good financial year and a bad one. That’s where Section 471 comes into play.
Section 471: Determining COGS for cannabis businesses
Regulations under Section 471 of the tax code lay out the framework for calculating COGS, including, according to the IRS, for cannabis businesses. A company’s specific business model – that is, whether it’s a distributor, a dispensary, or a producer/grower – determines how this calculation is made. Section 1.471-3(b) applies to distributors, while Section 1.471-3(c) applies to producers.
Per Section 1.47-3(b), COGS for a distribution business would amount to what the business pays a producer for cannabis, as well as the cost of bringing the product to the distributor. COGS for producers under Section 1.471-3(c), however, comprises expenses including direct material costs, direct labor, certain identifiable overhead costs, insurance, rent, utilities, and other costs necessary for the production of the product. There are opportunities and a little more wiggle room for deductions.
Structuring a cannabis business for success
It’s clear that, unlike non-cannabis businesses, cannabis entrepreneurs have fewer options for reducing their tax liability. Knowing this, it is vital for these business owners to focus on the structure of their business as the primary means of minimizing their tax bill.
Most entrepreneurs opt to structure their business legally as a limited liability corporation (LLC). However, there are two options for reporting taxes within this category: Either as a flow-through entity or a tax-paying entity. Each has its advantages and disadvantages.
Flow-through entities are taxed only at the individual owner level; cash distributions of taxable income are not taxed again. However, this means income is taxed at individual rates, which can be as high as 37%. In addition, individual owners will receive an annual K-1 for their share of income related to the company (including all of those non-deductible expenses), which may result in a higher taxable income rate than a tax paying entity.
A tax-paying entity (most often a C corporation), however, pays taxes at the lower federal corporate tax rate of 21%, and individual owners would not receive an annual Schedule K-1 form for tax reporting unless they receive a distribution of cash or property out of the company. However, those who do receive a distribution or dividends from the company could see an additional level of federal taxation anywhere from 15% to 23.8%.
There is no single “correct” structure for every cannabis business
It can be a tall order for any cannabis start-up to determine which business structure will be most beneficial to them long-term. The best way to make heads or tails of your options is to strategize and project out each scenario – how will your unique expenses and lack of deductions affect you and other stakeholders in the business? – and base your decision off of the analysis . Here are a few additional factors you will need to consider as well:
- Does your company both produce and distribute cannabis? If so, you may need multiple licenses, and to create separate divisions within the company or entities to operate within Section 280E’s limitations.
- Co-mingling divisions’ finances could cause the IRS to disallow all deductions across the company. It is important to create boundaries to ensure this doesn’t happen.
- The IRS will not be shy about auditing cannabis businesses – so it is essential to keep your books straight and follow the law to the letter, and to be prepared at all times for an audit.
Setting up a cannabis business is, in many ways, more time and resource-intensive than setting up a business in a less complicated (from a tax and legal perspective) industry. But “doing it right” is essential not only for long-term success, but also to navigate a rapidly evolving and often controversial regulatory environment. Those entrepreneurs who take the time to be thoughtful, deliberate and disciplined in their approach are likely to be the winners as the march to full legalization continues.