Internal Revenue Code Section 280E was drafted in order to disallow ordinary business deductions to any business that was deemed to be trafficking in a controlled substance. The legislative history of this law demonstrates the provision was aimed at illegal businesses; enactment was two decades prior to the relatively recent advent of state-approved marijuana businesses. Unfortunately, the law was written in a manner that requires the IRS to enforce its provisions even against state-approved marijuana businesses. Section 280E reads:

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) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Taken literally and applied without planning, this provision makes it uneconomical to operate any marijuana business where selling activities or salesmanship is a material activity of the overall business. More on this later in this article.

It is important to understand the limits of this provision. The Internal Revenue Code, Title 26 of the US Code, was enacted by Congress pursuant to the 16th Amendment to the US Constitution which granted Congress the power to tax income. Congress does not have the power to tax revenue under Title 26. The difference between “income” and “revenue” is generally called “Cost of Goods Sold” or COGS. IRC Section 61 defines gross revenue and IRC Section 471 helps to define what may be treated as COGS. The U.S. Tax Court has ruled that Section 471 and Section 61 “walk hand-in-hand down the aisle together” in determining the starting point for purposes of the Internal Revenue Code. Thus, any cost that may be legitimately treated as COGS is not subject to the disallowance provisions of Section 280E.

This is very important to understand. Because Section 280E cannot be applied to COGS, this creates two very different tax situations depending on whether the business is strictly wholesaling or strictly retailing. For businesses that produce marijuana products (cultivation of raw flowers, extraction of marijuana concentrates, manufacturing of marijuana edibles and disposable vape cartridges) and that sell them only on a wholesale basis, the added tax cost of Section 280E can be quite manageable. It is crucial that the business employ a very knowledgeable accountant to assist with their selection of their methods of accounting for inventory. This accountant will know the task is to apply full-absorption cost accounting principles to treat as many costs as possible as inventory rather than as period costs. If done properly, the business will have to wait until the inventory is actually sold before they can claim costs as reductions of revenue, but at least the revenue reductions will be allowed. Also for the wholesalers, there are many unique structuring techniques that can be applied to minimize the tax pain of Section 280E. Again, an accountant familiar with the marijuana industry should be employed at the early stages to assist with these structuring techniques: these include using put contracts where the buyer is obligated to purchase all of the production and using FOB Origination Point shipping terms, to name just a couple of these techniques.

Retailers of marijuana products are in a more difficult situation, since most of their daily activities involve advertising, selling and salesmanship. Section 280E is aimed directly at disallowing these types of costs. The knowledgeable cost accountant will again attempt to classify as many costs as possible as related to inventory, but this is an area of uncharted waters. For this reason, risk-averse operators should avoid marijuana retailing businesses; those who venture should be aware of the risks and hire the most industry-knowledgeable accountant they can find.

And if the above is not sufficient to scare you off, then consider the rules for dealing in cash and reporting cash payments under FinCEN Form 8300 filing requirements: marijuana businesses are often denied access to traditional banking services. Yes, the new marijuana industry has lots of treasure, but the treasure is sunken in shark-infested tax-waters.

*Luigi Zamarra is a Certified Public Accountant in Oakland, CA who specializes in the marijuana industry. A graduate of the University of Virginia business school and formerly a Director with PricewaterhouseCoopers, he was the Chief Financial Officer of Harborside Health Center, one of the largest marijuana retailers. He currently practices public accounting for a variety of marijuana businesses including cultivators, manufacturers and retailers.