Cannabis Industry Ordinary and Necessary Business Expenses Limited by IRS

Internal Revenue Code Section 280E does not allow for the deduction of ordinary and necessary business deductions for any trade or business that consists of trafficking in controlled substances within the meaning of schedule I and II of the Controlled Substances Act. Marijuana and products derived from marijuana are subject to this section of the IRS Code. This includes, but is not limited to, deductions for advertising, labor, rent, administration, professional fees, among other expenses that a “normal” business is entitled to take.

The IRS is actively enforcing IRS Code 280E across the country, which is resulting in marijuana operations paying substantial amounts of additional, unanticipated taxes, penalties, and interest. A reseller of marijuana is only entitled to deduct Cost of Goods Sold (COGS) in arriving at taxable income, which means the price paid for the product and reasonable transportation costs to retrieve said product. Producers of marijuana are entitled to a few more deductions, but bear in mind, the only expenses that are deductible are those crucial to producing the end product.

Cannabis operators should evaluate whether they can take steps to isolate different lines of businesses that operate under the same roof. The benefit of isolating different lines of business would be to allow the non-cannabis business to potentially avoid being limited by IRC Sec. 280E as to the business lines that don’t directly “touch the plant,” thereby creating the ability to deduct all ordinary and necessary business expenses for the eligible line or lines of business. The services of the isolated business must be substantially different from and stand on their own, separate and apart from dispensing marijuana to be considered another business.

The test of whether a separate line of business exists is facts-and-circumstances based. Some things to consider include:

  • The company has created a separate legal entity;
  • The company has its own dedicated space in the facility;
  • The company has its own separate books and records;
  • There are separate employees between the businesses; and
  • The percentage of overall revenue derived from the non-cannabis business.

The Tax Court has previously stated there can be more than one line of business under the roof of a dispensary. The mere presence of one federally illegal business does not negate the expenses related to the legal business. (Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173.)

A number of significant tax planning opportunities nevertheless remain in this landscape concerning the nexus of IRS Code and cannabis businesses.