CPA Chris Falco, of the Washington accounting firm Falco Sult, helps cannabis entrepreneurs understand Internal Revenue Code 280E.
Section 280E of the Internal Revenue Code forbids businesses from deducting otherwise ordinary business expenses from gross income associated with the “trafficking” of Schedule I or II substances, as defined by the Controlled Substances Act. The IRS has subsequently applied Section 280E to state-legal cannabis businesses, as cannabis is still a Schedule I substance.
“Although Internal Revenue Code 280E can be daunting, a deep understanding of which expenses can and cannot be deducted under the tax provision can help cannabis companies make better financial decisions and know what to expect when their taxes are due,” said Falco, a founding partner of Falco Sult.
The problem with taxation of cannabis businesses is primarily IRS Code Section 280E, which essentially punishes cannabis businesses with much higher tax rates because of them being engaged in trafficking of a Schedule 1 controlled substance. “However, cannabis companies are engaging many different strategies to minimize the tax effects of 280E,” added Falco. “One of the best strategies is to have a good understanding of 280E. Which of your expenses are either going to be cost of goods sold (COGS) in your cannabis business versus a potentially non-deductible expense? When you have a good understanding of that, you’re going to have the ability to make better financial decisions.”
Falco states that a lot of businesses don’t understand it enough, and get overly creative with both their corporate structuring and tax strategy. For example, there have been many businesses that have employed the strategy of a commonly owned management company. The understanding was that it would not be subjected to 280E, but a recent tax court case jeopardized this strategy and can certainly become an issue.
“As far as corporate structure, there are certainly things you want to be considerate of,” stressed Falco. “The type of license can determine how simple or complex you want to be in your tax strategy. Companies that are engaged in the manufacturing side, like cultivators or manufacturers of edible products or concentrates, will have most of their expenses fall under the category of cost of goods sold. They’re not going to be as affected by 280E if they’re engaged in manufacturing activities.”
The retail operations are where 280E really comes into play and how the corporate structure is set up may allow a business more options when it comes to the deductibility of other expenses. Cannabis business owners should have an understanding of how 280E is affecting their business as it relates to their disallowed expenses. Because of the ambiguity around deductible vs. nondeductible, the business owner must be very focused on implementing and maintaining a solid accounting system.
“Many times, I have seen even the best run operations fail miserably at investing in strong accounting procedures and reporting, including internal controls, which has made the process of taking maximum advantage of the deductibility rules difficult to defend in an audit,” concluded Falco. “You can be sure that the IRS will make a point to focus on cannabis businesses when it comes to audit potential. They know there is quite a bit of tax at stake with these companies and that the opportunity for additional tax assessment is great.”
About Falco Sult
Falco Sult looks at a business’ needs from a broad perspective by knowing where the company is in the business life cycle at all times and designing a plan accordingly. Falco Sult is a West Coast accounting firm serving clients nationwide. For more information, please call (425) 883-3111, or visit www.falcosult.com. The office is located at 16150 NE 85th Street, Suite 203, Redmond, WA 98052.
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