Internal Revenue Code for Cannabis Businesses
An Introduction to the Internal Revenue Code
Under the tax code, gross income means income derived from any source. 26 U.S.C. § 61(a). Gross income includes salaries, lottery earnings, and pensions. Congress drafted § 61(a) broadly with the intent to capture all sources of income. Gross income further includes all earnings from businesses. However, Congress also realized that not all gross income should be taxed. Congress reasoned that for businesses to operate, they must pay for supplies and operating expenses. Congress wanted businesses to grow and expand, so they created tax deductions and credits businesses could earn to encourage innovation and growth.
To promote growth, businesses can deduct supplies and operating expenses from their taxable income. At the end of the taxable year, businesses are not taxed on their gross income but rather their adjusted gross income (AGI). 26 U.S.C. § 62(a)(1). AGI is determined by subtracting all applicable deductions and credits from your gross income. Specifically, for businesses, provision § 162 allows for the deductions of “all necessary and ordinary expenses” paid or incurred during the taxable year for a business. 26. U.S.C. § 162(a)(1).
For example, an extremely profitable dry-cleaning business that makes $300,000 a year can deduct from its taxable income the money it paid to its employees and the supplies used to run the business. Hypothetically, assume the salaries and supplies cumulatively cost $200,000 for the dry-cleaning business. The $300,000 is considered the gross income under § 61(a), and § 162 acts as a deduction for all necessary and ordinary expenses incurred by the dry-cleaners. The AGI would therefore be $100,000 since it could deduct the $200,000 under § 162. Once the AGI has been determined, the dry-cleaner is taxed on its’ taxable income of $100,000. The dry-cleaner would pay roughly $22,250 in taxes from its $100,000 of taxable income.
Marijuana-related businesses face an additional hurdle other businesses do not. Congress specifically implemented § 280E to prevent any business trafficking illegal drugs from receiving deductions. 26 U.S.C. §280E. The provision prohibits any deductions or credits to businesses trafficking schedule I or II illegal drugs within the meaning of the Controlled Substances Act of 1970. Marijuana is currently classified as a schedule I drug. Because marijuana-related businesses such as dispensaries or farmers traffic marijuana they either are not applicable for any tax deductions under § 162 or are extremely limited on what they can deduct.
The IRS’ current stance on what marijuana-related businesses can deduct is summarized in Chief Counsel Advice 201504011. It allows for marijuana businesses to deduct some of their cost of goods sold (COGS). The memo allows for deductions under § 471 as long as they comply with § 280E. § 471 allows for the inventoriable cost of any good that can be capitalized to be deductible. 26 U.S.C. § 471. Meaning, raw materials or labor costs are deductible because they are used within a year to create a product. Although the IRS updated the tax code with § 263A to permit additional expenses included under inventoriable cost, the IRS memo prohibits marijuana-related businesses from using § 263A in their calculation of COGS.
§ 471 allows for the deduction of production costs to the extent they are incidental and necessary for production. 26 U.S.C. § 471. § 471 can further be broken down into direct (§ 471(b)(2)) and indirect (§ 471(b)(3)) production costs. Direct production costs include materials needed for production, labor costs, and basic compensation. However, § 471(b)(2) does not apply to marijuana-related businesses because of § 280E. The second half of § 471 is applicable because of Chief Counsel Advice 201504011. Indirect production costs include rent and property taxes, janitorial supplies, and utilities. 26 U.S.C. § 471(b)(3). § 471(b)(3) is further limited by § 471(c)(2)(ii) which explicitly states costs that are not deductible such as marketing expenses, research, and salaries based on performance.
The IRS memo separates marijuana businesses into resellers and producers. For resellers, meaning any dispensary, the only deductions they can claim are for the invoice price of purchased marijuana and the transportation costs necessary to gain possession of marijuana. Chief Counsel Advice 201504011 at 6. Producers are allowed to deduct indirect production costs which has been construed broadly to allow for deduction of: repairs, maintenance, indirect labor and supplies, and the costs of quality control. Id. This memo allows some deductions for emerging marijuana businesses, but the costs of operating still are burdensome. Because no direct costs are deductible, marijuana-related businesses still face anywhere between a 40-70% tax rate.
To put into perspective § 280E’s effect, a marijuana dispensary that makes identical profit to the dry-cleaner example before but is located in Denver, Colorado is taxed differently. Holding the facts the same as the dry-cleaner, the dispensary has salary and supply expenses worth $200,000. The AGI is higher because § 280E prevents direct production deductions, but § 471 allows for minor deductions. Because the dispensary is directly related in the traffic of marijuana (by selling it) their deductions are small and can be estimated to be around $40,000 (only 20% of what they normally would be able to deduct under § 162). The AGI of the dispensary is $260,000. Because the dispensary’s AGI is higher than the dry-cleaners, the dispensary is in a higher taxable income bracket and must pay a base of 39% instead of 34%. On top of the federal income tax, the business must pay a state retail marijuana sales tax rate of 15%, an excise tax of 15%, and a state sales tax of 2.9%. In total, the additional 32.9% is not deductible and limits the profits of dispensaries1.
The dispensary’s $260,000 AGI results in $101,400 taxed income, nearly five times greater than the regular dry-cleaner business because of § 280E. This violates horizontal equity because the two businesses, even though they produce the same income and expenses, are taxed differently. Horizontal equity is a principal that states two similar tax-entities should be taxed equally. If marijuana were rescheduled, the disparate treatment would be corrected because it would allow marijuana-related businesses to deduct their ordinary and necessary business expenses. 26 U.S.C. § 162. However, under the current code, Congress has explicitly shown it does not find marijuana businesses to be beneficial and has created tax barriers for the marijuana industry.
1 Marijuana Tax Data, https://www.colorado.gov/pacific/revenue/colorado-marijuana-tax-data (last visited Dec. 7, 2017).