The sweeping national trend toward the relaxation of cannabis prohibition laws at the state level continues to gain momentum in 2019, with Illinois recently becoming the 11th state to legalize recreational usage. Over the past several months, even the federal government has begun taking measured steps to loosen restrictions on the sale of cannabinoids (CBDs).

With broader societal acceptance, venture financing and public offerings (albeit generally in cannabis-friendly Canada) of cannabis and ancillary businesses has exploded in recent years. The introduction of equity investment has resulted in the need for audited financial statements, including a tax provision.

The Dreaded Sec. 280E

By now, almost every person in the cannabis industry is familiar with Section 280E of the Internal Revenue Code. Consisting of just one sentence and enacted during the “Just Say No” years of the early Reagan administration, this stipulation states: “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.” As a Schedule I substance, cannabis (other than CBD in certain cases) falls within this section. To date, no underlying regulations to Sec. 280E have been drafted.

Why was this provision established for otherwise illegal activities? The IRS requires that gross income be reported from any source in which it is derived (Sec. 61). As such, any income generated from the sale of cannabis, even though it is classified as an illegal substance, must be reported for federal tax purposes. The federal government realized years ago that it was easier to prove tax evasion than the criminal act itself (think Al Capone). Consequently, drug traffickers became smart and began paying their taxes and filing tax returns. By disallowing deductions, Sec. 280E became a countermeasure to ensure that involvement in these activities would be less lucrative.

The Chess Game Continues

Thanks to the 16th Amendment, which allows for the federal taxation of income (not gross receipts), Sec. 280E cannot disallow a deduction for cost of goods sold (COGS). COGS is not considered an expense under prevailing tax law but rather a component of gross income; hence, the IRS is unable to disallow the actual cost of inventory. Instead, all other deductions normally allowed in a for-profit business (such as wages, rent, etc.) are specifically excluded by Sec. 280E.

This rule turns traditional tax planning on its head for cannabis companies. Taxpayers typically want to deduct expenses as quickly as possible. The IRS, however, usually prefers taxpayers to capitalize as much costs into inventory as possible, as doing so pushes an otherwise immediate deduction into a future period. Nevertheless, in the world of cannabis where it can be both legal and illegal, nothing appears to be black and white.

To maximize the COGS deduction, a well-known tax planning strategy for cannabis companies is to group as many costs as possible into inventory. Taxpayers initially did this by taking advantage of Sec. 263A, a government revenue generator from the 1986 Tax Act, which requires the capitalization of certain otherwise deductible expenses into tax inventories.

In 2011, the IRS provided guidance to support the position that Sec. 263A could not be utilized by cannabis companies. Rather, the less beneficial Sec. 471 (i.e., direct material costs, direct labor costs and allocated indirect costs) would only be applicable, thus validating Sec. 263A as not a means to turn an otherwise nondeductible expense into a deductible one (as evidenced by the recently Harborside case in which the Tax Court sided with the IRS on this matter). Nonetheless, planning opportunities to profit from costs under Sec. 471 still exist today.

Another common strategy involves separating the Sec. 280E tainted cannabis businesses from the non-280E ones. Numerous cases have been litigated in this area since the taxpayer-friendly ruling in California Helping to Alleviate Medical Problems, Inc. (CHAMP). A string of IRS victories has resulted since the CHAMP case, most recently involving Alternative Healthcare Advocates, where the Tax Court found that management companies with the same ownership structure as cannabis dispensaries were subject to Sec. 280E. These cases have largely been determined based on taxpayer facts and circumstances, but taxpayers need to tread carefully because of IRS success in this area.

Finally, Some Good News

Some solace can be found in the Tax Cuts and Jobs Act of 2017 (TCJA), which reduced the corporate tax rate from 35% to 21%. Given the limited deductions that can be claimed, this rate reduction provides significant relief to cannabis companies operating in a corporate form.

The IRS provides additional relief (from a 2015 ruling) that allows cannabis companies to deduct the considerable state excise taxes imposed on all stages in the vertical (producers, processors and retailers). In that 2015 case, the taxpayer who paid the State of Washington excise tax was permitted to treat the expenditure as a reduction in the amount realized on the sale of the property.

At the state level, cannabis companies can take small comfort in the fact that states where recreational cannabis is legal generally do not conform to Sec. 280E. For example, California permits corporations in the cannabis industry both deductions and credits, which alleviates some of the otherwise draconian impacts of Sec. 280E.

Of course, cannabis taxpayers can always hope that Sec. 280E will eventually be repealed. To prepare for this potential scenario, cannabis companies should engage in practical planning strategies, such as capitalizing on as many costs as possible and depreciating assets straight-line over the Alternative Depreciation System. Additionally, protective filings may be considered to extend the statute in earlier years in the event that a favorable law or ruling can be retroactively applied.

What Does This Mean to the Financial Statements?

As a permanent unfavorable tax adjustment, Sec. 280E typically significantly increases a corporation’s effective tax rate. Take two similarly situated businesses – one that sells cannabis and another that sells alcohol. Assuming revenues of $1,000, COGS of $300 and operating expenses of $500, the federal effective tax rate for the cannabis company is 73.5% versus 21% for the alcohol company.

Cannabis companies must also assess and accrue for any uncertain tax positions pursuant to ASC 740-10 or similar IFRS rules. Areas of potential risk for a cannabis company may include:

• Inventory capitalization methods
• State nexus
• Transfer pricing with a related management company
• Whether ancillary cannabis business activities may rise to the level of trafficking
• Whether related businesses may be tainted by Sec. 280E
• Failure to file penalties for Form 8300 to report cash payments over $10,000 or other tax forms
• Sale of CBD which does not meet the Schedule I exceptions in the 2018 Farm Bill

Due to legality in Canada and other countries, many cannabis companies maintain their books in accordance with IFRS. This results in differing treatment of tax reserves relative to U.S. GAAP. For example, tax reserves under IFRS are measured on a probability basis versus the more likely than not technical standards of ASC 740-10.

Alvarez & Marsal Taxand Says

While the legalization of cannabis has created tremendous business opportunities, proper application of income tax accounting rules can prove challenging for the unwary. While effective tax rates are significantly higher than other industries, some of this impact may be mitigated with proactive tax planning.