State legislation has now been passed in 30 states to legalize cannabis for medical or recreational purposes. As cannabis was becoming legalized, entrepreneurs who were eager to invest in new markets began opening dispensaries. Once it became time for businesses to file their taxes, unforeseen tax implications led to Tax Court cases that are now being used as future guidance.
Several tax implications that have cropped up in the cannabis industry revolve around the substance being illegal under federal law. Code Section 280E, for example, was put into place because the federal government does not want you deducting business expenses that were incurred while performing a federally illegal business activity. To outline this reality, T.C. Memo. 2018-83 explains how this code section disallows all business expenses other than cost of goods sold in the computation of taxable income.
The true take away from T.C. Memo. 2018-83 is that while ordinary business expenses related to a federally illegal business are disallowed, they are allowed to deduct their costs of goods sold. Since the only allowable expenses are those that can be capitalized in inventory, which is part of the cost of goods sold calculation, it is essential for business owners in this industry to understand what costs can be capitalized into inventory in order to maximize their allowable deductions.
Another tax issue many dispensaries may face involves operating separate and distinct business segments while one segment involves selling cannabis. For example, if the owner of a coffee shop in Colorado decides that he wants to also become a dispensary, it would be very important to keep track of which business expenses relate to which source of revenue. If separate books are not kept to differentiate expenses, the IRS could decide to disallow expenses which may have been allowable if separate books were kept.
The idea of separating business segments becomes even more important when the company primarily generates revenue through cannabis sales. In T.C. Memo. 2018-83, the Tax Court found that Altermeds, LLC, whose primary revenue source came from the sale of cannabis, was not allowed to deduct business expenses relating to the sale of pipes and other paraphernalia because it was seen as only a supplement to their cannabis sales. One way Altermeds, LLC would have had a better chance at winning their case would have been to create Alterproducts, LLC and sell their other merchandise in a separate business entirely.
Another tax implication to consider revolves around doing business as an S Corporation. If a business owner decides to materially participate in the operations of the business and receives a salary, they are subjecting themselves to double taxation. This occurs because not only would taxes be paid on the salary taken by the owner, but they would also pay more taxes on flow-through income on their K-1 since the salary expense is not deductible.
Keeping up to date with Tax Court rulings, memos, and regulations can be cumbersome, but it is very important if you want your business to succeed. If you require assistance with starting up a business in this industry, finding different ways to maximize your allowable business deductions or other tax matters, please reach out to Larry Rubin or one of our tax advisors at 301.231.6200, and keep an eye out for future Aronson blog posts regarding the sale of cannabis.