As cannabis has been legalized in state after state the industry has attracted entrepreneurs, becoming a rapid-growth industry with unique challenges. This situation has set the stage for an interesting debate among companies that typically serve clients in the consumer goods sector. While the court of public opinion is moving toward legalization, so far US Federal law has not been swayed by the trend, and there are potential tax implications that need to be considered.
Federal Tax Law Regarding Controlled Substances
The current situation dates back to the early 1980s. A 1981 court case called Jeffrey Edmondson vs Commissioner ruled that even though Edmondson had been convicted of trafficking in cocaine and cannabis he could deduct business expenses since they were incurred in his trade or business. The legal finding was an afront to the war on drugs that Congress and the administration at the time were fighting. That ruling caused an addition to the pre-1987 Internal Revenue Code, known as IRC Section 280E, which 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.”
In simple terms, 280E forbids businesses from deducting business expenses, other than cost of goods sold, from income if the taxpayer’s trade or business is associated with the trafficking of Schedule I or II substances, as defined by the Controlled Substances Act.
The question under increasing debate is where the scope of 280E begins and ends. The IRS and the Tax Courts have not added any clarity to this debate. As the industry grows and additional cases are heard by the courts, the interpretation of 280E, and what businesses it can be applied to, has varied wildly. Some decisions have allowed a segregation of business activities, where others have collapsed entire structures and applied the restrictions of 280E to the entire organization, regardless of the structure or trade or business of the various entities.
Cannabis companies operating in a state that has legalized marijuana have the same needs as any other producer of goods. They need packaging, warehousing, transportation, possibly retail space, and so on. Are the providers of these services vulnerable to the restrictions that apply to the cannabis company itself?
Consumer goods companies need a myriad of supplies and professional services to operate effectively, and there is no shortage of providers that want to break into the cannabis space. They, the providers, see it as the next major boom industry to the economy in the U.S. and the world. However, their concern is where the limitations of 280E stop.
A common thought is that the touching of the cannabis plant is a deciding factor in the application of Sec. 280E, but this is not how the code section reads. The language of the section states clearly that the trade or business of the taxpayer must be the trafficking of a controlled substance to be subjected to the expense limitations of Sec. 280E. The judicial definition of trafficking is the crime of selling, transporting, or illegally importing unlawful controlled substances, such as heroin, cocaine, marijuana, or other illegal drugs. Using the language of the section and the judicial definition gives the appearance of a bright line test for the application of Sec. 280E.
How would this affect your business if you are thinking of serving the cannabis industry? The case studies below illustrate thoughts that should be considered.
Case Study #1: Commercial Rental Real Estate
Commercial warehouse space is a necessary element in the cannabis industry. If the cannabis company is looking to lease, rather than own their own real estate space, they typically have trouble finding a lessor that is willing to lease to them, with one of the top reasons being what negative IRS impact will it have on their business.
Using the discussion above, we would first look at the trade or business of the service provider. In the case at hand, the trade or business of the lessor would typically be commercial rental real estate. The company’s income is derived from its real estate asset, and not the trafficking of a controlled substance. Therefore, in the true, literal, reading of the code section, the lessor’s business should be exempt from the provisions of 280E.
Case Study #2: Laboratories
Production of a consumable product, such as cannabis, requires testing to ensure public safety. To ensure unbiased results, companies may use third party laboratories to test and report on the products produced. The question that arises from their activity relates to the fact that the laboratories actually touch the product. Does the physical touch and handling of the cannabis product give rise to the restrictions of Sec. 280E?
We once again go back to what is the trade or business of the laboratory. In this case, the laboratory was an unrelated third party service provider whose trade or business was the scientific testing of products. They did not sell, distribute, or perform any other activity with the products that they were testing that could be construed as meeting the definition of trafficking of a controlled substance. Therefore, the laboratory should be exempt from the provisions of 280E.
With medical marijuana legal in 33 states and recreational marijuana legal in 11 states, the trend toward legalization continues to play out in state legislatures. Eventually a conversation will have to take place at the federal level about whether a substance that is legal in so many states should still be on the list of controlled substances, or if Sec. 280E be amended to preclude marijuana from the application.
Your tax advisors at Frazier & Deeter will continue to monitor this situation.
About the Author
Matthew K. Foster, CPA
Matthew Foster is a Partner in the Atlanta and Las Vegas office tax practices and serves as Co-Chair for the firm’s Manufacturing & Distribution Group. He has over a decade of experience in public accounting, with the majority spent practicing at Frazier & Deeter, LLC. This experience has allowed him to help his clients with various opportunities, such as corporate structuring for tax strategies, mergers and acquisitions, planning, and other complex situations. His clients operate in a variety of industries including, but not limited to, manufacturing, distribution, technology, real estate and construction.