On March 30, the U.S. Treasury Inspector General for Tax Administration (TIGTA) released a report entitled: “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.”
In this report, TIGTA noted the problems that exist with taxation of cannabis businesses as a result of cannabis being illegal federally but legal in specific states. TIGTA estimated that the industry brought in revenue of $13 billion in 2019 and projected revenue of $25 billion in 2025.
Because of the rapid growth of the industry, TIGTA alluded to the likely increase of cannabis business tax audits. After a careful analysis of 237 cannabis business tax returns filed in California, Washington, and Oregon, as well as some statutory analysis of the Internal Revenue Code, TIGTA made recommendations to the IRS for how to approach cannabis audits and for guidance to provide to the public on how to comply with the tax code for cannabis businesses.
At the crux of the TIGTA report is the application of IRC 280E to cannabis businesses. Section 280E restricts businesses that carry on trade that “consists of trafficking in controlled substances” prohibited by federal law from deducting business expenses. Since cannabis is a schedule I controlled substance under the Controlled Substances Act, section 280E arguably restricts cannabis businesses from taking a deduction or credit for amounts paid or incurred the way most businesses can.
There are two main issues for cannabis business owners that are addressed in this report. The first is the extent of what qualifies as “cost of goods sold,” which unlike business expenses can be deducted from a business’s income, and what is a “business expense” restricted by section 280E.
There is no publicly available guidance on this issue from the IRS. The only interpretation was put forth internally by the Small Business/Self Employed Division of the IRS based on Treasury Regulation 1.471-11, which directed revenue agents who audit cannabis businesses to consider the cost of goods sold as direct cost of materials, direct cost of labor, and indirect costs, which may include maintenance, utilities, rent, etc.
However, costs like marketing, advertising, selling expenses, distribution, and interest expense would not be considered costs of goods sold and would instead be business expenses that cannabis businesses cannot deduct because of section 280E. That guidance was not part of a public release and is not an official regulation or position of the IRS.
The other significant issue highlighted in the TIGTA report is the interplay between section 280E and section 471 of the Tax Cuts and Jobs Act of 2017, which reduces the inventory tracking burden for “small” businesses that have gross receipts of $25 million or less on average over the prior three-year period. The concern of TIGTA is that some businesses that fall into this exemption may aggressively book expenses that would otherwise not be deductible under 280E as inventory expenses that could be deductible since 471 allows these businesses to use other accounting methods to book their inventory costs. As of now, the IRS has not issued any guidance on how these two sections apply to cannabis businesses and whether section 471 might provide an option to avoid the restriction in section 280E for deducting business expenses.
To illustrate the magnitude of the problem, TIGTA found that 59% of the tax returns it surveyed for the report included business expense deductions despite section 280E, which TIGTA estimated led to $48.5 million in unassessed taxes for the year of 2016 or $242.6 million when spread across a five-year period for those three states alone. TIGTA also discovered that 26% of cannabis businesses reviewed in the state of Washington either underreported income or failed to file a return.
The relevant takeaway for cannabis business owners is that the IRS is still adapting to deal with cannabis businesses. TIGTA provided the IRS with six recommendations, which focused on the development of a comprehensive compliance approach that provides clarity to taxpayers and IRS examiners that are specific to cannabis businesses and not just general cash businesses.
The only recommendation that the IRS declined was the recommendation to provide an answer on the interplay between sections 280E and 471, though the IRS did note that the IRS Chief Counsel would consider issuing some guidance on this issue after the 2019-2020 Priority Guidance Plan has been resolved.
Ultimately, whether it is through the courts or official guidance from the IRS, some clarity on these tax issues for cannabis businesses should be coming in the near future.
Kelly J. Shefferly is a member of the firm's Banking, Bankruptcy & Creditors' Rights and Transactional Law practice groups.
On behalf of his banking clients, Mr. Shefferly handles contracts and litigation, which includes ...
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