The Ultimate Guide to Taxation Pitfalls of the Cannabis Industry

Introduction: Is Cannabis a Legitimate Industry?

Despite recent legalization in 19 states, Washington D.C. and Guam, cannabis remains a lucrative and highly scrutinized industry. Regardless of what capacity they operate in, prevalent studies have shown that cannabis businesses are more frequently audited by the IRS than any other industry.

In addition, due to strict regulatory laws and rigid tax codes, the cannabis industry is also required to pay a higher portion of revenue in taxes – sometimes up to 80%.

As a result, it is imperative that those who wish to operate cannabis-dependent businesses are educated about potential tax pitfalls that can lead to audits and how to address them.

Why is Cannabis so Heavily Regulated?

Although the exact reason remains unknown, the IRS doesn’t believe that the cannabis business is a legitimate industry.

This perspective stems from the fact that although cannabis has been legalized in numerous states, the federal government still classifies it as a Schedule I banned substance, as it has a high likelihood of abuse and no currently accepted medical usage. See “Federal Drug Administration and Cannabis: Research and Drug Approval Process” (October 1, 2020).

As far as the federal government is concerned, the sale of cannabis continues to be illegal. This means that the production, distribution, and possession of cannabis also remains illegal, except in the narrow context of federally approved research studies.

However, business owners that generate income from cannabis are still required to pay taxes, even though it is treated as an “illegal source.” James v. United States, 366 U.S. 213, 218 (1961). 

More recently, federal courts have consistently upheld that state compliant cannabis dispensaries have taxable income. Olive v. Commissioner, 792 F.3d 1146 (9th Cir. 2015); Feinberg v. Commissioner, 916 F.3d 1330 (10th Cir. 2019); Beck v. Commissioner, T.C. Memo. 2015-149.

Because the federal government still considers cannabis to be an illegal substance, the tax laws and regulations surrounding income derived from cannabis sales differ vastly from those that concern legal businesses.

The reason why cannabis is such a highly regulated industry turns on Internal Revenue Code (IRC) § 280 (E) (“§ 280 (E)”), which denies deductions and credits for amounts paid or incurred while in the business of trafficking controlled substances in violation of federal or state law.

Section 280 (E) was developed in the 1980s to prevent drug dealers from making deductions related to trafficking controlled substances.

Consistent with cannabis classification as a Schedule I controlled substance, § 280 (E) forbids business owners from taking tax deductions and claiming tax credits attributable to cannabis businesses – deductions that their mainstream counterparts are able to take advantage of. See Congressional Research Service’s Publication, “the Application of Internal Revenue Code Section 280E to Marijuana Businesses: Selected Legal Issues,” Report No. R46709 (March 10, 2021).

The Cost of Goods Factor

Cannabis business owners may offset their gross income factoring in the cost of goods sold. Cost of goods sold (“COGS”) refers to “expenditures necessary to acquire, construct or extract a physical product which is to be sold.”

COGS include:

1. The cost of raw materials and supplies consumed in connection with the produce,
2. expenditures for direct labor, and
3. indirect production costs necessary to produce the item including an appropriate portion of management expense.

To simply further, this deduction includes expenses such as labor, materials and supplies, and facility utilities. It does NOT include the cost of selling goods, such as budtender wages, expenses for retail space, or advertising costs.

Section 280 (E) typically results in state-legal-cannabis businesses having to pay astronomical federal tax rates – as much as 80%  to 100% in many cases.