California has the largest legal marijuana market in the world and is on track to post a record $3.1 billion in cannabis sales this year, representing a 23% increase over 2018. As CPA’s and business advisors, one of the increasingly common questions we get from clients is how they can get involved in this burgeoning market.
However, tax law is not very friendly to cannabis companies. With marijuana’s classification as a Schedule I drug, the industry is subject to one of the more onerous provisions of the Internal Revenue Code in Section 280E. Under 280E, businesses are barred from deducting any amount paid or incurred in a trade or business that is trafficking in controlled substances. The lone exception is for the cost of goods sold (COGS). The determination of when 280E applies and what costs may be included in inventory (and thus COGS) are two of the most significant areas of opportunity for cannabis entrepreneurs dealing with significant tax burdens.
Businesses seeking relief from these provisions have become creative over the years, often with mixed results. A common argument made by marijuana companies is that their operations consist of multiple lines of business, only one of which deals with controlled substances. Two major court cases highlight the importance of proper planning in this area. In Californians Helping to Alleviate Medical Problems (CHAMP), 128 TC 14, (2007), the taxpayer was able to successfully argue that the caregiving services they provided constituted a separate line of business. In Patients Mutual Assistance Collective Corp., et al.,151 TC 11, (2018), the sale of non-marijuana-containing products was incident to the taxpayer’s primary business of selling marijuana and the expenses were disallowed.
State taxation does offer a silver lining. With excise taxes and income tax laws that vary between jurisdictions, State taxation largely contributes to the collective compliance headache. California, however, does offer some relief. Contrary to federal law, California allows corporations to deduct their ordinary and necessary business expenses in determining their income tax liability just like any other business.
On October 12, 2019, the signing of AB-37 extended this benefit to sole proprietors and partnerships. California continues to be at the forefront of cannabis legislation, and taxpayers and their advisers need to stay tuned in to new developments. The experienced cannabis team at RJI CPAs can help you navigate evolving tax laws surrounding cannabis and their impact on your business.
About RJI International CPAs
Established in 1980, RJI specializes in audit, accounting, corporate and international tax issues for publicly traded and privately held companies. RJI is PCAOB registered and the Southern California member firm of DFK International, one of the largest accounting networks in the world.