The Bottom Line on 280E in 2020
By Matt Sapowith, MGO Tax Partner
As the cannabis industry continues to evolve and mature, perhaps the single biggest obstacle to profitability remains: IRC Section 280E. By prohibiting expense deductions for businesses that produce, sell or distribute Schedule I and II substances, the Federal government is imposing an effective tax rate two to three times higher than traditional businesses.
While there has been no progress on 280E reform at the Federal level in 2020, legal decisions in recent years, such as the cases involving retailers Harborside Inc. and Alternative Health Care, have impacted the application of 280E and provided some clarity on what cannabis companies need to consider and prepare for with tax season on the horizon.
Extensive documentation is key to navigating 280E
The first rule of navigating 280E is that all cannabis businesses must document absolutely everything. If they don’t, then it is very, very unlikely that they will prevail during an audit or if they find themselves in Tax Court. Throughout the course of doing business, inventory and costs need to be diligently documented. By keeping thorough records, you strengthen your potential case, and at the very least may win some points for demonstrating "good faith" intent.
That is what happened in the Harborside case, where the Oakland-based company was hit with an $11 million IRS bill for back taxes from 2007 and 2012. In that case, Harborside had been comprehensive in its documentation and was able to substantiate all of its claims as it related to deductions. As a result, they were not assessed inaccuracy penalties and documentation played a role in lowering their debt owed.
Understanding Cost of Goods Sold and 280E
Another lesson from recent cases relates to calculating the Cost of Goods Sold (COGS), where a reduction is made during the process of calculating gross income. IRS regulation 471 states that if the usage of inventories is deemed necessary to determine a taxpayer’s income, then an inventory shall be taken by the best accounting practices in that trade. Per 471, there are different regulations whether a taxpayer is a reseller or a producer. For instance, for producers, inventory calculations should include the costs of raw materials and necessary indirect production costs.
In the Harborside case, the company claimed that for calculating COGS, IRC Section 263A was the correct approach. Under 263A, taxpayers are required to capitalize both direct and indirect costs related to actual personal property that it produces. Harborside argued that being disallowed from using 263A resulted in the company having to pay taxes on an amount in excess of their gross income.
The decision of the Court confirmed the IRS approach, dealing a blow to cannabis companies. Per the Court’s ruling, there were a number of aspects that impact the way cannabis can approach how they calculate COGS. Given the different approaches under 471 for those deemed either a “producer” or a “reseller,” companies need to understand how they will be classified, as it has a major impact on their accounting processes.
Tax structuring considerations for 280E
Another important aspect for cannabis retailers to consider is how they are structuring their business. In a case decided last year, Los Angeles-based Alternative Health Care tried to avoid 280E by having a management company operate its storefront. The management company was responsible for a number of critical day-to-day operations, such as paying employees. Given that Alternative Health Care wasn’t in charge of the storefront, it argued that it wasn’t subject to the tax laws of 280E. However, their argument lost in court and resulted in an expansion of the types of companies that are considered liable under 280E.
There may be a number of reasons why a cannabis retailer would want to avoid liability under 280E. But just because a management company is technically in charge, liability also extends to them. If a company is considering using a different company to handle its day-to-day business, there needs to be an understanding that 280E is still applicable and that trying to get around this can end up being costly.
There are many other benefits to structuring a cannabis company in a strategic way. It can allow specific business units to be utilized in a tax efficient manner and enhance a company’s ability to take advantage of special tax deductions. Additionally, a company can make bookkeeping much easier, while simultaneously reducing risks by separating certain business units. Structuring can also open up other opportunities down the line when it comes to joint ventures or shareholder investments.
Preparing for cannabis audits
Recent court decisions (and other rumors) have stoked fears that there will be an increase in audits of cannabis companies. There is no guarantee that there will be more audits or that a certain retailer will be audited in the next year. However, audits can happen, so it is paramount that a company protects itself in every way they possibly can.
Overall, it is always best to be prepared. As stated previously, document everything. Maintain all necessary paperwork. If you avoid being audited, there are many other benefits to appropriately documented financial and operational records. But if one crops up, you minimize the risk of potential penalties and create a much smoother process.
The bottom line on 280E
While changes to precedent and recent case developments have altered the 280E landscape, as the cannabis sector grows, and revenue numbers rise, greater attention is given to the industry by regulatory authorities. As a result, companies must make taking a strategic approach to 280E compliance a top priority.