With the legalization of cannabis in more states, the industry is experiencing unprecedented growth. It’s an excellent opportunity for cannabis companies to grow. Still, they face unique challenges related to taxation and financial management, among several tax compliance requirements in the IRS Tax Code 280E, which significantly limits the deductions available to businesses in this sector.
In this guide on cannabis business expenses, we explore the impact of 280E on equipment-related deductions, available rebates, and strategies for maximizing tax efficiency.
History of 280E
During the Reagan Administration, Section 280E was enacted in 1982. It happened when a convicted cocaine trafficker, during a court case in 1981, asserted that it is his legal right under the federal tax law to deduct ordinary business expenses. To prevent other drug dealers from following suit, Congress created 280E. The purpose was to ensure that no illegal drug trafficker could claim tax deductions for their illicit activities. Over the years, 280E deductions have applied to state-legal cannabis businesses, creating significant financial challenges for the industry.
What Is IRS Tax Code 280E?
IRS Tax Code 280E is a federal legislation that prohibits businesses engaged in the trafficking of Schedule I or II controlled substances from deducting ordinary business expenses from their gross income. Cannabis is also termed a Schedule I substance under federal law, implying while many state and local laws have legalized cannabis, at the federal level, it is still illegal.
For cannabis companies, it has profound implications as they can deduct the cost of goods sold (COGS); 280E prohibits companies from deducting many common business expenses such as rent, utilities, and employee salaries. When compared to other industries, 280E on cannabis earnings results in effective tax rates that are much higher.
Does 280E Apply to Growers?
Yes, 280E for growers is a significant concern in the industry. Section 280E applies to growers and all other medical marijuana cultivators where workers touch the plant or its products in the supply chain. As an exception, growers can include some of the cost related to the production of the product in COGS for deductions.
Do Dispensaries Pay Federal Taxes?
Just like other cannabis companies, dispensaries are required to pay federal taxes. Dispensaries do not have extensive deduction opportunities depending on the product they sell. According to the IRS, dispensaries sell or handle controlled substances.
The Impact of 280E on Equipment Expenses
By putting restrictions on cannabis companies, 280E creates financial implications that need attention.
What Can Be Deducted Under 280E?
There is little scope for cannabis business expenses to be deducted under 280E. Most of the deductions are limited to those that can be capitalized into the cost of goods sold. This includes cannabis equipment, such as machinery and tools directly involved in the production or acquisition of cannabis products.
What Can’t Be Deducted Under 280E?
Many typical business expenses are prohibited from being deductible under 280E for cannabis companies. If the equipment or expense is not directly linked to production, it cannot be deducted. This includes office computers, point-of-sale systems, security cameras, rent, legal fees, waste removal, online services, etc. Additionally, marketing, distribution, and general administrative costs are generally not deductible.
How to Maximize Equipment Deductions
Cannabis companies can take measures to maximize equipment deduction and overcome some of the constraints of 280E. Here are some steps to take:
- Carefully categorize equipment expenses, classifying them as part of the production process whenever possible.
- Structure business into two separate entities-one for production and distribution of cannabis and another for logistics, storage, and marketing. This way, equipment for the second entity can usually be deducted.
- Consultation with experienced tax professionals to optimize cannabis 280E deductions
Key Equipment Deductions for Cannabis Businesses
As mentioned before, equipment used in the cannabis business can be directly related to production and packaging or operations. Each category has separate tax deduction implications.
Let’s understand in detail.
Capital Equipment vs. Operational Equipment
In the cannabis industry, capital equipment such as large-scale cultivation systems and extraction machines is a long-term asset. These assets are typically depreciating over time. Operation equipment, on the other hand, includes smaller tools and devices used in day-to-day operations.
Capital equipment often requires significant investments and is more likely to qualify for inclusion in COGS. Cannabis companies can enjoy considerable deductions on such equipment that include:
- Industrial-scale grow lights
- HVAC systems for cultivation facilities
- Large-scale irrigation systems
- Commercial-grade trimming machines
Operation equipment may face scrutiny under 280E even when they are essential. Unless they are directly tied to the production of cannabis products, they may not be eligible for deductions. Standard operational equipment that can be deductible under 280E include:
- Hand tools for harvesting
- Small-scale packaging equipment
- Testing and quality control devices
- Personal protective equipment for cultivation staff
Examples of Deductible Equipment
If you are confused about the deductible equipment under 280E, here’s a comprehensive list of cannabis equipment that qualifies for deductions:
- Laboratory Equipment: All chemical analytical tools used for potency testing and quality control can often be included in COGS, as they directly relate to product development and safety.
- Extraction Machines: Equipment used to produce cannabis concentrates and oils is typically considered part of the production process and may be deductible under 280E. Root Sciences equipment qualifies as deductible equipment for cannabis companies.
- Processing Equipment: Pre- and post-processing machinery used in cannabis production for grinding, packaging, and labeling is also considered production equipment and may qualify for deduction.
- Drying and Curing Equipment: Harvesting systems involved in the drying and curing cannabis for sale are essential to the production and often deductible.
- Trimming Machines: Both automated and manual trimming equipment used to prepare cannabis flowers for sale can usually be included in COGS.
Depreciation of Equipment
Section 280E allows cannabis companies to consider depreciation when it comes to equipment deductions. The depreciation of equipment used in the production process can be included in the cost of goods sold. This allows cannabis companies to recover their capital equipment costs over time, even under the constraints of 280E.
Rebates and Incentives for Cannabis Equipment
To promote the cannabis industry and encourage producers’ participation, utility companies, government agencies, and manufacturers offer several rebates.
Types of Rebates Available
- Energy Efficiency Rebates: Many utility companies offer rebates for energy-efficient equipment installations. Like other production activities, cannabis cultivation is known to have high energy consumption. That’s why utility companies offer rebates for using energy-efficient cannabis equipment such as LED grow lights and high-efficiency HVAC systems.
- Local Government Incentives: Some local governments offer incentives to cannabis businesses to encourage economic development. For instance, in California, the Governor’s Office of Business and Economic Development (GO-Biz) provides the Cannabis Equity Grants Program for Local Jurisdictions to encourage participation in the industry.
- Utility Company Rebates: Energy companies and other utility companies offer rebates for water conservation equipment. It can help cannabis companies cut down cultivation operation costs.
- Green Technology Incentives: In a push to decrease carbon footprints, the cannabis industry seeks to reduce its environmental footprint by offering various incentives for implementing green technologies. This includes adopting solar energy, water reclamation systems, or biodegradable packaging equipment.
- Equipment Trade-In Programs: Several equipment manufacturers offer trade-in programs for cannabis companies, allowing them to upgrade their equipment at a reduced cost.
Eligibility Criteria
The eligibility for equipment rebates can vary depending on several factors. Some of the most common criteria include:
- The type and efficiency rating of the cannabis equipment
- The size and scope of the cultivation and production installation
- Compliance with local and state regulations
- Verification of energy or resource savings
- Timely application and documentation submission for rebates
How to Apply for Rebates
The first step to applying for rebates is to research the programs available in your area. You can visit the websites of your utility companies and local government initiatives. Another way to learn about potential rebate programs is to consult with equipment vendors who may be familiar with applicable rebate programs. Research equipment specifications to ensure they meet the rebate criteria. You must keep the proof of purchase to complete and submit application forms. Schedule any necessary inspections or verifications required by the rebate program.
Impact of Rebates on Tax Deductions
Rebates allow companies to cut setup and operational costs, which can directly impact tax deductions. As rebates reduce the cost basis of equipment, they can affect depreciation calculations and potential deductions, especially in the context of 280E cannabis regulations.
It would be best if you worked with a tax professional experienced in 280E deductions to ensure proper treatment of rebates in your tax filings.
Navigating Audits and Compliance
Cannabis businesses are more likely to find themselves facing audits from the IRS and other federal agencies as they are termed handling scheduled substances. There are some steps cannabis companies can take to handle audits.
How to Protect Against Audits
To minimize the risk of audits and ensure compliance with 280E, cannabis businesses should:
- Maintain meticulous records of all equipment purchases. It must include detailed invoices and documentation of how each item is used in cannabis production.
- Implement a robust inventory tracking system utilizing modern technology to allocate costs to COGS accurately.
- Work with tax professionals who specialize in cannabis 280E to handle equipment-related deductions.
- Regularly review the local laws and rebate programs related to cannabis equipment purchase, handling, and depreciation.
- Consider engaging in a voluntary disclosure program if past filings must be corrected.
Common Audit Triggers
Some practices that trigger audits from federal agencies include:
- Unusually high deductions compared to the industry average
- Discrepancies in federal and state tax filings
- Failure to document and report cash transactions accurately
- Sudden, significant changes in reported income or expenses
- Misclassification of equipment for deductions
- Benefiting from rebate programs without proper verification
Exploring Additional Tax Credits and Deductions
In locations where section 280E becomes irrelevant, cannabis companies can have access to several additional tax credits and deductions. Here are some of the significant tax benefits available:
Research and Development Tax Credits
Research and development in cannabis manufacturing and cultivation allow scope for tax write-offs for costs associated with material expenses and research time. R&D activities like the development of new cultivation techniques, the creation of new cannabis strains, and the improvement of extraction processes can help businesses offset as much as $250,000 in tax liabilities.
State and Local Tax Considerations
State and local tax codes may offer more favorable treatment for cannabis companies, such as Tax Cuts and Jobs Act (TCJA) benefits. Such initiatives allow more generous deductions.
The Intricacies of Cannabis Business Taxes
As a producer in the cannabis industry, there are several tax considerations to understand.
Navigating 280E: Strategies for Cannabis Businesses
Cannabis companies face most complications arising from 280E compliance. Here are some strategies to navigate 280E compliance:
- Maximizing COGS: Carefully analyze all expenses to determine which can be legitimately included in COGS. You may have to plan and restructure some business operations to make them eligible for the cost of goods sold.
- Entity Structuring: Another strategy producers can consider is to create separate entities for activities not directly related to cannabis production or sale. You can form real estate holdings or equipment leasing entities to isolate non-deductible expenses and maximize overall tax efficiency.
- Expense Allocation: Cannabis businesses can implement detailed systems for allocating expenses between deductible and non-deductible categories. You can have separate resource allocations for businesses with cannabis and non-cannabis product lines.
- Capital Investment Planning: Structuring major equipment purchases to align with production processes can help you capitalize on COGS deductions whenever possible.
State and Local Taxes: A Closer Look
Depending on the location of your cannabis business, state and local tax regimes can vary widely. As of 2024, 37 states in the United States have approved medical use of cannabis, and 19 states and the District of Columbia have approved measures to regulate non-medical use of cannabis.
You must look at the state-specific regulations that include:
- State-specific cannabis taxes based on weight, potency, or sales price
- Local excise taxes imposed by counties
- Sales taxes, which are usually higher for cannabis products
- Additional taxes for handling scheduled substances
The Impact of State and Local Taxes on Equipment Deductions
While 280E limits federal deductions, states that render the 280E section irrelevant may offer more flexibility regarding equipment expenses. Such states allow cannabis businesses to deduct equipment-related expenses such as equipment purchases and related costs on their state tax returns.
Future Outlook for Cannabis Business Taxes
While the current tax regime poses significant challenges for cannabis businesses, the evolution of the industry is initiating changes in taxes, too.
Potential Changes in Tax Legislation
The cannabis industry is actively lobbying for changes in federal laws such as 280E. Several bills have been introduced in Congress to repeal or amend 280E, including the Marijuana Revenue and Regulation Act and the Small Business Tax Equity Act. Such reforms will reduce tax implications that disproportionately affect cannabis businesses.
Trends and Predictions
Other trends shaping the future of cannabis business taxation include increased scrutiny, environmental considerations, and standardization of practices. As the cannabis industry matures, tax authorities are likely to implement frequent audits for compliance. Federal agencies like the IRS will likely standardize the approach to cannabis business taxation, providing greater clarity for operators. Furthermore, new tax incentives for energy efficiency and eco-friendly operations may become available as sustainability becomes increasingly important.
Conclusion
Navigating the intricate tax landscape of the cannabis industry, especially under the constraints of 280E, presents significant challenges for operators. However, with careful planning, strategic allocation of expenses, and the use of available rebates and incentives, cannabis businesses can minimize their tax burden. Key steps include accurately categorizing equipment expenses, structuring entities, and taking advantage of state-specific tax benefits where 280E doesn’t apply.
As the industry continues to grow and evolve, the potential for changes in federal tax legislation may alleviate some of the financial pressures imposed by 280E. Until then, cannabis businesses should maintain meticulous records, work closely with tax professionals experienced in this sector, and remain proactive in adapting to changing regulations. In doing so, they can improve financial efficiency and position themselves for long-term success in an increasingly competitive market.
