Section 280E of the Internal Revenue Code Severely Straining Washington Marijuana Businesses

By Darren Smith, Weekend Contributor

Entreating the GodfatherWashington marijuana businesses are becoming financially tenuous in large part due to the imposition of heavy taxation. The matter has been further compounded beyond simply an unsustainable state excise tax of twenty five percent levied at all stages of the supply chain (marijuana producers, processors, and retailers) but a federal tax code that prevents the excise tax and conventional business expenses from being deducted from federal income taxes. This is due to a prohibition specifically applicable to marijuana. The accounting effect of this means marijuana businesses must also pay federal tax on what the business pays in state taxes.

Marijuana retailers have stated in interviews this double taxation alone swallows much of their profits. It shows another formidable challenge to the survivability of the licensed cannabis industry in Washington..

The applicable section of the tax code reads:

26 U.S. Code § 280E – Expenditures in connection with the illegal sale of drugs

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Marijuana is a Schedule I drug for the purpose of federal law.

The seeds of today’s state legal cannabis industry trouble germinated in 1982 when Congress passed legislation resulting in § 280E. The impetus for this change to the tax code stemmed from a reaction to a case where a Minneapolis drug dealer named Jeffrey Edmonson deducted expenses on his tax return related to sales of cocaine, amphetamine, and marijuana. The disputed expenses, among other items and claims, included rent expense, scales, packaging costs, travel, and telephone costs.

In 1981 A U.S. Tax Court ruled in Edmonson v. Commissioner that these constituted “an ordinary and necessary expense of petitioner’s trade or business and is to be allowed as a deduction.”

Congress, after the Tax Court’s ruling, sought to further restrict the illicit drug industry by applying additional financial pressure by enacting § 280E. At the time, of course, marijuana was illegal on both the federal and state levels for general business purposes. Now with the introduction of legalized recreational marijuana industries in two states and several others pending the section is likely outdated but nevertheless in force.

160px-IRS.svgA partial mitigation to this prohibition by 280E on deductions against marijuana sales revenue would be to classify certain expenses as “Cost of Goods Sold”. These are costs for a business related to material and labor to produce products or the wholesale price of goods to a retailer. These are considered an adjustment rather than a deduction and therefore do not fall under the purview of 280E.

For a marijuana producer/grower COGS encompasses many costs because most of these are directly related to production. Some include the following: electricity for grow lamps; seeds; hydroponic supplies; labor relating to cultivation; etc. Retailers on the other hand can only use the Cost of Goods Sold adjustment for wholesale costs of marijuana and not for expenses for sales employees, utilities, rent and the like relating to their business operation.

The net result of the lack of deductibility of the state marijuana excise tax means effectively that the twenty five percent tax levied on the sale price becomes part of the complete lack of deductibility on business costs generally–effectively adding a tax upon a tax.

The confiscatory nature of the two tax systems is crushing businesses who otherwise have high sales numbers.

Cannabis City, the first marijuana retailer in Seattle, has the third highest sales volume in the state at just over two and a half million dollars in gross sales since the beginning of July. It is “struggling to stay alive” according to store owner James Lathrop.

James stated that in order to just cover his expenses and tax obligations, he would have to sell marijuana at three times the wholesale price. “To actually make it work you have to put it on the shelf at $36 per gram,” he said during a recent interview “We’re just taking a hit to pay those taxes and keeping the doors open.” Menu prices for their products are about $22 per gram. For reference, the black market price is about $10 per gram.

Marijuana Leaf150px-Eisenhower_DollarAccording to State Liquor Control Board records, Cannabis City claimed $2,524,685 in total sales and therefore owes $631,171 in Marijuana Excise Tax. The IRS will consider the dollar amount of excise tax paid as income. If the business pays thirty to forty percent tax rate the federal tax on this is $189,351.30 and $252,468.40 respectively. The latter amounts to ten percent of the total gross sales, an amount often considered a good profit margin for numerous retail entities. But that is only the tax on the excise tax. It is not the full tax liability which includes the federal income tax on the sales revenue without nearly all the deductions for operating costs that would be provided a regular business. Again, cost of goods sold appears to be one of the few significant reductions for tax liability.

Dean Guske, an accountant who represents one hundred fifty clients in the cannabis industry, sees the state marijuana excise tax as a significant challenge to the industry. In an interview with Crosscut, he stated:

“I would say that the biggest problem right now under 502 is the current structure of the excise tax,” he said, referring to Initiative 502, the ballot measure that voters approved in 2012 legalizing recreational marijuana in Washington. “It’s making it extremely difficult for retailers in particular to really be profitable.”

The tax problems endemic to the cannabis industry are at least, allegedly, being addressed by members of the Washington State Legislature.

Ann Rivers
Ann Rivers
Brian Hatfield
Brian Hatfield

State Sen. Ann Rivers of La Center along with Brian Hatfield of Raymond stated they are working together on legislation that would change the state’s marijuana excise tax to that of a Business and Occupation Tax which would allow these businesses to write off the amount as an expense against their federal taxable income.

B&O taxes, along with Sales Taxes, are collected under different accounting rules than excise taxes. They are not considered income because according to the Internal Revenue Code a business is effectively holding the money on behalf of the state whereupon it is then transferred to state revenue departments. But in the case of the marijuana excise tax the IRS sees this as part of the sales price and therefore it is considered revenue.

The hope is that for at least the state level, some progress can be made simply by changing the regulation of the excise tax’ nomenclature but there is no guarantee such legislation will pass, especially when the legislature is busy with addressing an unfunded school classroom size initiative that could cost the state a billion dollars to implement and a ruling by the State Supreme Court holding the legislature in contempt for failing to fund education.

Congress on the other hand has not shown any substantial progress in assisting the fledgling cannabis industry through the passage of basic legislation to enable the industry to operate legally and profitably. The removal of Section 280E from the Tax code, one simple paragraph, will make a polar change for the industry on a national scale as far as the tax code is concerned. But the will of politicians to make this happen is not something to risk relying on for investment in the industry to fully commence.

By Darren Smith

Edmonson v. Commissioner via
Cannabis City
Washington State Senate (Photo Credit)

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