As all cannabis business owners know, there are many challenges the industry faces when managing taxes and the IRS, particularly where IRC Tax Section 280E is concerned. This fact was harshly underscored earlier this year when the Treasury Inspector General for the Tax Administration (TIGTA) released a report suggesting large noncompliance throughout the industry.
Their study reviewed the tax returns from 2016 for cannabis businesses, and uncovered several millions of dollars in lost tax revenue. With an industry still pushing to be seen as legitimate, the findings were concerning to say the least. But the report also illuminated what could be seen as a beneficial loophole in the tax code for cannabis businesses.
Most people may not have heard of TIGTA, much less know what the agency is tasked with doing. In 1999, it was established to create an independent oversight, serving as an Inspector General for anything related to the IRS.
The agency’s focus is to ensure fair administration within the federal tax system as well as holding the IRS accountable for the tax revenue collected each year. Because the agency is autonomous and holds an impartial position, their findings should be considered trustworthy and fair by the IRS, tax professionals, and business owners.
Among the findings in TIGTA’s report, the most obvious takeaway were the numerous struggles that cannabis businesses face, chiefly when it came to Section 280E.
They noted that among the cannabis businesses operating in California, Oregon, and Washington, 59% of taxpayers were not in compliance with 280E. It’s estimated that in 2016 alone, there was $48.5 million in unpaid tax liabilities by these businesses. A five year projection modestly shows this number could grow to $242.6 million in unpaid taxes, which doesn’t actually account for the massive growth the industry has seen in recent years.
The takeaway? Auditing cannabis businesses could be seen as extremely profitable for the IRS. What’s more, roughly 50% of TIGTA’s recommendations to the IRS revolve around ways to enhance auditing efforts and increase collections.
Unfortunately, there is no way around Section 280E. This code section has been challenged by many taxpayers, some even taking their cases to the Supreme Court. The reality? There is no legal way to avoid the wide reach of Section 280E today.
What businesses can do, however, is mitigate the costs while still technically following the code. In their report, TIGTA uncovered a loophole that could be one possible solution. This comes in the form of the 2017 Tax Cuts and Jobs Act (TCJA).
Before covering how this can impact taxpayers, it’s important to review some details about Section 280E for clarity. Within the code it states that no credit or deduction shall be allowed for any amount paid or incurred in carrying on any trade or business that consists of trafficking in controlled substances.
Congress, in an attempt to proactively defend against the constitutionality of this law, made a provision allowing taxpayers subject to this provision to deduct their cost of goods sold (COGS) to determine their actual taxable income. Essentially, this means that cannabis businesses are only allowed to deduct their cost on the goods they sell.
Here is where it gets confusing with math and rules. Calculating the cost of goods sold is rather complicated and business owners do anything possible to get the maximum deduction. The rules determining what costs can and cannot be included in inventory is determined in Section 471.
That said, it’s a fairly ambiguous set of rules which makes full compliance difficult, as well as a lengthy process. The new changes to Section 471 were designed to help small businesses through eliminating the burden of accounting for inventory. Instead, they give the taxpayers (who fit within a set of criteria) the flexibility to treat their inventory how it works best with their own accounting procedures.
What does this mean for cannabis businesses? The change is huge. Instead of having to go through a painstaking and detailed process to track inventory costs and having no other deductions due to the exacting rules of 280E, these businesses can treat all costs as COGS. This means they can now receive a deduction for other expenditures beyond goods alone.
By adopting this accounting policy, cannabis businesses can circumvent the major losses once faced by Section 280E while still remaining in full compliance with the law. In an industry that typically sees effective tax rates beyond 80%, this change is bringing cannabis businesses closer to perigee with traditional businesses and provides a significant reduction in taxes.
Before business owners jump to take advantage of this loophole, they must ensure they meet the criteria outlined in Section 471(c). There are two major hurdles companies must get past: the gross receipts test and the applicable financial statement (AFS) exception.
In order to pass the gross receipts test, businesses and their affiliates must have less than $25 million in average annual gross receipts (indexed for inflation) for the previous three years. Also, they must not have an AFS. This means any audited or reviewed financial statement will exempt them.
Among their recommendations in their report, TIGTA pushed for the IRS to create a specific guidance for how this code could be interpreted. Unfortunately, the IRS declined due to other priorities within the agency. This was the only recommendation out of the six made that the IRS dismissed. As such, silence from the IRS means that cannabis businesses and their tax advisors must carefully weigh the risks when determining how to utilize this tax loophole to their benefit.