Cannabis and Income Taxes: The Basics

Cannabis is legal in the State of Michigan but illegal at the federal level, so how does that work you may ask? The answer is slightly dysfunctional and a bit complicated really. Despite the mess of it all it can be boiled down to a few key points to get an initial understanding.

Reportable Income

Little known fact about the Internal Revenue Service is that they like to get paid more than any mob boss around. Illegal activities don’t scare them in the slightest. IRC section 61(A) defines gross income as “all income from whatever source derived” so money made on ANY illegal activity should be reported and taxed according to the IRS.. In all seriousness though, all sales of cannabis should be reported to the federal government regardless if they are legal or illegal in the state that in the sale is made in or the business is operating in.

Business Expenses

While most businesses are allowed to deduct ordinary and necessary business expenses when determining their taxable income, those directly involved in the cannabis industry cannot. The reason they are disallowed is due to IRC section 280E which states:

“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 classified by the DEA as a Schedule I substance which is defined as “substances, or chemicals with no currently accepted medical use and a high potential for abuse” Schedule I substances also include heroin and LSD. Given that it has the classification of Schedule I this means that it cannot take ordinary and necessary business expenses but rather is limited to cost of goods sold. This means that taxable income is on gross profit rather than net income effectively resulting in a much higher tax bill for anyone operating in the industry.

Cost of Goods Sold

You may be thinking “If only cost of goods sold is deductible I will just call all my expenses cost of goods sold. Problem solved.” If only it were that simple. Over the last few years there have been several court cases that have helped us determine what is and is not allowable to be included in cost of goods sold. Internal Revenue Code section 471 is the current code section that is to be used for guidance on what should be pulled into cost of goods sold.

State Taxes

While each state has their own filing requirements and nuances for income taxes most use federal taxable income at the starting point. After that they have various items they add or subtract from the number to determine the taxable income in that state. Since taxable income from the federal tax return in the case of a cannabis taxpayer was limited the taxes at the state level are significantly higher as well.

What can be done?

We have all heard the old quote “Nothing is certain but death and taxes” and Marijuana is not exempt from this. Taxes cannot be avoided…or they can but most certainly will result in winding up on the IRS naughty list. Since we cannot eliminate the tax, the best thing that can be done is manage it as efficiently as possible. Tax planning can be done to legitimately maximize cost of goods sold and minimize taxes. Tax planning should be done in conjunction with business consulting so the full picture is being considered. The team at Maner can work with business owners to provide insight on these matters as well as serve in our other traditional accounting related roles.

 

About the author

Jennifer Terbrack, CPA, jterbrack@manercpa.com, is a manager in our tax department and who is heavily focused on the for-profit entities. She has experience in traditional tax preparation as well as IRS and state representation and business consulting. In the last few years she has worked to continuously develop knowledge of the cannabis industry to become attuned to the very specific industry issues these businesses face so she may advise on the relevant industry issues.