Cannabis and Taxes: What Cannabis Business Owners Need to Know
You have to pay cannabis taxes without getting tax benefitsBy Canaan Suitt, J.D. | Last updated on March 27, 2023 Featuring practical insights from contributing attorney Eric D. Shevin
Use these links to jump to different sections:
- Do Cannabis Businesses Have to Pay Federal Taxes Even Though Cannabis is Federally Illegal?
- Section 280E: The Crushing Tax Code for Cannabis Businesses
- What About State Taxes for Cannabis Products?
- Will Federal Law on Cannabis Change Anytime Soon?
- You Need a Cannabis Law Attorney
If you are a cannabis business owner or an investor seeking opportunities in the cannabis industry, you’re in for a tough time when it comes to taxes.
Though many states have either fully legalized or decriminalized cannabis, it remains federally illegal. As a result, cannabis businesses aren’t entitled to any business tax deductions or benefits. But even in states where cannabis is legalized, taxes for the industry are onerous.
Potential cannabis entrepreneurs and investors need to be fully informed about the business risks before taking action. To do this, consultation with an experienced cannabis attorney is essential.
With this overview of the tax situation for cannabis businesses, you can confidently meet with an attorney about your goals as a cannabis professional.
Do Cannabis Businesses Have to Pay Federal Taxes Even Though Cannabis is Federally Illegal?
The answer is an unqualified yes.
“The Fed’s approach is that you could be selling methamphetamine or cocaine and you still owe them taxes,” says Eric D. Shevin, a cannabis law attorney at Shevin Law Group in Sherman Oaks, California.
“Taxes aren’t limited to legal activities. If you’re doing anything in collecting money, the federal government wants their piece.”
Section 280E: The Crushing Tax Code for Cannabis Businesses
“For federal tax purposes, the most relevant and detrimental provision controlling the cannabis industry is Internal Revenue Code Section 280E,” says Shevin.
As the IRS states in their 2020 cannabis industry frequently asked questions, Section 280E prohibits businesses that illegally traffic Schedule I or II controlled substances from receiving tax deductions or credits for any amount paid or incurred in carrying on their trade.
“Notwithstanding the fact that many states have legalized cannabis for various uses, cannabis remains federally illegal as a Schedule I controlled substance,” Shevin says. “And nobody is entitled to any federal tax benefits or business expense deductions when they’re engaged in illegal drug activity.”
Still, “[Businesses] are entitled to the benefit of the costs of goods sold offset.” The costs of goods sold (COGS) are the expenses involved in producing goods–things like materials and labor. “For example, if you have somebody who buys $500,000 of cannabis and sells it for $1 million, they can offset their taxable income by the $500,000 [purchase of cannabis]. But they would still pay full federal income tax on the remaining $500,000, which is the adjusted gross income. For that, there are no deductions.”
The lack of tax deductions hits dispensaries and distributors especially hard. “Retailers aren’t able to reduce their tax liability by deducting rent, employee expenses, insurance, advertising, lawyers’ fees, or operating costs—all things that other businesses can deduct,” says Shevin.
Things aren’t as bleak for cultivators and manufacturers since most of what those businesses do is produce goods. These businesses can use creative accounting methods to capture a much bigger percentage of the COGS offset.
280E’s Negative Impacts on Entrepreneurs and Investors
“When I break down the terrible tax situation to people who want to invest in cannabis, they just get this glossy look on their face, and one of two things happen,” Shevin says.
“Either they’re like, ‘We understand all that, but we just really want to do it.’ And you can’t argue with that. They just have this idea that it’s going to be like printing money if they can just get into the cannabis business. But then the majority who are real business people realize, ‘What were we even thinking?’”
For people trying to enter the cannabis industry now, “The tax piece almost makes it impossible,” adds Shevin. “When you’re a new investor, you’ve got to ask yourself, ‘OK, if everything goes well, how long will it take before I get my money back?’ And when you break it down in cannabis, you might not live long enough.”
Unfortunately, this situation will continue until cannabis is rescheduled at the federal level.
“After all, the Internal Revenue Service relies on its codes, the code is specific to the scheduling of substances, and as long as cannabis is scheduled as a level I controlled substance, then 280E applies.”
What About State Taxes for Cannabis Products?
If you thought cannabis tax woes ended at the federal level, think again.
“It’s not just the federal tax. It’s also state taxes,” says Shevin. “For example, California has an excise tax, which is 15 percent of the gross income that goes to the state. In Los Angeles, you have to pay another 10 percent in gross income taxes to the city, plus another 10 percent sales tax.”
All of that, and then you don’t benefit from the business sales deduction. “The effect of all this is that your margins are only about 10 percent. So, on a revenue of $1 million, you’re only going to get around $100,000.”
In addition to the unique tax burdens on cannabis businesses, “Competition with the black market makes it even more difficult since you have to be competitive,” adds Shevin. “The reality is that the lowest price will always be on the illegal black market. And so, the convergence of all these taxes combined with the black market makes it nearly impossible to profit unless you’re producing at a very large scale.”
Will Federal Law on Cannabis Change Anytime Soon?
There are several federal bills slowly making their way through Congress, Shevin says, though they may never pass.
“One of them is the Safe Banking Act, [which has already failed to pass a couple of times]. This bill would allow cannabis money to be deposited in regular banks. Currently, banks in states where cannabis is legal are allowed to do that. Still, the IRS requires a whole administrative process that is so expensive and onerous that banks either won’t do it or will charge astronomical fees to customers to cover the administrative costs.”
In Shevin’s view, “Making everyone deposit their cash in banks would be the best thing the Feds could ever do to help fight the cannabis black market. It would get cash off the street.”
Another potential provision of the Safe Banking Act would be to provide an exception under 280E for business expense deductions, which would bring major benefits to cannabis companies and investors.
Right now, these reforms are only possibilities. Though the state of cannabis law at the federal level can seem bleak, Shevin is encouraged by the history of state-level cannabis reforms. Rather than a story of inevitable decline, it’s been “one step forward, two steps back,” which is at least some progress.
One sign of potential progress came in 2022, when President Biden signed the Medical Marijuana Research Act, which, Shevin says, “Didn’t get a lot of attention and was sort of promoted as just further research on the medical benefits of cannabis, which is kind of ridiculous since there’s so much research on that already.
“But when you read deeper into the bill, it’s also to study interstate distribution models. So, the Feds are getting their stuff organized. Legalization is not a matter of ‘if’ but ‘when.’ There’s so much money on the table.”
You Need a Cannabis Law Attorney
When asked about the need for legal counsel in the cannabis industry, Shevin says: “It’s incredibly critical.”
For one thing, cannabis is one of the most regulated and taxed industries on earth. “And where there are overly granular regulatory processes and onerous tax limitations, you need highly skilled attorneys to create structures that mitigate those tax burdens in order to be competitive,” he says.
Without getting organized from a business structure standpoint, “You won’t have a competitive advantage or be competitive on any level,” says Shevin.
Additionally, “The legal process of getting a cannabis license is very involved. It can take you four times as long if you don’t have legal counsel. And when you’re doing any kind of business transaction or raising capital, you can’t do that without proper legal counsel to protect everyone’s rights. You would never invest in any cannabis activity if you didn’t meet with the lawyer for the team and get clear on who’s in charge if something goes wrong and who is ensuring they’re following the rules.”
Ultimately, “Every aspect of the operation requires legal backup,” says Shevin. “There are all kinds of surprise inspections and enforcement activities. You could find that you’ve done everything legally, but someone you’ve done business with has done something illegal, and now you’re being questioned about it.
“Let’s face it: Cannabis is still federally illegal, so you want to follow the letter of the law and be well represented at all times. The consequence of non-compliance is that you lose everything. That’s the real risk here.”
To find a highly experienced and reputable lawyer in the industry, look for a cannabis law attorney in the Super Lawyers directory.
For more information about this area of law, read our overview of cannabis law.
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