We know that every small business entrepreneur dreads an IRS tax audit, but it can be especially painful for cannabis dispensaries. Stay informed to keep your business in an optimal tax and legal standing.
Internal Revenue Code Section 280E is the federal tax law responsible for the key tax problem that prevents legitimate cannabis businesses from writing off most “normal’ business deductions, and creates a very high effective tax rate. The IRS has subsequently applied Section 280E to state-legal cannabis businesses, since cannabis is still a Schedule I substance.
Section 280E originated from a 1981 court case in which a convicted cocaine trafficker asserted his right under federal tax law to deduct ordinary business expenses. In 1982, Congress created 280E to prevent other drug dealers from following suit. It states that no deductions should be allowed on any amount “in carrying on any trade or business if such trade or business consists of trafficking in controlled substances.”
Federal income taxes are based on a fairly simple formula: start with gross income, subtract business expenses to calculate taxable income, and then pay taxes on this amount. Owners of regular businesses often derive profits from these business deductions.
Cannabis businesses, however, pay taxes on gross income. These businesses often pay tax rates that are 70% or higher. As John Davis, owner of the Northwest Patient Resource Center in Seattle, WA states, “I’m taxed on nearly double the amount that my business actually makes.”
Below is a simplified model that illustrates the tax structure for cannabis businesses compared to a normal businesses. In this scenario, the normal business’s taxable income is $150,000, while the cannabis business is taxed on $350,000, despite having the same costs and expenses.
Non-Cannabis Business Cannabis Business
|Cost of Goods Sold||$650,000||$650,000|
|Deductible Business Expenses||$200,000||$0|
|Effective Tax Rate||30%||70%|
The tax problems of medical marijuana dispensaries are not limited to tax audits by the IRS. Our tax dispute attorneys have seen sales tax audits by the California State Board of Equalization (SBE or BOE) claiming that the medical marijuana dispensaries did not report all of their income for California Sales Tax purposes. Without good records the BOE can be expected to make wild guesses about the amount of income based upon such flimsy evidence as the number of people walking through the door. Nevertheless, when the BOE makes a determination, it is up to the cannabis dispensary to prove that the BOE’s estimate is wrong. Worse yet the owners of the marijuana dispensary can become personal liable for any unpaid sales taxes. Our tax lawyers have had years of experience helping all types of business fight these types of sales tax problems.
Conversely, because medical marijuana dispensaries don’t have a bank account to write checks on it becomes difficult to prove that expenses have been paid, even if they are of a type which can be deducted.
Marijuana businesses are also not immune from traditional payroll tax problems such as whether workers are employees or independent contractors. This is another area where if the wrong decision is made the owners and operators of marijuana dispensaries may become personally liable for payroll taxes which the IRS claims should have been deducted from payments to workers, and turned over to the IRS. On top of that they are subject to possible penalties for failure to deposit payroll taxes electronically. The IRS has issued guidelines which ease this tax problem, but the guidelines still require cannabis businesses to make an effort to pay payroll taxes electronically.
If your marijuana business is contacted by the IRS or the SBE, contact our office for a confidential consultation.