Cannabis Businesses Need to Think Strategically to Handle Higher Taxes

So…You Want to Start a Cannabis Company

Imagine: The state you live in now legally recognizes the recreational use of marijuana, and you’re eager to start a business that capitalizes on the law change. As an intelligent entrepreneur, you recognize that sound legal, business, financial, and tax advice are integral to your company’s success, so you seek out input from trusted advisors. Your jaw hits the floor when your attorney tells you that, depending on how your business operates, you may end up paying a substantial amount more in federal income taxes than you otherwise would if your business were not a cannabis-related concern. You wonder, “Why does it make a difference?”

Cannabis Laws Differ at the State and Federal Levels

Though it may be legal in your state, cannabis is still considered illegal by the federal government. As a result, cannabis companies aren’t eligible to claim the federal tax credits or deductions available to other types of businesses. This is outlined in Section 280E of the Internal Revenue Code, which states that:

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.

Many Cannabis Businesses Will Incur High Federal Taxes

Under the Controlled Substances Act of 1970, cannabis is classified as a Schedule I drug. Per the statute cited above, the income tax on a cannabis business becomes a tax on gross income, rather than net income. This is an important distinction, because a tax on gross income results in a higher overall tax.

Generally, a business is able to reduce its gross income by claiming various deductions, such as rent, utilities, wages, and other “ordinary, necessary, and reasonable” expenses. Doing so allows it to lower the amount subject to federal income tax. Since cannabis businesses can’t claim these deductions, they aren’t able to lower their amount of income subject to federal income tax, and thus end up paying tax on a higher amount of income.

Segregating Expenses Can Mitigate Tax Burdens

As you pick your jaw off the floor and walk away with your head hanging low, your talented tax attorney offers you a glimmer of hope. There are different ways by which you may be able to claim some of your cannabis business expenses and, in turn, lower your income tax. You learn that it’s possible to claim expenses, so long as they are part of the “cost of goods sold,” or COGS. You also learn that it may be possible to segregate your business to isolate the cannabis component, thereby allowing you to deduct other non-cannabis-related expenses. Your mood changes, and you’re suddenly optimistic – armed with this new information, you realize that your new cannabis venture may not have to face a significant federal tax burden after all.

That said, the federal tax laws in this arena are highly complex and not at all settled. Before entering the market, the savvy entrepreneur should ensure that he or she has as clear an understanding of the regulations as possible, and should regularly engage his or her tax professionals for guidance.