Marijuana is quickly becoming legal across the country – albeit not federally legal. Dozens of states have legalized medical marijuana and some allow the recreational use of marijuana. Investors are quick to jump into marijuana investments. Some invest in grow operations. Some invest in retail operations. And some invest in vertically integrated operations (grow and retail). After representing a number of investors in various states, and entities seeking licensure nationwide, I have seen financial models of existing operations and pro-forma models for future operations. The most overlooked item in all these financial models is Internal Revenue Code (“IRC”) Section 280E. In fact, most financial models do not even account for Section 280E, which in my opinion is a mistake. Section 280E is an extremely important consideration when owning or operating a marijuana endeavor, or investing in one. Anybody in the marijuana space cannot truly model out their investment without serious consideration of Section 280E, yet it is the most overlooked consideration in all the models I have seen. The most likely reason not knowing how to apply Section 280E and understanding its impact.
Internal Revenue Code Section 280E – Expenditures in connection with the illegal sale of drugs:
“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.”
Despite the language of the Internal Revenue Code, the Senate made clear that businesses subject to Section 280E are allowed to deduct its Cost of Goods Sold (“COGS”). This is the saving grace and where the creativity comes in. A taxpayer is generally required to report inventory on the accrual method under IRC Section 471. Under this accrual method, the taxpayer must capitalize the costs to acquire or produce the inventory and only deduct these costs when the merchandise is sold (as COGS). While it was widely believed IRC Section 263A added value to the available COGS deduction by capitalizing those pro-rata attributable expenses (marketing, training, transportation, meals and entertainment, etc) within the COGS, a recent (2015) Chief Counsel Advice Memorandum held that since 263A specifically states that the available deductions therein cannot run contrary to the Internal Revenue Code, no additional items were to be added to the COGS amount beyond what is allowed under Section 471. Specifically, IRC Section 263A(a)(2), states: “any cost which could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.”
By way of example, take a marijuana operation with $750,000 of gross revenue, $375,000 of COGS without any Section 263A expenses, and $200,000 of other expenses (payroll, rent, insurance, storage, etc.). Then let us assume that $100,000 of these other expenses are attributable to the inventory costs by way of Section 263A. The operator would be able to reduce its taxable income accordingly: $750,000-$375,000-$100,000 = $275,000 of taxable income. Absent the Section 263A allocation, the taxable income would be: $750,000-375,000 = $375,000 of taxable income.
An important item to note is that this Chief Counsel Advice is not legally binding. It is only the Internal Revenue Service’s interpretation of the Internal Revenue Code. It does not necessarily mean it is the right interpretation. If you take a strict reading of this interpretation, then a grower may only include the following direct and indirect costs (must be “incidental and necessary for production”) in its COGS:
- Seeds
- Direct labor costs – those costs associated with planting, cultivating, harvesting, etc.
- Indirect costs such as quality control, utilities, maintenance, supplies, fertilizer, certain insurance, accounting and attorney fees.
While it is more challenging for a retailer, there are a number of strategies to reduce the tax bill for a grower or a retailer. For example, providing ancillary services at a marijuana retail establishment (i.e. yoga) may allow allocating certain expenses to this segment of the business without the limitations of Section 280E. There are also a number of other strategies to limit the harsh tax impact. It remains to be seen how the IRS will treat various allocations and capitalization structures, but there is no doubt it is a very fluid practice today and will be flushed out in the years to come.
Adam Fayne is a partner with the law firm of Arnstein & Lehr LLP. Fayne was an attorney with the IRS Office of Chief Counsel. He may be reached at 312-876-7883 or
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