Taxation of a Cannabis BusinessBy
As the number of U.S. states allowing the sale of cannabis grows, owners of cannabis businesses face the question as to which business expenses are deductible for federal income tax purposes.
Taxpayers engaged in a cannabis business are in a complicated position when it comes to federal income taxes. Internal Revenue Code (IRC) §162 allows the taxpayer to deduct business expenses paid or incurred in carrying out the business from the business income received or earned. But because the product is considered a Schedule I controlled substance, cannabis businesses generally can’t deduct business expenses for federal income tax purposes. (Depending on the state in which the business is operating, business expenses may still be deductible for state income tax purposes.)
The question is: Can the taxpayer in a cannabis business deduct any expenses associated with their operation for federal income tax purposes? It depends, in part, on the type of business and its operations.
IRC §280E provides the general rule associated with deducting costs associated with cannabis as well as other controlled-substance businesses. The law states, in part, that no deduction or credit is permitted if such trade or business consists of trafficking in controlled substances, which is prohibited by federal law or the law of any state in which the trade or business is conducted. The Controlled Substances Act (CSA) of 1970 assigns controlled substances to one of five schedules (I through V). Schedule I includes “opiates, opium derivatives (e.g., heroin and morphine), and hallucinogenic substances (e.g., LSD, marihuana (aka marijuana), mescaline, and peyote)” (see Chief Counsel Advice (CCA) 201504011).
Although businesses involving controlled substances can’t deduct ordinary and necessary business expenses such as salaries and rent, they’re able to deduct the cost of goods sold associated with the product if they are in compliance with the inventory valuation rules. Of course, their ability to do so depends on whether the business is a producer or a retailer. The inventory valuation rules for tax purposes are provided in Treas. Reg. §1.471-1 through §1.471-11. (It should be noted that these rules aren’t the same as the Generally Accepted Accounting Principles (GAAP) used for financial statements.)
Treas. Reg. §1.471-3(c) provides that merchandise produced (i.e., a producer) by a taxpayer must include in the costing of that product the expenditures of direct materials going into the product or consumed by it, for direct labor, and for indirect production such as an appropriate portion of management expenses.
A producer is required to capitalize, as part of inventory, those indirect expenses that otherwise would be a deduction under IRC §162 (i.e., ordinary and necessary business expenses). In so doing, the producer (as opposed to a retailer) can’t deduct business expenses until the product is sold and income is reduced for cost of goods sold. But producers of Schedule I or Schedule II controlled substances (e.g., cannabis or marijuana) can’t deduct business expenses in their cost of goods sold because IRC §280E doesn’t allow such deductions.
If these producers of cannabis or marijuana could pass their indirect business expenses through the cost of goods sold that aren’t currently deductible per IRC §280E by capitalizing them, this ploy would allow taxpayers trafficking in Schedule I or Schedule II controlled substances to capitalize disallowed business deductions and therefore deduct them as part of their cost of goods sold (see CCA 201504011). Bonus and accelerated depreciation also are generally treated as indirect inventoriable costs to producers; however, these charges can’t be included in inventoriable costs for marijuana producers (see Lord v. Commissioner, TC Memo 2022-14).
Treas. Reg. 1.471-3(b) provides that retailers or resellers of merchandise purchased as their products must capitalize the invoice price less trade or other discounts into their inventory cost. In addition, any transportation or other necessary charges incurred in acquiring the product are included in the inventory value. As a result of this tax law, retailers would like to claim the product is further developed (in other words, not retail but a manufacturing operation) so that they could capitalize some of these indirect costs and deduct them as part of their cost of goods sold.
In the Richmond Patients Group case (TC Memo 2020-52), the taxpayer, a California nonprofit mutual benefit corporation with members and not shareholders, contended that it was a producer for purposes of IRC §263A and IRC §471 and should be entitled to deduct indirect inventory costs under IRC §1.471-3(c). IRC §263A and its accompanying regulations, however, define “produce” to include construct, build, install, manufacture, develop, improve, create, raise, or grow. The court agreed that the IRC §471 regulations further provide that “costs are considered to be production costs to the extent that they are incident to and necessary for production or manufacturing operations.”
The court, however, noted that Richmond didn’t provide live plants, clones, or seeds to its members. Rather, it purchased bulk marijuana grown by its members for resale. The member providers trimmed the marijuana flowers before Richmond purchased them, but no improvements were made to the marijuana from the time it was purchased to the time it was sold. Richmond inspected, sent out for testing, trimmed, dried, and maintained the stock, then packaged and labeled the marijuana. As a result, the court concluded that these activities are those of a reseller and not a producer.
A taxpayer can be operating more than one business and could be allowed to include indirect costs in inventory on those businesses that aren’t Schedule I or Schedule II controlled substance businesses.
CHAMPS (Californians Helping to Alleviate Medical Problems, Inc., 2007, 128 TC 173) operated a dual-purpose business. Its primary purpose was to provide caregiving services for its terminally ill clients. Its secondary purpose was to provide its clients with access to medical marijuana pursuant to the California Compassionate Use Act of 1996 and to instruct those individuals on how to use medical marijuana to benefit their health. The court acknowledged a taxpayer may be involved in more than one business, but whether the activity is a separate business or not is a question of facts that depends on the degree of economic interrelationships between the activities.
In the CHAMPS case, the taxpayer clearly demonstrated its caregiving services as a separate business. As a result, the court ruled the taxpayer’s primary function as being a community center for seriously ill patients and the secondary function as a place to access their medicine (i.e., marijuana), and the overall expenses will be apportioned accordingly. Therefore, the important aspect of demonstrating that activities are separate involves the substance (not just the form) of the operation, which is supported by the taxpayer’s recordkeeping and documentation of purpose.
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