Running a legitimate cannabis business can be tricky, especially since cannabis is still illegal on a federal level in the U.S. There are 36 states plus the District of Columbia where recreational and/or medical cannabis is legal. The cannabis industry is worth $61 billion in the United States, with sales increasing 67% in 2020.
Operating a federally illegal business requires special considerations by the IRS. The agency supports these small businesses and promotes tax compliance.
Understanding and complying with cannabis tax requirements can be confusing. The last thing you need is to receive an IRS letter or notice of an audit.
Even if you understand current regulations, you must keep up-to-date. This includes always being aware of state laws, federal laws, and the IRS tax code that are constantly changing.
The best thing you can do for your business is to find tax professionals who provide the services of both tax attorneys and CPAs. This will put your cannabis business in the best position if it receives a letter from Uncle Sam.
Expenditures in Connection With Sale of Illegal Drugs, 26 US Code § 280e
The 280e tax code came into law in 1981 when Ronald Regan declared a war on drugs. This was the same year in Jeffrey Edmondson vs. Commissioner, 42 T.C.M.1533 (1981) the tax court ruled that a convicted drug trafficker can deduct ordinary business expenses from their taxable income. This includes deducting the cost of goods sold, including packaging, phone expenses, vehicular expenses, and home expenses relating to his running an illegal drug trafficking business.
A year later the decision was overturned. Businesses selling Schedule I and/or Schedule II controlled substances cannot deduct business expenses. The Controlled Substance Act (CSA) defines a controlled substance as one that has no medical use but has the potential for abuse.
Under federal law, Marijuana is a Schedule I controlled substance, making it illegal. This means that despite legalization in more than 50% of the states, the federal government considers any cannabis business to be drug trafficking.
With the overturning of Edmondson businesses selling cannabis are unable to deduct business expenses. The exception is for the cost of goods sold.
Cost of Goods Sold
This is an exclusion made to § 280e that allows businesses to deduct for the cost of goods sold, even if the product is illegal. The exclusion covers inventory costs. This includes shipping from the manufacturing facility to a retail location, plus other related expenses.
The IRS side-steps tax laws coming into effect following the enactment of 280e which would allow the deduction of indirect costs. This means is the process of distribution is not an allowable deduction under the cost of goods sold. Deductions for rent, overhead, shipping, paying contractors, repairs, maintenance, marketing, advertising, insurance premiums, utilities, and employee wages are not allowable deductions.
The allowable cost of goods deductions only applies to purchasing cannabis seeds and the soil, water, and nutrients necessary for planting and cultivating the product.
Impact on Business
The impact of § 280e on your cannabis business is you pay taxes on your gross profit, not your net income. Putting that into perspective, you will pay more taxes than a non-cannabis business generating the same amount of revenue.
This is because a cannabis business’ only allowable deduction is the cost of goods sold. Other businesses deduct their cost of goods sold, plus additional expenses including employee salaries, benefits, utilities, and rent. The loss of these deductions has a huge impact on the cannabis business taxable income.
Maximize Cannabis Business Tax Deductions
When you exercise proper accounting practices and compliance, you can pay fewer business taxes. Last year, 55 corporations paid $0.00 in taxes on their profits. While you don’t have large corporation tax advantages, you can pay less with proper business handling.
The first step may be setting up your cannabis business structure as a C-corporation. Under this structure, you pay taxes only on salaries and dividends.
You may want to switch to a shared services agreement. This means dividing the business into two entities. Remember, the 280e tax code refers to trafficking Schedule I and II controlled substances.
When you set up two businesses, the first is responsible for producing and distributing cannabis. The second business handles all legal responsibilities, including the management of retail space, selling related merchandise, care, and counseling.
The first business producing and distributing must comply with the § 280e tax code and the cost of goods sold requirement. The second business is able to take all normal deductions for payroll, utilities, rent, administration, promotion, marketing, and sales.
To make sure your business is compliant with all laws and tax regulations, consult with a professional tax attorney or CPA. They have legal knowledge on how to develop a compliant business structure.
Designating Employee Positions
You must provide accurate reports about your employee salaries to ensure tax code compliance. To fulfill this obligation you must designate each employee’s position in the company and pay them accordingly. This is because an employee that works part-time as a cultivator will fall under a different tax code than a part-time ‘budtender’.
If one employee takes on several different tasks, you need to track their time separately for each task. This determines how many hours you are able to deduct under § 280e.
Cannabis Tax in States
According to the Federation of Tax Administrators as of June 23, 2021, the laws regarding state taxation of businesses are as follows:
In 2017 the state revenues from cannabis businesses were $1,749,497million. July 2016 is when the first cultivation license was issued and retail sales began in October 2016. The state collects an excise tax of:
- $50 per ounce for mature flowers or buds
- $15 per ounce for trim
- $25 per ounce for immature flowers or buds
- $1 per clone
The Licensing and Tracking Marijuana Control Board and the Alaska Department of Revenue handle tax administration.
Licensing of retail cannabis businesses began on January 16, 2021. There is a 16% tax on marijuana sales, in addition to a transaction privilege tax and a use tax.
Regulation administration is under the Arizona Department of Health Services and taxes are under the Department of Revenue.
In California, personal use and growing became legal in November 2016, with retail sales starting in January 2018. The revenue from stores was $4.4 billion in 2020, a 50% growth over 2019 sales. This represents 27% of all legal sales in the United States.
Taxes on cannabis businesses include:
- $9.65 per ounce cultivation tax for flowers
- $2.75 per ounce cultivation for leaves
- $1.35 per ounce cultivation for fresh plant material
- 15% excise tax on retail sales
- 25% state retail sales tax plus local taxes
The Department of Cannabis Control regulates and licenses all cannabis activity in the state.
Colorado was the first state to approve retail sales of cannabis, beginning January 2014. As of October, total sales in 2021 are $1,902,490,501 for the state. Taxes on these businesses are:
- 2.9% state sales tax on in-store sales
- 15% state retail marijuana sales tax
- 15% excise tax on wholesale sales or transfers
- Up to 8% local option retail tax
Rules are administered by the Colorado Department of Revenue.
This state has approval for possession and sales of recreational marijuana pursuant to SB 1201. Retail sales will likely begin by the end of 2022. Taxes for businesses in this state will be:
- 625 centers per milligram excise tax on THC for cannabis flower
- 9 cents per milligram excise tax for other product types
- 75 cents per milligram for edibles
- 35% retail sales tax
- 3% municipal sales tax
The agencies administering control in this state are the Connecticut Department of Consumer Protection and the Connecticut Department of Revenue Services.
Sales from licensed dispensaries received approval for sales beginning January 1, 2020. Taxes being administered are:
- 7% sales tax to dispensaries
- 10% retail excise tax on marijuana with a THC level of 35% or less
- 20% retail excise tax on cannabis-infused products
- 25% retail excise tax for marijuana with a THC level of 35% or higher
- Up to 3% local option tax
The agencies administering control are the Illinois Department of Financial and Professional Regulation and the Illinois Department of Revenue.
Retail sales of marijuana began on October 9, 2020. Taxes in the state are:
- $335 per pound excise tax on flowers
- $94 per pound excise tax on trim
- $1.50 excise tax per seeding
- $0.35 excise tax per seed
- 10% retail sales tax
The Office of Marijuana Policy, Main Department Administrative and Financial Services, and Main Revenue Service administer the regulations.
The issuance of the first cultivation license took place on June 21, 2018. November 20, 2018, was the opening of the first retail store. Cannibals business taxes are:
- 75% retail sales excise tax
- 25% retail sales tax applies
- Up to 3% local option excise tax
Regulations are administered by the Massachusetts Cannabis Control Commission and the Massachusetts Department of Revenue.
December 6, 2019, is when retail sales began. The state has a 10% retail excise tax and a 6% state sales tax. Administration takes place through the Michigan Department of Licensing and Regulatory Affairs and the Michigan Department of Treasury.
Retail sales of marijuana will begin in 2022, with the state having taxes of:
- 4% of the retail price of medical marijuana
- 20% of retail price on marijuana and marijuana-infused products
- Up to 3% local option tax
The Montana Department of Revenue regulates the cultivation, transportation, manufacturing, and sale of products. The agency accepts applications for licenses. When you can apply depends on whether you previously held a license or if you are a new applicant.
With sales beginning July 1, 2017, the following taxes apply in Nevada:
- 15% wholesale excise tax
- 10% retail tax
- 85% sales tax plus local taxes
Regulations are monitored by the Nevada Department of Taxation.
Recreational retail sales of marijuana begin in April 2022. The state will impose a 12% retail sales excise tax that increases annually beginning in 2025 to a total of 18%. A retail sales tax also applies.
The Cannabis Control Division of the Regulation and Licensing Department will be responsible for licensing and collecting taxes.
On January 1, 2021, a constitutional amendment applies a 6.625% state sales tax to recreational marijuana but prohibits additional state sales taxes. Local governments have the authority to enact an additional 2% sales tax on recreational marijuana sales.
The regulation of processing, cultivation, and sale is overseen by the Cannabis Regulatory Commission.
Recreational marijuana sales will begin April 1, 2022, and the following taxes will apply:
- 5 cents tax per milligram of THC in flower
- 8 cents tax per milligram of THC in Concentrate
- 3 cents tax per milligram of THC in edibles
- 9% retail tax plus statewide local tax of 4%
The New York State Department of Taxation and Finance will oversee licensing, tracking, and taxes.
Retail sales at medical dispensaries began in October 2015 with recreational marijuana sales beginning October 2016. Taxes that apply are:
- 17% retail sales tax
- 25% temporary tax on medical dispensary sales from January to December 2016
- Up to 3% local option sales tax
Handling of regulations is through the Oregon Liquor Control Commission and the Oregon Department of Revenue.
In November 2021 the South Dakota Supreme Court ruled that Constitutional Amendment A is unconstitutional. The amendment’s purpose is to require laws to pass providing a program for the sale of hemp and medical marijuana. The amendment includes a marijuana sales tax of 15%.
The court ruling is because the amendment violates Article XXIII § 1. This section requires amendments to deal with only one subject. The amendment contains provisions under the subjects of medical marijuana, hemp, and recreational marijuana. While this ruling nullifies sales of recreational marijuana, it does not affect the legalizing of medical marijuana.
Retail sales are to begin October 1, 2022, according to Bill S.54. Bill status shows it is currently in the Governor’s office. The governor did allow it to become law without a signature.
Sales will be subject to state sales tax plus a cannabis excise tax of 14% of the retail price. The Cannabis Control Board and Department of Taxes will administer the licensing, tracking, and taxes.
Retail sales of marijuana will begin January 1, 2024, pursuant to SB 1406. There will be a 21% retail sales tax on all products sold through marijuana stores plus an optional 3% local sales tax.
Control will be overseen by the Virginia Cannabis Control Authority that is being created. The organization will issue regulations no later than July 1, 2023.
Washington is the second state approving retail sales of medical marijuana and licensing of dispensaries as of June 2016. There is a 37% tax on retail sales plus a 6.5% retail sales tax plus any local taxes. Medical marijuana is exempt from sales taxes.
The Washington State Liquor and Cannabis Board handles licensing, tracking, and taxes.
Cannabis Tax Audit
Cannabis businesses generate a substantial amount of federal tax revenue, despite the fact that they are still illegal on the federal level. High tax revenue, combined with being a cash-intensive business, increases the likelihood of an IRS audit.
To assist you in becoming familiar with the audit likelihood you face, the IRS has a cash business audit techniques guide on their website. The IRS recommends business owners follow this guide in addition to the recommendations on their ‘Marijuana Industry’ webpage.
Understanding and following these intense regulations while trying to run a business can be overwhelming. Having a team of cannabis tax experts that can help you set up an accounting program, are familiar with regulations, and will assist you in preparing tax returns is the best insurance policy for a successful audit.
A successful audit requires impeccable accounting records. You must keep track of every transaction and retain 100% of your receipts. If you are unable to prove deductions you take are valid, you will be subject to IRS fines and penalties.
To save money on taxes make sure you pay attention to your floor plan and its impact on your business. You must also be attentive to employee classifications.
Cannabis Tax Professional Help
When managing a cannabis business, you need to concentrate on the latest cannabis news regarding products and business operations to ensure your cannabis investments are made wisely. One of the best business decisions you can make in this industry is hiring a cannabis tax expert to handle that aspect of your business.
With 100 combined years of tax resolution experience, Polston Tax can help. We handle everything tax-related with our team of over 100 tax attorneys, CPAs, tax preparers, accountants, case managers, and more. Contact us today to schedule a free consultation.