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For most of us, the process of determining how much income tax we are obligated to pay follows a few standard rules. In the United States, the federal government’s power to levy income tax is based on the 16th Amendment, which states quite plainly that, “The Congress shall have power to lay and levy taxes on incomes, from whatever sources derived, without apportionment among several States, and without regard to any census or enumeration.”
The 16th Amendment & Edmondson v. Commissioner
So as long as you are making income, Congress has the power to tax it. One of the crucial points here, which loomed quite largely in cannabis tax history, is that “income” as defined under the 16th Amendment made no distinction to income made legally or illegally. “Income” as used in the 16th Amendment was all-encompassing, and made no distinctions on how it was derived, whether within legal means or not, or “from whatever sources derived.” So in 1981, at the same time that the Tax Court found that a drug trafficker was required to pay income tax on the income he derived from his illegal drug trade, the court also found that he was allowed to deduct ordinary business expenses, just as all other taxpayers are allowed to do.
Of course, this case resulted in what has now become, at least to legitimate cannabis businesses, the rather infamous IRC 280E. Congress enacted 280E specifically to address the result of the gaping hole wherein drug traffickers availed of the same right and privilege to make deductions to their taxable income, much as other taxpayers engaged in legitimate businesses could do. But when Congress stated that those engaged in the trafficking of prohibited and controlled substances could not avail of any credit or deductions to their taxable income, it was a safe bet that they never expected drugs that were classified as prohibited or controlled would be legalized under state law.
In any case, most taxpayers, in determining their income tax, follow the same general rules:
- Determine gross income
- Determine adjusted gross income
- Adjusted gross income less either the standard deduction or allowable itemized deductions
- The result is the taxable income
- Taxable income falls under certain predetermined ranges or brackets, and the tax rates that are applied depend on the tax bracket each taxpayer falls under
- Multiply the tax rate to the taxable income, and you have the amount of tax owed
To put it more simply, taxable income is your adjusted gross income less standard or allowable itemized deductions. And while the tax bracket and tax rate are pretty much standard across the board, the taxpayer’s efforts at minimizing the taxes they owe end at numbers 3-4 in the list above. By availing of all the allowable adjustments and deductions, they can reduce their taxable income. A lower taxable income means a lower tax bracket and a lower tax rate.
Cost of Goods Sold
For cannabis business owners, however, their efforts at reducing your taxable income end at number 2 in the list above or in adjusted gross income. IRC 280E effectively prohibits cannabis businesses from availing of any kind of standard deduction or allowable itemized deductions, creating a host of cannabis tax issues. Most adjustments are also not available to cannabis businesses, save for one exception. Cannabis businesses can make one adjustment to their gross income, and only one: the Cost of Goods Sold (COGS).
Given that IRC 280E was intended to apply to illegal drug traffickers, this application to legitimate cannabis businesses seems wholly unfair and discriminatory. Perhaps Congress will enact a law to rectify this untenable situation – but for now, cannabis producers and dispensaries can only work with what they have. So in a scenario where your taxable income is your gross income less cost of goods sold, successfully operating your cannabis business also means you should get really good at identifying and adjusting for cost of goods sold.
-Jin Kim. Tax attorney Jin Kim represents cannabis businesses under audit or who owe state or federal tax debt. To learn more about tax relief options for the cannabis industry call her office at (916) 299-9913 for a free consultation.