Marijuana Dispensary Tax Deduction Issues

Nothing is certain but death and taxes, as the old adage goes. And taxes, at least, seems to have plagued the cannabis industry since it was first legalized for medical use in California in 1996, particularly when you consider that cannabis has a very long history of being a prohibited or controlled substance, on both the federal and state level, since the 1930s.

In this article, we take a closer look at the tax deduction issues for marijuana dispensaries and cannabis businesses

Tax Deductions as a Basic Concept

In general terms, tax deductions are the costs or expenses that a taxpayer deducts from their gross income. The difference is what is referred to as the taxable income, which is then used as the basis for determining how much tax is owed.

Hypothetically, say in a month, your businesses generated a gross income of $1,000. But you also paid wages and rent and incurred other expenses which amounted to some $400. The difference of $600 is your taxable income, against which the prevailing tax rate will be applied to determine how much tax you owe. If the tax rate is, for instance, 10%, that would be 10% of $600, or $60.

Consider the difference if you did not have or were not allowed any tax deductions. The 10% tax rate will be applied to your gross income of $1,000, which means that the tax you owe would be $100 instead of $60.

The federal income tax rates are also considered “progressive,” which means that the applicable tax rate is adjusted depending on what tax bracket you fall under. Essentially, the higher your income, the higher the tax rate that applies to you. As of 2020, the highest tax rate is 37% for those with taxable income ranging from $518,400 and over for single filers. There are currently seven taxable income brackets, with tax rates ranging from 10% to 37%. So literally, the amount of your taxable income goes a long way in determining your tax bracket and your taxable income, and your taxable income is, in turn, determined by how much in deductions you can apply to your gross income. The more deductions you have, the lower your taxable income and tax bracket, the lower your tax.

No Deductions for Cannabis Businesses under IRC 280E

Right from the outset, cannabis businesses are operating at a huge disadvantage compared to other legitimate businesses. The reason is that marijuana is still classified as a Schedule I substance under the Controlled Substances Act, and under IRC 280E, any trade or business “trafficking in controlled substances” are not allowed to claim a deduction or credit against their gross income. In the example above, regardless if the cannabis business incurred the same kind of costs and expenses that other legitimate businesses can validly deduct, cannabis businesses are still expected to pay tax on the gross income of $1,000 instead of only the $600.

IRC 280E was originally intended to curb and penalize the illegal drug trade, so that those who engaged in drug trafficking were required to pay taxes on their gross income, regardless of whether or not they were a legitimate business, and regardless of whether or not they were legally engaged in business. By not being able to claim any deductions at all, IRC 280E was intended to make a financial hit on drug traffickers.

Now, however, with the “dual” status of marijuana as being a controlled substance under federal law, but a legally permissible business under state law, the practical effect is that legitimate cannabis businesses are experiencing the same financial hit that was originally intended to penalize drug traffickers.

Cost of Goods Sold

While tax deductions for cannabis business expenses are barred by IRC 280E, marijuana businesses can still use cost of goods sold to reduce their taxable income. The calculation of cost of goods sold will differ depending on whether the cannabis taxpayer is a retailer or producer, so guidance from a cannabis attorney or CPA is necessary.