Mitigating the impact of section 280E for cannabis businesses

Cannabis businesses, while legal in many states, face numerous challenges because of federal law. One of the most significant is the high federal effective tax rate, which can easily exceed 50%. These high rates are caused by Section 280E of the Internal Revenue Code.

Background

Section 280E generally denies all tax deductions and credits for businesses engaged in trafficking Schedule I or II controlled substances, including cannabis. This means normal expenses such as rent, utilities and marketing may not provide any tax benefit. Instead, cannabis businesses typically pay tax on their gross profit — or gross receipts minus the cost of goods sold (COGS).

An employee stock ownership plan (ESOP) is a qualified retirement plan that allows employees to become indirect owners of their employer. ESOPs are tax-exempt entities and serve as a retirement benefit for employees.

Cannabis ESOPs

If a cannabis business is organized as an S corporation, the corporation itself does not pay tax; instead, income flows through the S corporation and is taxed to its shareholders. When one of those shareholders is an ESOP — which is tax-exempt — the income of the S corporation escapes taxation.

In short, ESOP ownership of a cannabis business effectively nullifies the impact of Section 280E while motivating employees and improving retention.

However, there is a cost to establishing an ESOP for a cannabis business. The current owners must sell part or all of their equity in the business to the ESOP. To the extent the historic owners retain ownership, Section 280E will continue to apply to their portion.

Section 471(c)

For cannabis businesses that do not wish to pursue an ESOP transaction, there are other ways to mitigate the impact of Section 280E. Without changing ownership, a business may be able to include additional costs in COGS so those expenses are not denied under Section 280E.

Section 471(c) allows certain “small businesses” — those with average annual gross receipts of less than $31 million, averaged over the past three years — to use an alternative method of accounting for inventory. This method may include certain costs that otherwise would not be included in COGS. Section 280E will still apply to the business but will deny a smaller portion of deductions.

While using Section 471(c) to account for inventory differently will not reduce tax liability as much as ESOP ownership would, it can allow some cannabis businesses to achieve an effective tax rate closer to that of an average business not subject to Section 280E. In addition, implementing this inventory accounting method is much simpler than setting up an ESOP and allows business ownership to remain unchanged.

Jason W. Klimek is a co-leader of Harris Beach Murtha’s Cannabis Industry Team

and a member of the firm’s Tax and Corporate practice groups. Jason’s comprehensive understanding of the cannabis industry complements his experience as a successful corporate and tax attorney, uniquely qualifying him to counsel cannabis companies on business and tax matters. He’s developed a stellar reputation working with cannabis companies of all forms and sizes on entity selection, taxation, funding, licensing, regulatory navigation, employment issues, securities transactions and a host of other matters.

Ryan E. Dunn, a member of Harris Beach Murtha’s Cannabis Industry Team and

Tax and Corporate practice groups, advises businesses and individuals on all aspects of U.S. taxation, focusing on cross-border activities and transactional matters. He also provides domestic tax advice to partnerships, corporations, S corporations and their respective owners on various business transactions, including formations, mergers, acquisitions, internal restructurings and divestitures. Ryan’s experience spans a myriad of sectors, including cannabis, technology, finance, real estate and advertising.