Mackay, Caswell & Callahan, P.C.
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How to Counsel Clients on Structuring Around Section 280E


As you may be aware, to date there are 11 states that have legalized recreational cannabis and over two dozen more have decriminalized or can legally sell medical marijuana. With more states waiting in the wings to legalize, it may be time to acquaint yourself with the provisions of IRC Section 280E.

Feb 25th 2020
Mackay, Caswell & Callahan, P.C.
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Section 280E pertains to businesses which sell so-called “controlled substances,” as defined by the federal government.  In this post, we will discuss the impact of IRC Section 280E on businesses which sell recreational cannabis and then go over a technique these businesses can use to place themselves in a more favorable position.

As we will see, with a bit of business maneuvering, these businesses can lessen much of the negative financial impact of Section 280E.

Basics of IRC Section 280E

As mentioned, Section 280E refers to businesses which generate income from the sale of federally controlled substances. Specifically, Section 280E forbids these businesses from taking deductions for ordinary business expenses which follow from generating income from the sale of controlled substances.

Importantly, Section 280E does not forbid these businesses from subtracting the cost of goods sold (COGS) when computing taxable income. But businesses selling controlled substances are barred from taking deductions for any other expenses aside from COGS. Because cannabis is still a controlled substance at the federal level, cannabis retailers must comply with the restrictions of Section 280E.

Section 280E Can Produce Large Tax Bills

Because cannabis retailers and other businesses which sell controlled substances must comply with Section 280E, these businesses can end up with unusually large tax bills. In many cases, businesses rely on taking deductions for ordinary business expenses in order to turn a profit.

When Section 280E is imposed, cannabis businesses end up paying taxes on income which isn’t “real” or “true” income because ordinary expenses haven’t been taken into account. Let’s consider a common scenario: a cannabis business has total or gross revenue of $1 million, COGS of $250,000, and ordinary business expenses of $350,000.

When this business pays taxes under Section 280E, it will be taxed on income of $750,000, rather than $400,000. If the business pays taxes on $200,000 based on taxable income of $750,000, this business would have an effective tax rate of 50 percent, because its “true” income is only $400,000! These high tax bills can quickly eat away at a business’s profit margin.

Business Structuring Around Section 280E

Until Section 280E is amended or removed, how can cannabis retailers place themselves in a better financial situation while still being in full compliance with this section? Fortunately, if cannabis businesses split their business into two separate entities, they can get around Section 280E without violating it.

Here’s how this strategy works: the cannabis retailer creates two separate businesses (i.e. two LLCs, LLPs, etc.), and each of these two business entities will perform a different function. One business entity will generate income from selling cannabis products, and then the other business entity will perform every other function (i.e. maintenance, storage, marketing and advertising, other merchandise, building management, etc.).

The entity which actually sells the cannabis products will comply directly with Section 280E and take the COGS deduction. The other entity will be outside the purview of Section 280E and will take all deductions for ordinary business expenses.

This maneuver will require a bit of money to actualize – i.e. legal fees, advisory fees, other setup costs, etc. – but, given the impact of Section 280E, businesses which utilize this strategy will see a big net benefit. This strategy has actually been expressly approved by the courts. In CHAMP v. Commissioner, the court upheld a cannabis business’s implementation of this strategy.

This decision was then expressly supported in another case, Canna Care v. Commissioner. When implementing this strategy, it is imperative that the business maintains impeccable recordkeeping, otherwise an argument may be made that the business is actually just a single business rather than two separate businesses.

Cannabis retailers need to obtain competent legal counsel and a competent accountant when attempting this strategy. But again, the benefits of this strategy will greatly outweigh the costs of hiring competent professionals.

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Replies (1)

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Cannabis Accountant Brad Green
By Green Flower CFO
Feb 24th 2021 23:24 EST

While the background on 280E in this article is useful, the separate entity strategy is guaranteed to flag owners to the IRS.

It's not enough to have separate business entities anymore as we have seen in these 2 recent (ish) cases
- Patients Mutual Assistance Collective Corporation v. Commissioner (2018)
- Alternative Healthcare Advocates v. Commissioner (2018)

The court found in both of these cases that entity structure and non-cannabis divisions / product lines etc have limited influence in whether or not 280E applies. Rather it's the overall "business purpose" of the entities involved.

"A single taxpayer can have more than one trade or business, or multiple activities that nevertheless are only a single trade or business. (citation omitted). Even separate entities’ activities can be a single trade or business if they’re part of a ‘unified business enterprise’ with a single profit motive. Whether two activities are two trades or businesses or only one is a question of fact. To answer it, we primarily consider the ‘degree of organizational and economic interrelationship of various undertakings, the business purpose which is (or might be) served by carrying on the various undertakings separately or together, and the similarity of the various undertakings. (emphasis supplied).

The IRS and the courts are seeing through these attempts to avoid 280E and are hitting cannabis businesses and there owners with hefty fines and penalties. As long as cannabis remains federally illegal the excessive 280E burden will remain.

There are other ways to minimise the 280E liability that won't put businesses at risk
- Vertical integration provides many more opportunities for allowable deductions
- Correct cost accounting according to GAAP principles, particularly for cultivators
- Small businesses may have some IRC 471 opportunities
- Audit proof financial records that support the tax position taken

In addition the the above, it's hard to go wrong by being well capitalised and focusing energy on building brand and market share.

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