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Marijuana Startups: What to Know About Tax Section 280E

Marijuana growing operation; cannabis business
By Lisa M. Schaffer, Esq. on July 27, 2018 | Last updated on March 21, 2019

When is the sum of the parts greater than the whole? When it's tax time in the cannabis industry.

By now, everyone understands that the federal government does not recognize the decriminalization of cannabis, regardless of state law. Marijuana must be included in any federal law that deals with Schedule I controlled substances. This is where tax section 280E comes into play. If you're i the marijuana startup biz, here's what you need to know about this tax section:

What Is Section 280E?

The one federal law from which no one can escape is the Federal Tax Law. Specifically, 26 U.S. Code Section 280E states that all businesses engaging in the trafficking of cannabis is barred from taking tax deductions or credits of any kind. Translation: cannabis companies have to pay corporate taxes on all revenue.

As of December 2017, the highest federal corporate tax rate was 35%. However, most corporations had an effective tax rate of 21%, and some even as low as zero, by offsetting revenue with allowable deductions such as operating expenses, employee salaries, travel expenses, bad debts, and equipment, to name just a few.

Cannabis companies were stuck at the 35% rate unless they could take a 280E "Cost of Goods Sold" (COGS) Exception, which allows for the deduction for COGS, such as costs incurred in production and shipping, even where the goods are illegal under federal law. But there's one caveat: very modern accounting systems for cannabis companies must be used because the exception went into place after the legalization and incorporation of cannabis businesses in most states.

Strategize Twice, Incorporate Once

The best, or maybe only, time to set up the requisite different accounting systems is during incorporation because to do it correctly, a marijuana startup actually has to create two companies. One company declares it handles all of the parts of the business that can't take deductions due to Section 280E, such as marijuana production and distribution. The second company declares that it handles all of the "legal" business, such as production and sale of pipes, care services, and even owning and managing the building that house both companies.

Done correctly, it's possible to get the tax rate of the second company down to zero. This may seem like a sham, but tax courts have been quite supportive, even to the point of allowing employees to work for both companies, getting minimum wage in the first company, and a higher wage in the second.

With sound corporate structure and accounting from the outset, cannabis companies can cut their tax liability in half. If you are thinking about entering this budding industry, make sure to see a tax attorney first, or you may see all your hard earned green go up in smoke.

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