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As a cannabis business owner in California, you're no doubt familiar with the unique challenges and complexities that come with operating in this highly regulated industry. From navigating stringent licensing requirements to staying current on the ever-evolving legal landscape, managing a successful cannabis enterprise requires a high level of attention and vigilance.
One particular aspect of running a cannabis business that can be especially daunting is understanding the tax implications, specifically the notorious Section 280E of the Internal Revenue Code. In this blog post, we'll dive into the details of Section 280E, its impact on your cannabis business, and offer some guidance on how to navigate this tricky tax provision.
What Is Section 280E?
Section 280E was introduced by Congress in 1982 as a response to a U.S. Tax Court case involving a cocaine drug trafficker who successfully claimed deductions for ordinary and necessary business expenses. To prevent illegal drug dealers from benefiting from such deductions, Congress enacted Section 280E, which states that no deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business consists of trafficking in controlled substances.
As cannabis remains a Schedule I controlled substance under federal law, cannabis businesses are subject to Section 280E, even though they operate legally under state law. This means that while other businesses can deduct ordinary and necessary expenses from their gross income, cannabis businesses are limited in the deductions they can claim.
This means that legally-operated California cannabis businesses spanning cultivation, manufacturing, distribution, and retail sales are all affected by Section 280E. The inability to claim standard deductions results in a higher effective tax rate for these businesses, which can significantly impact profitability and cash flow.
For example, a cannabis retailer may be unable to deduct expenses such as rent, utilities, and employee salaries, while a cultivator may not be able to deduct costs related to growing equipment, fertilizer, and water. This puts cannabis businesses at a competitive disadvantage compared to other industries and can lead to financial strain.
Potential Deductions and the Importance of Recordkeeping
While Section 280E limits the deductions available to cannabis businesses, there may be some deductions they can claim.
To maximize any deductions available, cannabis businesses must maintain accurate and detailed records. This includes tracking inventory, production costs, and sales data. Furthermore, careful recordkeeping can help businesses demonstrate compliance with state and federal regulations and avoid potential audits or penalties.
How Will California AB 37 Help Licensed Cannabis Businesses?
Signed into law by Governor Gavin Newsom in October 2019, California Assembly Bill 37 (AB 37) has the potential to change the financial landscape for these businesses by easing some of the tax burdens imposed by Section 280E of the Internal Revenue Code.
AB 37 is a state-level bill that allows licensed cannabis businesses to claim deductions for business expenses on their California state income tax returns. Prior to the passage of AB 37, California conformed to federal tax law, meaning that cannabis businesses were subject to the same restrictions on deductions as imposed by Section 280E at both the federal and state levels.
By allowing cannabis businesses to deduct ordinary and necessary business expenses from their state taxable income, AB 37 aims to reduce the overall tax burden on these businesses and promote growth within the industry.
The primary benefit of AB 37 for licensed cannabis businesses is the ability to claim deductions for business expenses on their California state income tax returns. This can lead to significant tax savings and improved cash flow, which can be reinvested into the business or used to cover operational costs.
It is important to note that AB 37 does not impact federal tax obligations for cannabis businesses, which are still subject to the limitations imposed by Section 280E of the Internal Revenue Code.
To take full advantage of the benefits offered by AB 37, licensed cannabis businesses must maintain accurate and detailed records of their expenses. This includes retaining receipts, invoices, and other documentation to substantiate deductions claimed on state tax returns.
While AB 37 provides much-needed relief for licensed cannabis businesses in California, it is a temporary measure that is set to expire on January 1, 2025. The future of cannabis taxation in California will depend on legislative actions taken before this expiration date, as well as potential changes to federal tax law regarding the treatment of cannabis businesses.
To learn more about cannabis tax laws, read our recent article about tax credits provided to cannabis businesses and an article about advice for cannabis businesses from the IRS.
At Purdy & Bailey, LLP, we understand the complexities of cannabis laws and strive to provide our clients with comprehensive guidance on cannabis business laws and compliance. Contact us online or call us at (858) 360-7080 to schedule a consultation.