Filing tax returns for your cannabis industry clients is not easy because their businesses are still classified as “trafficking in controlled substances” under Section 280E of the U.S. Internal Revenue Code. Such classification means these businesses cannot deduct ordinary and necessary business expenses from their gross income, ultimately leading to higher tax rates.
The federal government justifies Section 280E through the Controlled Substances Act (CSA) combined with Congress’s authority to regulate trade across state lines under the Commerce Clause.
But the future of Section 280E is unclear. With recreational use of cannabis now legal in 24 states, two territories, and the District of Columbia, state-legal, intrastate activity challenges the foundation of the federal laws. The court case Canna Provisions v. Garland challenged the prohibition of cannabis under the CSA, and despite being dismissed by the U.S. District Court of Massachusetts, the case could reach the Supreme Court.
The Canna Provisions case has opened the door for the potential argument that Section 280E should not relate to state-legal markets anymore. With the future of Section 280E uncertain, cannabis-specialized accountants may be unsure how to help their clients. Changes to the cannabis tax landscape and potential revisions to Section 280E will be explored in the upcoming webcast “Cracks in 280E: Why Cannabis CPAs Must Prepare for a Constitutional Shift.”
It’s unclear when or if the de-scheduling of Section 280E could happen, so you need to know your options.
Exploring constitutional grounds against Section 280E
There is still a position for you to prepare a Section 280E tax return using Section 471(a) or 471(c) provisions, which essentially allow cannabis companies to optimize the amount of cost of goods sold (COGS) or direct expenses they can deduct.
When filing a non-280E return, three constitutionally grounded arguments may be presented to demonstrate that taxing state-legal operations based on gross receipts could violate constitutional protections.
Related to the Commerce Clause, the federal government cannot reach into state-legal programs that are operating at the state level only — and Canna Provisions v. Garland was disputing this fact. State-level operations are not using federal banking nor are they crossing state lines. If cannabis businesses operate entirely within state borders and comply with all state laws, should federal statutes still apply to them?
The second argument cites Standing Akimbo v. United States and how the federal government takes both a “half-in, and half-out regime that simultaneously tolerates and forbids local use of marijuana” in a Supreme Court opinion.
Third, according to the Sixteenth Amendment, the IRS can only tax companies on income. However, the way that Section 280E contemplates income is through gross receipts and not net income.
The three arguments also demonstrate how much has changed since Section 280E was enacted and suggest that the current classification may no longer be applicable.
Strategies as you navigate Section 280E
Run scenarios by your clients that depict their position with or without Section 280E and try to understand their risk tolerance.
If your client opts to declare that Section 280E does not apply to their cannabis business, next steps include carefully documenting legal claims, monitoring litigation developments, and determining the cost of potential exposure. The process is laborious but could be beneficial in a post-280E environment.
Amended returns with refund claims may be filed, asserting under a “reasonable basis” that Section 280E does not apply to the taxpayer. A tax position that is supported by a sound legal argument and properly disclosed can avoid penalties.
Document your client’s arguments, maintain detailed support for COGS calculations, and monitor court cases like Canna Provisions. Properly filed refund claims could result in significant recoveries if courts rule that Section 280E is unconstitutional for state-legal cannabis businesses.
If you and your client assert that Section 280E is not applicable on their tax return, this claim must be treated as an uncertain tax position under FASB ASC 740, Income Taxes. Uncertain tax positions must be disclosed on financial statements. To be disclosed, the position needs to meet the “more-likely-than-not” threshold.
Preparing for a constitutional shift in cannabis taxation
Section 280E has loomed over the cannabis industry for 43 years, and it does overly complicate matters for these businesses.
It’s unlikely that marijuana will be rescheduled from Schedule I to Schedule III anytime soon. Such a change would acknowledge marijuana’s accepted medical use, and Section 280E would no longer be applicable to cannabis businesses. A Supreme Court ruling or a shift in IRS priorities could also end Section 280E.
Until change happens, we as accountants can still provide our expertise to help cannabis businesses navigate the complexity. They’re a legitimate industry that deserves to have high-quality advisers who can lean into these complex areas.
The flaws of Section 280E are now visible, and you can learn more by registering for the upcoming January 12 webcast, “Cracks in 280E: Why Cannabis CPAs Must Prepare for a Constitutional Shift.”