In 1981, with the “War on Drugs” in full swing, a U.S. Tax Court allowed an amphetamine, cocaine, and cannabis trafficker to deduct his ordinary and necessary business expenses related to his drug business from his taxes. Edmondson v Commissioner set a precedent in which illicit drug traffickers were authorized tax deductions for: rent, drug packaging, telephone bills, automobile expenses and small scales. Congress responded by enacting Section 280E of the Internal Revenue Code, still in effect today as originally enacted, which provides:
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 (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted. 26 U.S.C. § 280E.
Essentially, Section 280E prohibits a taxpayer from deducting ordinary and necessary expenses when determining gross income if that taxpayer is engaged in trafficking a Schedule I or Schedule II controlled substance, except for the adjustment of gross receipts by the cost of goods sold. Cannabis is (still) categorized federally as a Schedule I substance, even in legalized recreational states.
Legal cannabis companies statutorily fall under Section 280E, and face significant hardships because of its designation. On top of facing hefty layers of taxes, cannabis businesses are being denied nearly all deductions. Section 280E was initially interpreted to deny any taxpayer involved in illicit drug trafficking operations deductions for rent, salaries, phone bills, electric bills, and all other ordinary and necessary exceptions. In 2007, Californians Helping to Alleviate Medical Problems, Inc., v. C.I.R. shifted Section 280E interpretation to permit deductions in circumstances where a business offers distinct cannabis and non-cannabis products or services. Surprisingly, in 2015 Canna Care, Inc. v. C.I.R., the Court denied deductions for expenses incurred operating a nonprofit, medical cannabis dispensary.
Despite the congressional intent behind Section 280E to simply keep drug traffickers from using illegal activity to their benefit, this outdated code impedes the legal cannabis industry in two main ways: by financially burdening legal cannabis businesses and causing inflation, thereby pushing the market back to the streets. Another important point is, especially in 2022, criminals tend to not pay taxes. Meaning the code does not ease criminal activity, instead it hurts the legal cannabis industry, many of which are small businesses.
Currently, cannabis businesses may be left with tax liabilities of up to 70% of their income, while banned from deducting employee salaries, utility costs, health insurance premiums, marketing costs, rent, repairs, maintenance, and payments to contractors. How would Section 280E reform look? There are different viable strategies, accomplishing it by either modifying the code itself or by the reclassification of cannabis so it would no longer be considered a Schedule I or II substance. All things considered, we at Greenbelt believe Section 280E reform is necessary to not only align with today’s public policy, but as a matter of common sense and sound business.