In the US, the tax laws surrounding the production and trading of recreational and medical cannabis significantly vary under two different jurisdictions—the federal and state laws. As a cannabis business owner, navigating the ins and outs of these tax rules and tax obligations is not only challenging but also confusing.
Under federal and state laws, cannabis business owners are entitled to tax deductions and tax credits. It is good news for operators, given that the cannabis industry may be one of the most heavily taxed industries in the country.
These tax deductions and tax credits are only applicable under certain circumstances, however.
If you are here to learn whether you qualify for either tax deductions or tax credits, read on. In this article, we will explain the difference between tax incentives and deductions, the qualifications for the exceptions, and what it means for your business.
Let’s start.
Tax Credits vs. Tax Deductions for Marijuana Businesses
As of today, cannabis-related business operators are entitled to two tax perks: tax credits for research and development activities and tax deductions under tax code 280E.
In summary, here’s how each rule differs:
Research and Development (R&D) tax credit or tax incentive is a federal law that rewards private sectors that conduct and invest in research and development activities. It is awarded as a “non-refundable credit” by returning a percentage of the business or organization’s qualifying R&D expenses.
The tax deductions, on the other hand, are exemptions under the IRS Tax Code 280E. These deductions include direct and indirect costs associated with the production of the goods.
Tax Deductions: The IRS Tax Code 280E & What It Means for Cannabis Businesses
The IRS Tax Code 280E is a law that halts a taxpayer’s power to claim tax deductions from the production and sales of controlled substances, namely marijuana, cocaine, and amphetamines. In other words, marijuana business owners—as well as illegal traders of cocaine and amphetamines—are not entitled to the benefits of deductible tax expenses that other businesses in other industries enjoy, such as shipping, transportation, and packaging.
Cannabis business owners are more likely to pay higher federal taxes compared to other businesses in other industries as a result. Essentially, section 280E of the tax code can significantly impede the growth of marijuana businesses financially.
Moreover, cannabis, despite its recent legalization in several states of the country and increased medical use, remains under Schedule 1 controlled substance. Hence, even if your business is operating in a state where the medical and recreational use, production, and trading of marijuana is legal, your right to claim tax-deductible expenses remains invalid.
Does It Apply to Cannabis Growers?
Section 280E of the IRS tax code stops recreational cannabis growers’ right to claim deductible tax expenses, too. Businesses related to medical cannabis that involve touching the plant and by-products in the supply chain are covered as well.
Cannabis verticals like (a) cultivators, (b) retail dispensaries, (c) businesses that involve extraction and infusion of cannabis products, and (d) businesses that sell wholesale marijuana products to other sellers are also affected by section 280E of the IRS tax code.
Exceptions to Section 280E of the IRS Tax Code
Under section 280E of the tax code, two exceptions allow cannabis business owners to claim deductions for standard business expenses. These are State-level Exception and Cost of Goods Sold (COGS) Exception.
State-level Exceptions
The state-level exception is a state-governed tax rule that excludes section 280E in the computation for state income tax. The states of Colorado, New York, and Oregon are two of the few states that exclude section 280E.
In essence, it enables cannabis business owners operating in states where section 280E is invalid to deduct standard business expenses. For an industry that may be heavily taxed, it means reduced tax pay and a chance to grow financially.
Cost of Goods Sold Exception
The cost of Goods Sold (COGS) Exception is an exclusion ruled after the federal tax court case CHAMP vs. Commissioner, where the former won. The exception claims that section 280E of the IRS tax code should not prohibit taxpayers from claiming the cost of goods sold.
Cost of Goods Sold are necessary expenses used to construct, acquire, and extract a physical product to be sold. In the federal tax court case between the Californians Helping to Alleviate Medical Problems Inc. (CHAMP) and Commissioner, the former argued that, as a taxpayer, they should be able to take off the cost related to production, as well as services given to the community that did not involve touching of the plant. The organization won and has since then set a precedent for other marijuana-related businesses—be it for recreational or medical use.
This exception to section 280E can significantly help business owners raise their profit by deducting their total tax liability. Some examples of deductible labor under COGS are cleaning, curing, inventory, trimming, packaging, and indirect product expenses such as equipment maintenance.
The only disadvantage to this exception is that the rules are too complicated and laborious. If you want to understand this exception better as well as benefit from it, it is best to reach out to Cannabis CPA firms and work with a cannabis accountant.
Tax Deductions Under Section 280E
As per the Cost of Goods Sold Exception, a cannabis business owner is allowed to deduct several expenses related to the construction, extraction, and acquisition of cannabis products that were sold. These deductible expenses are divided into two categories: direct and indirect costs.
Direct Costs
Here’s how they differ:
Direct costs are divided into two categories: direct labor costs and direct material costs. Direct material costs refer to the materials used—or a material that has become an essential part of the by-product—during the production of cannabis products. Direct labor costs, on the other hand, include sick leave pay, holiday pay, vacation pay, payroll taxes, and compensation.
But not only that! Here are a few more direct costs that you can deduct:
Maintenance
Repairs
Plant nutrients
Garden supplies
Grow medium
Clones or seeds
Processing materials
Packing materials
Single-purpose agricultural products
Special-purpose agricultural products
Tools and equipment that are not capitalized
Indirect Costs
Indirect costs are also known as manufacturing overhead during the production process. It cannot be tied to specific produced items as well.
Here are a few samples of what you can deduct as indirect costs:
HVAC system
Cannabis cultivation taxes
Security and alarm
Indirect supplies and materials
Paid property taxes for the production facility
Compensation of the janitorial staff
Product equipment depreciation
Wages of the quality control staff
Salaries of cultivation managers
Tax Credits: Research & Development Tax Incentives & What It Means for Cannabis Businesses
In the United States, taxpayers are allowed to take tax credits through several programs. A tax credit is an amount of money that taxpayers can deduct dollar-for-dollar from their income taxes. As a result, it directly reduces a taxpayer’s final tax liability—unlike tax deductions that only minimize the amount of taxable income.
Tax credits are divided into three categories: non-refundable tax credits, refundable tax credits, and partially refundable tax credits. Each category is obtained through several programs, such as education-related credits (for partially refundable tax credits), Earned Income Tax Credits (for refundable tax credits, and Research and Development Tax Incentives (for non-refundable tax credits).
But what do these tax credits mean to canabis entrepreneurs? Per the IRS, some cannabis businesses may be qualified for Research and Development Tax Credits.
Who Can Use the Research and Development Tax Credits?
The Research and Development (R&D) Tax Incentive is available to several diverse businesses and organizations that participate in projects or activities related to R&D, such as developing new products and enhancing existing techniques, processes, and formulas. It applies to businesses in industries like manufacturing, finance, as well as food and beverages.
Small- to medium-sized business owners are now allowed to take advantage of the R&D tax incentives, too. Any type of business, so long as it is participating in activities given by the IRS, is qualified to apply for the tax credit.
How Will Cannabis Businesses Benefit from R&D Tax Credits?
Some businesses in the cannabis industry may or may not benefit from the R&D tax incentives. Cannabis products that contain a significant amount of THC—more than 0.3%—remain illegal under federal law. With that, businesses that sell and produce cannabis with high amounts of THC are not qualified to apply for any federal tax incentives, including R&D tax credits.
Businesses that sell and produce cannabis products with low THC levels, on the other hand, may be able to utilize the R&D tax incentives. Through the Agriculture Improvement Act of 2018, cannabis products and hemp that contain low THC levels—less than 0.3%—are removed from the definition of “marijuana” under the Controlled Substances Act (CSA).
The tax rules and regulations surrounding cannabis products may be too complicated for ordinary folks. It is best to consult a tax firm that specializes in cannabis businesses.
What Qualifies for R&D Tax Credits?
A qualified cannabis business must have participated in qualified research expenses such as (a) paid supplies used to conduct the research, (b) salaries of employees, and (c) services related to qualified research.
Here are a few typical expenses that can qualify for the R&D tax credit:
New extraction techniques and oil product
Development of new products
Learning and testing the use of LED lighting for indoor growing
Cultivating new types of cannabis products
Studying the use of cannabis for biofuel and other materials
Developing new methods to process, create, improve, and store shelf-life products