Some marijuana businesses face a tax trap in Tax Code section 280E.
[UPDATE: http://www.huffingtonpost.com/pat-oglesby/marijuana-advertising-the_b_3810341.html or here; and there are several more recent posts on this blog, searchable by 280E.]
Section 280E doesn’t say much: “No deduction or credit shall be allowed for any amount paid or incurred . . . in carrying on any trade or business . . . of trafficking in controlled substances . . . which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” https://newrevenue.org/2013/03/13/marijuana-tax-code-section-280e-text-and-joint-committee-legislative-history/
Here’s the key language: “To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the Act.” So the only tax deduction for folks in the state-legal marijuana business is cost of goods sold – what they pay to produce or to buy the product.
The Constitutional Red Herring
Possible challenges on constitutional grounds would have been far-fetched. A tax without a deduction for COGS might not be an income tax, explicitly authorized by the 16th Amendment. But then it’s like a national sales tax. I don’t see the argument that a sales tax is unconstitutional, so a tax on receipts without a deduction for cost of goods sold is OK. I was on the Staff of the Joint Congressional Committee on Taxation when 280E was passed. I didn’t work directly on 280E – my work was in the foreign area – but I saw it become law. Staff was inherently cautious, and my take is that that constitutionality language is just excess of caution. [Update September 12, 2014: not allowing a deduction for COGS would penalize non-vertically integrated operations to the point of no return. Without a COGS deduction, the tax would pyramid on every sale along the supply chain. The grower couldn’t deduct his costs, and the wholesaler couldn’t deduct what he paid the grower, and so on. There would be huge amounts of phantom income to be taxed.]
[Update February 15, 2017: The staff of Joint Tax tended to favor tax purity — taxing all income the same. One possible explanation for the allowance of a deduction for cost of goods sold is that it restricted the effect of 280E. Maybe Joint Tax staff (or Finance Committee staff) got that restriction into 280E so as to limit the damage to tax purity that it caused.]
280E hardly hits growers; retailers have a bigger problem. That’s because cost of goods sold – deductible expenses – includes all the expenses of growing a plant, like water, rent, labor, and packaging. And a retailer can deduct the amount he pays the grower for product. But the retailer can’t deduct advertising, rent, payments to selling personnel, utilities – you name it. That’s the problem. (Growers, likewise, can’t deduct advertising or salaries of sales people, but those amounts might tend to be negligible.)
The distortions of 280E offer tax planning opportunities. Vertically integrated businesses can try to add value by shifting costs from selling to manufacturing – as well as by shifting costs to non-marijuana businesses like caregiving, as in CHAMP v. Commissioner, 128 T.C. 14 (2007); see Newman, http://ssrn.com/abstract=1086692. Beyond the CHAMP non-marijuana business ploy, retailers may be able to create consumer interest through packaging, which can be deductible as cost of goods sold if done just right. Pure retailers, in a three-tier system like that under Washington State’s 2012 Initiative 502, may have to charge huge margins, or they may problems attracting capital. Retailers will be pushed into bare-bones operations.
If you want legalized marijuana, you’ve got to figure legalization will involve some revenue going to the federal government. 280E’s bias against advertising and the entire selling function operates to keep selling low-key and hidden. If you think the natural opponents of legalization are parents of children, then low-key and hidden marijuana sales are likely to avoid getting them irritated. So 280E may be about as good a deal as the marijuana industry can hope for. In any event, in the federal budget process, repealing 280E would be scored as a tax cut that would have to be offset by tax increases or spending cuts. 280E is a blunt instrument: its denial of deductions for license fees, for instance, is a random result that is hard to justify. But my guess for now is – 280E is here to stay for a while.