By John Schroyer
A new IRS memo about tax issues tied to cannabis companies could end up costing the marijuana industry millions of dollars annually, reducing already-slim profit margins for scores of businesses.
Last Friday, the IRS sent a memo to a Denver lawyer in response to an inquiry regarding 280E, a section of the U.S. tax code that prohibits deductions for any business activity that involves trafficking in controlled substances.
Tax professionals say the memo appears to close a loophole that many cannabis businesses have been using to at least partially get around 280E, whereby marijuana companies classify certain expenses as cost of goods sold, or COGS, a specific categorization for qualifying costs.
In essence, the IRS outlined its position on that strategy, providing a much narrower definition of what can be classified as COGS than many cannabis companies are currently using.
As a result, tax bills in the industry will be significantly higher – making it that much harder for cannabis companies to post a profit.
The memo essentially represents an attempt to “harm the marijuana industry through broader application of Section 280E than ever before,” Levy wrote.
Section 280E essentially penalizes MMJ dispensaries and recreational retailers by banning otherwise-ordinary business tax deductions because marijuana is still illegal at the federal level.
But classifying some expenses as COGS has helped businesses lower their tax bills.
California attorney Henry Wykowski, who provides legal services to cannabis companies, offered a hypothetical as an example.
Say a recreational shop in Colorado purchases a bag of cannabis for $1,200 and sells it for $2,000; that would leave a net profit of $800.
But to prep the cannabis for sale, an employee has to trim it, weigh it, package it, and so on. Say that takes $150 worth of materials and time. The shop owner could then write off both the $1,200 and the $150 as cost of goods sold on the shop’s federal taxes, thereby getting a deduction that would typically be prohibited under 280E.
Removing that ability to classify certain costs as COGS, Wykowski said, will cost the industry “millions and millions, without a doubt.”
Under a previous precedent from 2007, the U.S. Tax Court has held that marijuana companies are entitled to COGS, but the memo from the IRS indicates that the agency is taking a stricter view.
The matter is far from settled, however.
“The Tax Court has not ruled on this. This is (the IRS’s) position, and it has yet to be reviewed,” Wykowski said. “The logic that they use is subject to challenge, and the IRS continues to treat cannabis dispensaries than every other type of retail outlet, and they’re just continuing that policy with this memo.”
Wykowski predicted that the policy espoused in the memo will “absolutely” be challenged in court, though it may take a year or more for a ruling to be handed down.
Levy also suggested that the memo could result in a backlog of federal tax audits and appeals, including at the Tax Court level, since he expects thousands of marijuana companies to be audited this year.
John Schroyer can be reached at firstname.lastname@example.org