3 best practices for IRC Section 280E tax compliance

Marc A. Claybon, Tiffany Richardson
5/26/2021
3 best practices for IRC Section 280E tax compliance

Avoid unnecessary risks and update your accounting practices. Follow these best practices for IRC Section 280E tax compliance and long-term growth.

Internal Revenue Code (IRC) Section 280E remains one of the most challenging and frustrating issues for the cannabis industry. The decades-old federal statute continues to significantly limit cannabis profits by prohibiting companies from deducting typical business expenses from their federal taxes. In response, cannabis company decision-makers need to analyze exceptionally technical tax laws and regulations to help them manage their tax liability, from the determination of cost of goods sold (COGS) to entity structuring.

To compound the dilemma, tax guidance on Section 280E is a moving target. Recent U.S. Tax Court decisions have prompted questions regarding the application of tax principles. Cannabis companies that cannot quickly adjust and that do not frequently reevaluate their Section 280E positions risk serious consequences that could hamper their cash flow and long-term growth. Consequences include potential tax filing errors that bring harsh penalties as well as making a business less attractive to future investors.

What does a sound approach to Section 280E look like in today’s environment? Crowe specialists offer three best practices to consider.

1. Stay current on what deductions are allowable for different business types

Cannabis businesses should analyze their inventory rules and how costs are allocated across the business and then apply consistent methodology for their COGS calculations. Allowable deductions can vary greatly depending on the type of business license a company holds (for example, retail, manufacturing, distribution, or integrated licenses). As a general matter, tax inventory rules are less punitive to manufacturers and growers than to retailers because more costs of manufacturers are production related and therefore included in COGS. Retail operations, on the other hand, generally are more restrictive in what is included in COGS. For an integrated company, distribution company, or delivery company, the rules fall in between. Thinking through what rules apply, to what kind of operation, and consistently applying inventory methodologies can either create significant value or significant tax risk to companies.

Businesses should periodically review how the most recent federal court decisions and IRS guidance affect their 280E positions.

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2. Make careful decisions when setting up the legal entity structure

Companies seeking tax advantages by separating their business into different legal entities should proceed with caution. The IRS will scrutinize these decisions and might argue that all related-party businesses are unitary and subject to 280E.  Establishing separate profit motives is a critical step. Companies should also follow the formalities of the entity structure that is created, including having written operating agreements, lease agreements, royalty agreements, and appropriate documentation of intercompany loans. Companies should model the tax implications of various entity structures and choose a structure that best fits their tax risk profile.

3. Maintain thorough documentation and bookkeeping

High-quality recordkeeping arguably is the most fundamental cannabis accounting best practice. Finance leaders should maintain separate accounting books for a company’s different legal entities and check that recordkeeping aligns with the business structure and accounting methodologies set up at the outset. Detailed documentation should back up all decisions and deductions, from employee wage allocations to shared service agreements.

Patience is a virtue in today’s environment

A bright future appears to await the cannabis industry. The U.S. legal cannabis market is projected to reach $35 billion by 2025, and prospects are growing for cannabis-friendly federal legislation. Now is the time for cannabis businesses to mitigate their risks on Section 280E tax compliance, monitor potential changes in tax policy, and establish accounting foundations for long-term growth.

 

Qualified organizations only. Independence and regulatory restrictions may apply. Some firm services may not be available to all clients. Given the continued evolution and inconsistency of various state and federal cannabis-related laws, any company should seek competent legal advice relating to its involvement in the cannabis industry, including when considering a potential public offering as a cannabis-related company.

3 fundamental truths about IRC Section 280E

Cannabis businesses that successfully navigate federal tax compliance understand 3 fundamental truths about Section 280E. Are you up to speed?

Contact us

Turn to cannabis tax specialists who understand the industry and can leverage the experience and resources of a top 10 accounting firm. Since 2014, Crowe tax professionals have helped cannabis industry clients with entity planning, inventory optimization, IRS audit defense, and federal, state, and international tax compliance. Contact us to discuss your needs. 
Marc Claybon
Marc A. Claybon
Cannabis Tax Services Leader, Principal
Tiffany Richardson
Tiffany Richardson
Partner