Income Tax Accounting Issues in the Cannabis Industry

As the nation gets closer to legalizing cannabis at the state levels, many more states have jumped on board. Over the past several months, even the federal government has begun taking measured steps to loosen restrictions on the sale of cannabinoids (CBDs).

With broader societal acceptance, venture financing and public offerings (albeit generally in cannabis-friendly Canada) of cannabis and ancillary businesses has exploded in recent years. The introduction of equity investment has resulted in the need for audited financial statements, including a tax provision.

The Dreaded Sec. 280E

By now, almost every person in the cannabis industry is familiar with Section 280E of the Internal Revenue Code. Consisting of just one sentence and enacted during the “Just Say No” years of the early Reagan administration, this stipulation states: “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.” As a Schedule I substance, cannabis (other than CBD in certain cases) falls within this section. To date, no underlying regulations to Sec. 280E have been drafted.

Why was this provision established for otherwise illegal activities? The IRS requires that gross income be reported from any source in which it is derived (Sec. 61). As such, any income generated from the sale of cannabis, even though it is classified as an illegal substance, must be reported for federal tax purposes. The federal government realized years ago that it was easier to prove tax evasion than the criminal act itself (think Al Capone). Consequently, drug traffickers became smart and began paying their taxes and filing tax returns. By disallowing deductions, Sec. 280E became a countermeasure to ensure that involvement in these activities would be less lucrative.

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