The legal marijuana industry is growing – and fast! As of
2019, 11 U.S. states and Washington, DC, have legalized marijuana for
recreational use. The number of states that allow medicinal use of the drug is also
steadily growing. As the legal marijuana industry grows, there is also a
growing need for business and tax advice. This raises a few questions for CPAs.
Becker instructor and tax expert Tim Gearty has detailed the
ins-and-outs in his recent CPE webcast, Understanding
the Tax Implications of the Legal Marijuana Industry. Throughout the course, Gearty details the key issues faced by
CPAs in serving the legal marijuana industry at both the federal and state
level. Here’s what you need to know.
Federal Tax Issues
For federal tax purposes, it’s most important to know which
expenses are deductible at the federal level. In general, Section 162 of the
Internal Revenue Code (IRC) permits the deduction of ordinary and necessary
business expenses. This would include general and administrative expenses,
overhead expenses, advertising expenses, etc.
However, IRC Section 280E prohibits the deduction of
expenses associated with trafficking in controlled substances. Ordinary and
necessary business expenses are not deductible for marijuana businesses because
marijuana is considered a controlled substance at the federal level.
essentially nullifies Section 162 for purposes of the legal marijuana industry.
Cost of goods sold is not a deduction, but rather a
reduction of gross income, codified in the regulations of the tax code under
Regulation Section 1.61-3(a). Thus, income in the legal marijuana industry may
be reduced by the cost of goods sold, even if those goods are a controlled
substance under federal law.
difference in deductibility at the federal income tax level between cost of
goods sold and ordinary and necessary business expenses creates additional risk
for CPAs working in this area.
Business owners in the legal marijuana industry may be
tempted to inappropriately shift operating expenses into cost of goods sold. As
such, CPAs may need to apply special scrutiny when evaluating these areas for
tax and audit purposes.
CPAs should be especially vigilant in reviewing and gaining
comfort with operating costs and cost classification. Due to the differences in
federal tax treatment for certain costs, business owners in the legal marijuana
industry may be motivated to take especially aggressive tax positions in the
Classifying their business as a producer rather
than retailer in an attempt to capitalize indirect costs into inventory.
Shifting costs from operating costs (i.e.,
ordinary and necessary business expenses) into cost of goods sold.
Incorporating other financially inconsequential
elements or business lines (i.e., also selling clothing, accessories, wellness
classes, etc.) into their primary business model in order to justify shifting overall
operating and overhead costs into those business lines, claiming they are
deductions under Section 162.
In addressing these issues, CPAs should consider:
The primary structure, function, and operation
of the business; are they really producing the product or just acting as an
intermediary between the producer and end consumer?
How do the margins of the business compare to
industry averages? For example, if a marijuana dispensary is reporting gross
margins 40% below the industry average, then there is a higher risk that this
business owner has inappropriately shifted operating costs into cost of goods
When evaluating business lines, CPAs should
focus on substance
over form. What is the real primary purpose of the business? Where are the
majority of revenues derived?
State Tax Issues
In states where recreational or medicinal use of marijuana is
permitted, there are state-specific income tax questions to consider,
especially when reviewing state corporate returns and state individual returns.
Recall that at the federal level, Section 280E prevents the
deduction of ordinary and necessary business expenses associated with
trafficking in a controlled substance. What about in states where marijuana use
Four states have specifically permitted deductions disallowed
under Section 280E, including California, Colorado, Hawaii and Oregon. Arkansas
does not disallow 280E deductions. In these states, the starting point for
calculating state income tax return is the federal tax return. Then, adjustments
are made for state-specific items that may be added back or further deducted.
Beyond income tax considerations, sales and excise tax considerations also apply at the state level. In 13 states where medicinal marijuana is permitted, it is not subject to sales tax.
In 17 states, the sale of medical marijuana is subject to sales tax.
The sale of marijuana for recreational use is generally subject to sales tax, with the exception of Oregon, which has no state sales tax.
Separate from sales tax, some states impose an excise tax on marijuana, ranging from 3-37%. Additionally, some states impose a specific excise tax on controlled substances, which may or may not include marijuana. CPAs should understand whether these controlled substances taxes apply to legal businesses.
Since marijuana laws greatly vary across the U.S. and continue to change, it’s important to keep a close watch on your state’s stance. Check the AICPA’s listing of state board positions for a better understanding of your state’s enforcement of providing services to businesses in the marijuana industry.
for CPAs to Consider
Will providing these services in a state where they
are permitted affect a CPA’s reputation with clients in another state where
marijuana is not legal?
Does the CPA or the CPA firm have the
industry-specific expertise to serve the clients in a professionally competent
A clear engagement letter detailing the exact services
to be provided.
A signed representation letter from management, updated
regularly, that states management understands the requirements of state law
related to the cannabis business and that they intend to fully comply with
those requirements at all times.
Full documentation of all communications and services