Tax Code Section 280E is one of the biggest obstacles cannabis business owners and operators face when trying to turn a profit. The cannabis industry in the US has been desperately hoping for a change in 280E law. Unfortunately, the US Tax Court decision last month in the Alterman v. Commissioner case brings more bad news to the emerging cannabis industry. In the following we will take a look at 280E and discuss the Alterman v. Commissioner case and lessons learned from an unsuccessful attempt to contest a 280E ruling.
A Quick Look at 280E and the Cannabis Industry
For those unfamiliar, 280E is a law that prevents cannabis owners from deducting common business expenses not related to Cost of Goods Sold (COGS). The law’s roots are meant to prevent drug dealers from deducting expenses related to “trafficking in controlled substances.” But cannabis businesses, operating legally under state and local laws, are now caught in the crossfire as the controversial scheduling of cannabis at the federal level lumps them in with the activities of those dealing “illicit substances.” As a result, cannabis business owners and operators cannot make the routine tax deductions that help “mainstream” businesses lower their tax burden and turn a profit.
Within the cannabis industry, 280E has long been perceived as an unfair disadvantage for legitimate businesses operating within regulatory guidelines. Despite decades of lobbying by advocates, no significant changes to 280E have been made, but a number of court cases have helped define the boundaries and established precedents to contest 280E rulings.
What Happened in Alterman v Commissioner?
In 2009, Coloradan cannabis entrepreneur Laurel Alterman opened her medical cannabis dispensary – Altermeds LLC (Altermeds). In 2010, state law required dispensaries to grow 70% of their product. So Altermeds rented a warehouse space and began cultivating cannabis, while continuing to sell third-party products. On 2010 and 2011 tax returns, Altermeds reported the following revenue, COGS, and general and administrative (G&A) expenses:
Revenue $894,922 $657,126
COGS ($464,119) ($253,089)
G&A ($385,489) ($384,814)
The IRS subsequently audited Altermeds’ tax returns and denied all G&A expenses (excepting depreciation deductions) under Section 280E. Additionally, the IRS reduced the COGS deductions. These adjustments resulted in deficiencies of $157,821 and $233,421 in 2010 and 2011, respectively. For good measure, the IRS also tacked on penalties for underpayment totaling nearly $80,000.
Altermeds’ Case vs the IRS
In contesting the IRS’ determination, Altermeds’ legal team made the case that the dispensary sold “non-marijuana merchandise,” like pipes, papers and other items “used to consume marijuana.” As such, this constituted a second business distinct from the production and sale of cannabis, thereby not subject to Section 280E.
Altermeds made a second contestation that they had miscalculated COGS in the years under review and sought to adjust the deduction to $600,217 and $417,570, respectively. The majority of the adjustment was related to costs of purchased and produced cannabis and an additional claim stated that 40% of wages paid to dispensary employees were for “trimming activities” directly related to cultivating/manufacturing product, and thereby qualified as a COGS expense.
A Decisive Judgement
Altermeds’ contention that the sale of paraphernalia – pipes, papers, etc. – constitutes a secondary business follows one of the few effective precedents in contesting 280E rulings. In 2007, the “Californians Helping to Alleviate Medical Problems” (CHAMP) ruling established that a cannabis facility can have multiple lines of business. If those lines of business are demonstrably distinct from the sale and production of cannabis, 280E does not apply to expenses related to this secondary line of business.
In the Altermeds case, the defendant was only able to substantiate 4% of Altermeds’ sales as non-cannabis merchandise. The Tax Court determined this was insufficient in establishing a distinct second line of business. Additionally, Altermeds’ record-keeping was cited as inadequate. In this instance, Altermeds failed to document expenses attributable to the second business line. Instead, they presented a percentage of total G&A expenses as the sale of non-cannabis merchandise. This decidedly imprecise method was not accepted by the Tax Court.
Failure to properly maintain records also undermined Altermeds’ second contention regarding recalculating COGS. For 2010 and 2011, Altermeds reported only $12,279 and $0 of ending inventory, respectively. The Tax Court determined it was unlikely that Altermeds had no inventory at year’s end, and instead, had likely deducted every dollar of purchased and produced cannabis as COGS, even if that product was still on hand at year end.
Regarding Altermeds’ argument that 40% of dispensary salaries were in service of trimming, and thereby deductible as COGS, the Tax Court found no compelling evidence of the activity, despite the (apparently unconvincing) testimony of employees. Additionally, Altermeds did not maintain a sufficiently detailed inventory count or records regarding employee activity.
Finally, Altermeds made a last-ditch attempt to calculate COGS as a percentage of revenue (following the precedent established in the Olive v Commissioner case of 2012). In this instance, expert testimony was ruled inadmissible for reasons that remain unclear, and the effort failed.
What Have We Learned About Contesting 280E?
The lesson the tax professionals at ELLO emphasize with clients is that proper financial documentation absolutely needs to be a priority for any cannabis operation. The Alterman v Commissioner case represents decisive confirmation of the importance of this approach. Had Altermeds maintained sufficiently detailed records, they may have been able to get a more favorable ruling. But throughout the Tax Courts opinion, Altermeds is cited for variations of “the record is unclear” dozens of times. Meaning that when an argument pointed to verifiable evidence, Altermeds’ books were found decidedly lacking.
Altermeds’ contention that they had a second line of business failed primarily because they could not substantiate it. At ELLO, we advise all of our clients to treat a second line of business as truly distinct operation. That means keeping a separate set of accounting records; a business plan with the same level of detail as the primary business activity, a distinct budget, and documentation of all steps taken to develop the business, including market studies, hired consultants, etc.
How Should Cannabis Businesses Respond to the Ruling?
One thing we tell our clients regarding keeping good financial records is everything has its price. To get proper financial documentation, cannabis businesses need to invest in the personnel and infrastructure to generate records and maintain them appropriately. The related costs are more than offset by the tax savings that result from being able to take optimal COGS, G&A and other tax deductions. Attempts to constructs records after the fact, and in the worst case scenario, presenting them at Tax Court is a very expensive alternative. Legal fees alone typically amount to $75,000-$100,000, and that’s before the cost of adjustments and fines.
Navigating 280E is something every cannabis enterprise must keep top-of-mind. The core of 280E is the calculation of COGS and many complexities exist in determining what does or does not count as COGS and how to provide documentation that supports these determinations. For guidance on this, we highly recommend consulting with a tax advisor familiar with 280E, COGS and the financial and operational peculiarities unique to the cannabis industry.
For more information about 280E, cannabis tax payments or other financial planning concerns, please contact us here.