Are you considering operating a marijuana microbusiness under the Michigan Regulation and Taxation of Marihuana Act (MRTMA)? If so, having an understanding of financial and tax implications in this regulated industry is critical for success. Tax regulations, such as IRS code section 280E, have a significant impact on income tax expense for marijuana businesses. Marijuana microbusiness license holders should be aware of and plan for potential tax consequences of §280E.
What is IRS § 280E?
All marijuana business owners should be aware of and know that tax regulation §280E impacts their business. This has been true since Congress enacted this regulation in 1982. §280 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.”
Further explanation from Congress at the time of enactment provided an important provision. “All deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.”
See more information and the source of the above here.
Simply put, this states that marijuana businesses cannot take deductions for expenses. This is true for marijuana microbusinesses as well. Marijuana businesses can only adjust their revenue to reduce it by their “cost of goods sold” before federal income taxes are calculated.
Generally, cost of goods are those costs that go into producing a product in order to make it ready for sale. Cost of goods may also include certain overhead allocations and other costs that are necessary in order to make a product sellable. Once a product is sold, the cost to make the product is then recouped. This ‘recouping’ of the cost of the product is what Congress has determined as the only allowable deduction for marijuana businesses.
How does § 280E specifically effect marijuana microbusinesses?
Under the MRTMA, marijuana microbusiness license holders can cultivate, process and sell marijuana products produced at their business location. The cultivating, processing, and retail components of a marijuana microbusiness will each have different types of costs. While many of these costs may be considered cost of goods sold, or “COGS”, other will not be. Costs that are not considered to be part of COGS are not deductible for federal income tax purposes. A marijuana microbusiness should carefully plan for and understand any restrictions on the deductibility of its costs.
The cultivation component of a marijuana microbusiness will generally have all of its related costs included in COGS. This means that in general cultivation related costs are deductible for federal income taxes. Why? Expenditures for cultivating are related to costs necessary to grow plants (inventory). These costs may include soil, water, nutrients, testing, and direct labor. Grow light electricity, equipment depreciation, and allocated building rent may also be included in COGS. These costs are to grow and produce the plant inventory.
The processing component of a marijuana microbusiness will also generally have all of its related costs included in COGS. These costs would then also be deductible for federal income taxes. Processing costs will include those costs necessary to manufacture the processed product. These costs may include extraction materials, edible and topical ingredients, testing, and direct labor. COGS may also include costs for equipment electricity, extraction or kitchen equipment depreciation, and allocated building rent for the processing area. These costs are to produce inventory that will be sold by the marijuana microbusiness, such as oils, edibles, and topicals.
In general, the costs paid for cultivation and processing aspects of a marijuana microbusiness are deductible as part of COGS for federal income taxes. It is crucial that a microbusiness have a thorough accounting system in place to ensure these costs are well documented.
After the marijuana microbusiness’s products are grown and produced however, further costs incurred are generally not deducible because of §280E. These non-deductible costs include any selling activities, marketing expenses, and other general administrative expenses. Non-deductible costs also include any management, administrative or sales employee salaries. Building space, display cases and other sales floor furniture are also not deductible costs for federal taxes.
How can marijuana microbusinesses limit the impact of § 280E?
To limit negative tax impacts of 280E, a marijuana microbusiness license holder should seek to limit non-deductible expenses where practical. Cost control is important to the success of any business, new and old. Cost planning and management for a marijuana business is even more critical to its success. Microbusinesses must also carefully balance cost elimination with what is practical for employee and customer satisfaction, and business growth goals. Sometimes creative planning and the help of an expert can be well worth it!
Knowing that cultivation and processing activity costs are generally deductible, one avenue of limiting exposure to 280E is to strictly manage the retail component of the business. The retail sales floor area costs will not be deductible, such as prorated rent and utilities. Administrative office areas are also not deductible. One method of limiting these costs would then be to limit the space of these areas. For example, let’s assume the retail sales area was 10% of the space of the entire microbusiness building. In this case, 10% of the building overhead cost would not be deductible. Comparatively, the cultivation and processing areas might take up 80% of the buildings space. Assuming another 10% of space allocated to administrative offices, the non-deductible space is limited to 20% total.
When planning space allocations for the various business activities, it is also important to consider how customers and employees will react. For example, a retail space of 10% may not be adequate to accommodate all products for sale and customer aesthetic appeal. Or, small office spaces may not be comfortable for your administrative employees to work in.
Another form of limiting exposure to §280E is to have revenue streams that do not involve selling marijuana products at all.
A simple example of this is if there was a separate room (and cash register) for sales of non-marijuana products, such as custom blow glass tools or apparel. The trick here however is that these non-marijuana product sales be able to “stand on their own” as a business activity. This means that sales must be sufficient enough to support any costs allocated to this portion of the business.
A marijuana microbusiness license holder may also find creative service offerings to incorporate into their business model. For example, this could potentially include paid and guided tours of the cultivation and processing components of the business. Since marijuana products are not being sold in this scenario, §280E does not come into effect.
Deciding to incorporate non-marijuana products or services into a business model as a method of limiting 280E exposure can be complicated. The business should work with a professional to ensure that all accounting and business legality needs are considered.
We can help!
Accounting allocations, bookkeeping, record keeping and tax planning for a marijuana business must all be consistent in order to support any costs or revenue that are affected by §280E. Here at Marijuana Micro Business, our team of professionals can help your business plan and maintain a successful strategy for managing §280E. From selecting appropriate accounting software, ensuring complete bookkeeping, and providing ongoing reporting, we will help you stay on track with §280E management and compliance.
For more information or to schedule a no obligation consultation, please contact us here.