By now most, if not all of you, are aware of IRS Code Section 280E that prohibits the deduction of expenses for any business that is trafficking in controlled substances. If you aren’t aware of this law, you need to be, but more importantly, you need to plan your cash flow (there’s that term again) to be prepared for higher than expected federal income taxes.
Currently, marijuana is considered a Schedule I drug per the Controlled Substances Act and as such is treated as a federally illegal drug. Income from the sale of illegal drugs is taxable for federal income tax purposes but expenses related to the sale of illegal drugs are not deductible. This is Section 280E in a nutshell. You must pay tax on the income of your cannabusiness and your associated expenses are not deductible from that income.
There is one tiny glimmer of light in this dark IRS tunnel and that is that expenses associated with cost of goods sold i.e. your inventory costs, are deductible. Perhaps now you understand why I have devoted so many words in my blogs to the subject of inventory. Since currently it is the only deduction available to you for federal income tax, it’s hugely important. I’ve touched on what can be included in inventory/cost of goods sold in previous blogs, that’s not the focus here. The focus in this writing is to help you plan for the tax liability you will ultimately face.
So far this doesn’t sound that bad. But here’s what happens. Your income statement may indicate that your company has made $130,000 for the year, that number being the net income after taking into account expenses for rent, payroll, and all of your other operating expenses. But the federal taxable income for that same period might be well over $350,000, because you cannot deduct (for the most part) rent, payroll and your other operating expenses. You’ve been expecting taxes on $130,000 in income but in fact you will pay tax on $350,000. The difference will mean many thousands of dollars in tax.
Complicating this further is the fact that federal tax liability occurs at various levels depending upon how your cannabusiness is organized. The only instance in which the business itself is taxed directly is if that business is organized as a “C” corporation; most small businesses don’t opt to be “C” corporations. More common for small business is to be organized (in some form or fashion) as a sole proprietorship or partnership. In these instances, federal tax liability occurs at the individual level. In other words, taxes are paid by the person(s) who have ownership in the company and not by the company itself.
Likely you, as an owner in a cannabis business, will have federal taxable income generated from that business. If you have partners in the business, your partners will have taxable income as well. Each of you will be reporting the taxable income from your business on your individual income tax returns. It’s a complex thing to manage because you and your partners may not be in the same tax bracket so the tax liability could be very different for each of you. How do you plan for a tax liability that is different for each partner? I wish I could say there is a simple answer but I don’t know of one.
What I have recommended to cannabusinesses is that they calculate the expected tax liability based on each individual’s tax situation and carry that as a line item on their cash flow plan. Your CPA can help you determine how much cash should be reserved for these taxes, then you should keep that reserve or distribute it to partners and they can reserve it personally.
Individual taxpayers who do not have adequate amounts of federal taxes withheld are required to make estimated payments on their income. This is a factor that will play into reserves and cash flow planning as well, meaning that dealing with this only at year end is not a good option. You will need to calculate and pay the tax quarterly.
Unfortunately, there are no easy answers. The two most important takeaways from this writing are:
Know that the net income reported on your income statement is not taxable income; taxable income will be much higher
Reserve cash in your company, or individually, to pay the tax so you are not caught with unexpected tax bills and penalties associated with unpaid or underpaid taxes.
Not much good news here. Until marijuana is legalized at the federal level or the law is changed regarding Section 280E, you are stuck with high taxes. Just don’t let it surprise you 🙁