280E Tax Primer

by | Mar 26, 2021 | Free, Macro, Thematic Research

If you don’t know what 280E is, this is a high-level “what investors need to know” summary of IRS Code 280E.

Any cannabis investment thesis that includes federal legalization will need to consider tax and margin changes without 280E, since legalization eliminates it (though it may be replaced, as discussed in this main article on the investing implications of 280E).

Apologies to accountants and lawyers for oversimplifying a bit; 280E is extremely complex and a legal grey area, and this article deals with the general financial and investment implications at a high level, not the legal or accounting details or nuance on specific companies. Call an accountant or lawyer for more specifics on individual companies; this is not legal or accounting advice.

280E = US Federal 21% Income Tax Rate (and some State Income Taxes) on Gross Profit on “Plant Touching”

Companies dealing directly with marijuana in the United States (“touching the plant”, e.g. cultivators, processors, and retailers) are required to pay Federal income taxes effectively on gross profit and cannot reduce their pretax income by deducting traditional expenses like rent, salaries, or even interest expense as “normal” businesses do.

The 280E provision applies because, despite following state law, these companies are still breaking Federal law and illegally trafficking in a CSA Schedule I or II controlled substance.

Companies operating only in Canada, and US companies supplying ancillary non-marijuana services like fertilizer and software to the US industry do not pay 280E because they are not trafficking in a Schedule I or II controlled substance.

Some states, such as Massachussetts, also apply state income taxes in the same way the Federal IRS does to plant touching businesses as well, despite the business being legal at a state level.

The subsector categories on our comp table generally correspond to those paying 280E (the US-Focused Operators) and not paying 280E (Canada-Focused operators, Hemp/CBD, and Ancillary Services).

Descheduling marijuana to CSA Class III or altering Federal laws to specifically make 280E inapplicable to state legal marijuana operators would remove this burden – and it is a big one.

With an average gross profit margin of 54% expected in 2021 or the US operators on our comp table, and a current Federal corporate income tax rate of 21%, 280E taxes are simplistically equal to about 8-11% of revenue, and results in a 50-90% effective tax rate (though because it is not tied to pretax income, it can theoretically be over 100%).

Every company is different, depending on its business model and cost structure; higher gross margins mean higher 280E taxes, and lower pretax margins mean a higher effective tax rate. In the worst-case scenario, no expenses can be taken as an adjustment to revenue, and the Federal tax of 21% applies to revenue.

Also keep in mind that some of the 280E tax is the normal Federal corporate income tax any company would pay, so not all of it goes away with the elimination of 280E. A Federal income tax at 21% of pretax income will still need to be paid (the difference between 54%*21% =11% of sales, which implies no tax at all, and 8% of sales with a 21% tax on theoretical pretax income).

Of course, changes to the Federal corporate tax rates will change the 21% applied to gross profit. Talk of Biden raising the tax rate to 28% would flow through to cannabis companies accordingly until 280E is resolved.

Any US plant-touching operators that have not properly paid or overestimated the COGS adjustments could be liable for back taxes as well. In a theoretical worst-case scenario of a company that never paid 280E taxes and has no allowable COGS adjustments, it would be liable for 21% of historical revenue (and potentially 35% at the old corporate tax rate before the 2017 Tax Cut and Jobs Act passed), before any late penalties are applied.

Due diligence on potential acquisitions must include a thorough review of the past accounting to ensure the adjustments were not too aggressive and taxes have been properly paid, otherwise there could be a hidden tax liability for the new owner.

For more reading, a recent Congressional report on 280E can be read here, and a webinar at MJBizDaily with Mike and 280E expert Mitzi Keating CPA CFE can be viewed here.