Taxation of a Cannabis Business
New Mexico has seen a large number of cannabis businesses open their doors with the legalization of cannabis for recreational use. Many of the taxpayers starting this type of business operation find themselves in a complicated position when it comes to federal income taxes. Since the product sold is still considered a Schedule 1 controlled substance, cannabis businesses generally can’t deduct business expenses for income tax purposes like other business can. So what expenses associated with a cannabis business deduct? That depends on the type of business and its operations.
Federal tax laws (Internal Revenue Code 280E) impacts the deductibility of expenses for cannabis operators. This section provides the general rule associated with deducting costs associated with cannabis as well as other controller-substance businesses. This section states that no deduction or credit is permitted if such trade or business consists of trafficking in controlled substances, which is prohibited by federal law or the law of any state in which the trade or business is conducted. The Controlled Substances Act of 1970 assigns controlled substances to one of five schedules and cannabis is listed under schedule 1. So, although it is now considered legal in New Mexico, the federal laws prevail in the tax treatment of business expenses and operations associated with cannabis.
Businesses involving controlled substances generally can’t deduct ordinary and necessary business expenses such as salaries and rent under IRC 280E, but are able to deduct the cost of goods sold associated with the product if they are in compliance with the inventory valuation rules. This really applies to producers of product, where various expenses are allowed in producing the final product that is sold to a distributor or retailer.
Producers are able to include the costs of direct materials that go into the product or consumed by the production process, which includes direct labor, packaging, and other related production costs, which can also mean a portion of indirect costs including an appropriate portion of management expenses. These costs are capitalized as inventory and are not expensed when incurred, but are deducted once the product is sold (cost of goods sold).
Retailers or resellers of merchandise purchased as their products must capitalize the invoice price less any discounts into their inventory cost, along with any transportation or other necessary charges incurred with the acquiring the product. It is hard to argue that other business costs should be allowed outside of the acquisition costs of inventory as part of the actual cost of product, making them deductible instead of non-deductible under IRC 280E. Case law has ruled against new cost inclusions for retailers, so care must be taken in deducting retailer operating expenses as part of costs of goods sold.
What happens if you have multiple businesses associated with cannabis manufacturing and retail operations? It is important to separate costs out by each type of business to ensure you are taking accurate deductions for each type of operations.
Until cannabis is removed from Schedule 1 of the Controlled Substances Act, great care must be taken in the preparation of your income tax returns to ensure you are following the appropriate rules depending on your business type. You should work with your team of professionals, including a knowledgeable CPA who is familiar with the tax implications of cannabis business operations.