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By Michael Harlow, Cohn Reznick
Over the years we have had many planning meetings with clients where they express extreme frustration when they see their projected tax liability. More than one has told us that 280E makes it very difficult to invest in and grow their business. We then must remind them that was the entire point: 280E is supposed to be punitive by design.
Most in the cannabis industry consider the federal income tax imposed on cannabis companies to be one of the biggest challenges to the industry. This is because Internal Revenue Code Section 280E (Section 280E) disallows the deduction of “ordinary and necessary” business expenses for Drug Enforcement Agency (DEA) Schedule I or II drugs. Cannabis is currently listed as a Schedule I drug by the DEA, alongside heroin, LSD, and ecstasy, amongst others. This means that under the Controlled Substances Act of 1970, cannabis companies are federally prohibited from deducting anything other than cost of goods sold as a deduction to arrive at taxable income.
In August of 2023, the Department of Health and Human Services (HHS) made an official recommendation to the DEA to reschedule cannabis from a Schedule I drug to a Schedule III drug. In January of 2024, the HHS provided to the DEA and released for public consumption its 250-page long rationale behind the rescheduling. While rescheduling is still far from a certainty, there is renewed hope within the industry that the handcuff of Section 280E will be removed and cash flow relief will be granted.
As a result of Section 280E, cannabis companies are left with significantly higher effective tax rates than a company that is not subject to Section 280E. A company’s effective tax rate is its total tax expense divided by its US GAAP pre-tax book income or loss. In the case of cannabis companies, many have losses under US GAAP, but owe a significant amount of income tax on a federal, and sometimes on a state, basis. This is unique to state regulated cannabis markets. No other industry in the country operates in an environment where they owe federal tax on business that is cash flow negative.
In his article called “The immediate impact to cannabis firm’s DCF valuations as a result of removing the IRS 280E Federal tax,” Lane Bruns, CEO of ICANIVEST, highlights the difference in free cash flow for a hypothetical cannabis entity. He uses an entity with $400 million in pre-tax book loss and one example where the company has a 70% effective tax rate (with Section 280E) and a 22% effective tax rate (with cannabis rescheduling). The variance in free cash flow is staggering, with the entity with cannabis rescheduling having $296 million in free cash flow and the Section 280E entity having only $120 million in free cash flow; a difference of $176 million.
The problem with using the total tax expense as a basis to quantify cash tax savings is that it includes the deferred tax expense as a portion of the total tax expense. Using deferred tax expense assumes that temporary differences will be reversed, causing no effect to the total tax expense over time. To illustrate the limitation, let’s say a company has a temporary book to tax difference of $100 in year one that will unwind over five years. In year one, this results in a net $80 unfavorable book to tax difference. By using the total tax expense, however, it is assumed that this $80 does not increase your overall total tax expense, and therefore effective tax rate, because it will even out over time. Nonetheless, this would leave this company with a higher tax liability in year one which will reverse over the next four years. So, while this doesn’t negatively impact the company’s cash tax due over a five-year period, the company is not going to like the increase to their cash tax expense in year one.
Let’s pretend for a moment that cannabis has been rescheduled as a Schedule III narcotic. Great news, you are no longer subject to Section 280E! You now have many additional tax opportunities and consequences that you previously were not entitled to or did not need to explore. Here is what you need to know about the necessity of tax planning and all the complexities therein.
Interest Expense
Many cannabis companies have significant debt financing. Interest expense is not a component of Cost of Goods Sold and therefore is nondeductible under 280Eost. This means that companies were not impacted by the interest expense limitation under IRC Section 163(j) because these interest expenses were already being disallowed under Section 280E. If Section 280E no longer applies, now 163(j) does. The interest expense limitation allows a deduction for interest expense only to the extent of 30% of adjusted taxable income – a defined term. This will likely result in interest expense limitations – a temporary book to tax difference, meaning any amount disallowed can be carried forward and used to the extent that there is adjusted taxable income in a subsequent year.
Research and Development
Cannabis is a research and development intensive industry. Starting in 2022, companies are now required to capitalize and amortize their R&D costs (over five years for domestic R&D and 15 years for international R&D). What we have seen is that R&D costs are sometimes booked as SG&A costs. Like 163(j), R&D did not matter as much because these costs were mostly disallowed under Section 280E. Well, now you will be required to capitalize your R&D costs and amortize them over time. This can reduce a company’s cash tax savings year to year depending on the amount required to be capitalized and how much carryforward it has. But there is good news!
Now that you are no longer subject to Section 280E, you are allowed to take advantage of the R&D credit. The R&D credit can reduce your income tax liability and sometimes your payroll tax liability. What the IRC allows as qualifiable for the R&D credit isn’t quite as expansive as what is required to be capitalized under Section 174; but while you are analyzing your R&D costs for purposes of Section 174, it makes sense to analyze your R&D costs for purposes of the R&D credit. Typically, the value of the credit can be 5-10% of actual R&D expenses, the largest single cost of which is typically salaries.
Inventory
In 2023, are your average gross receipts over the prior three-year period $29 million or greater? If so, you are subject to the Uniform Capitalization Rules (UNICAP) under IRC Section 263A. UNICAP was previously not as important because all indirect costs were disallowed under Section 280E. Now you are required to capitalize a portion of your indirect period expenses as they relate to inventory. These costs are then deducted as inventory is sold over time. This can be a burdensome calculation and generally requires someone with UNICAP expertise.
Fixed Assets/Buildings/Energy credits
Under Section 280E, you were not allowed to take bonus depreciation. With Section 280E gone, you now have to strategize as to when to take bonus depreciation and when to place fixed assets in service. In order to maximize fixed asset deductions, you probably want to undergo a cost segregation study. A cost segregation study allows you to maximize the amount of fixed assets into a shorter term fixed asset bucket rather than depreciating over a longer term leasehold/land improvement (15 years) or building (39 years). Given all of the potential unfavorable book to tax differences, maximizing your fixed assets deductions will be important. Maybe you are considering placing a facility into service during the year; It would be beneficial to place this facility in service after the rescheduling takes place.
Furthermore, you are in an energy intensive industry. It is now time to start exploring the applicability of renewable energy credits. These credits can apply to energy generated by renewable energy resources, such as solar or wind powered facilities. The tracking of renewable energy can be cumbersome but can result in significant income tax savings.
Labor
You are also in a labor-intensive industry. Previously, much of your accrued bonus, vacation, wages, commissions, etc. were allocated as SG&A costs and were therefore disallowed under Section 280E. Now these same costs are subject to Section 461 which can limit the deductibility of various wages from year to year. Some of these indirect labor costs also may be subject to UNICAP as mentioned above.
The good news is that there are certain credits that you now may qualify for. The Workers Opportunity Tax Credit (WOTC), for example, can be a significant credit in labor intensive industries. You may be able to claim the WOTC if you hire employees who are in a WOTC targeted group.
Net Operating Losses
Maybe despite all the above, you are still generating taxable losses. We have seen a limited number of cases where prices declined so rapidly that operators sold product for less than the actual cost of acquisition or production. For C corporations these losses need to be tracked and it is important to pay attention because a change of ownership may limit future credits. If there has been a change in ownership, net operating loss and credit limitations can come into play under IRC Section 382 and 383, respectively. A 382 and 383 study will be required to determine if there has been a change in ownership and calculations need to be run to determine exactly how limited your losses and credits are.
Other Considerations
- If cannabis is rescheduled in the middle of the year, we do not yet know how the IRS will handle this. We are hopeful that they will allow the Section 280E applicability to be retroactive to the start of the year, but no one knows for sure. If they do not address the issue, it will be beneficial to incur more SG&A costs in the second part of the year.
- Our assumption is that any rescheduling will be solely on a prospective basis, except for the potential to apply to the beginning of the current tax year.
- We have mentioned just a few potential credits above, but there are other state credits that should be explored and considered.
- Rescheduling may require accounting method changes to be filed with the IRS and method change tax planning strategies should be explored.
The Bottom Line
Rescheduling of cannabis to a Schedule III drug will increase a cannabis company’s cash flow. Will it result in the cash flow relief that the industry is hoping for? Maybe, but significant tax planning will be required. Will it simplify a cannabis company’s income tax filings? Not a chance.
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