Players in the cannabis space already understand that federal tax law as currently structured extracts a far greater tax bite from marijuana businesses than corresponding companies, as cannabis companies are prohibited from deducting their business expenses from gross income. Of course, with U.S. cannabis sales expected to grow by nearly 2.5x from 2018 to 2025, the excessive tax liability still leaves lots of room for cannabis companies to experience outsized profits. Clearly, navigating the perils of the tax code is a critical step in any cannabis valuation.
Internal Revenue Code Section 280E
Because marijuana is classified as a Schedule I controlled substance under the Controlled Substances Act, the production, distribution and possession of cannabis is illegal, even where marijuana is legal under state law. As a result, Section 280E prevents taxpayers from taking any tax deductions or claiming tax credits attributable to marijuana businesses.
This short overview by the Congressional Research Service, The Application of Internal Revenue Code Section 280E to Marijuana Businesses: Selected Legal Issues, frames the issue well: “Under federal law, all income is taxable, including income from unlawful activities. In contrast, not all expenses are deductible from a taxpayer’s gross income.” Consequently, given this imbalance in the tax code, all cannabis businesses, “from farmers and processors to distributors and retailers, are prohibited from writing off many of their day-to-day expenses and overhead costs, such as rent, utilities, compensation, costs of administration, and charitable gifts to promote goodwill.” In limited cases the tax courts have shown some leniency to multiple-service facilities, allowing the deduction of expenses for that aspect of a community center that provided caregiving services for sick members, while prohibiting the deduction of expenses incurred by that community center in dispensing medicinal marijuana. But wherever multiple activities within a single enterprise “share a close and inseparable organizational and economic relationship,” the tax court will not find the operation of more than one trade or businesses, precluding that business from taking deductions. Likewise, Section 280E prohibits deductions even for unrelated activities if they are “ancillary” to the cannabis business. While a marijuana company can reduce its gross receipts by the cost of goods sold, no deductions that reduce gross income are permitted.
Legislative Proposals to Limit or Eliminate Section 280E
The CRA compiled an array of legislative proposals that would render Section 280E inapplicable to cannabis businesses by recasting marijuana as a Schedule III controlled substance, or by entirely de-scheduling it altogether. Short of making cannabis federally legal, other legislative efforts have sought to create an exception to Section 280E for marijuana companies operating legally under state law. There are a number of proposals under consideration and the legislative landscape is far from settled.
So what does all this mean for cannabis valuation? Under current conditions, marijuana companies owe outsized federal tax liabilities given their inability to deduce expenses. While it is beyond the scope of this post to analyze the extent to which the IRS has actually been enforcing these laws and pursuing cannabis companies for taking improper deductions, any appraisal of marijuana companies and their assets must take into account the lack of deductions under current US tax law. This factor alone doesn’t necessarily sink cannabis valuations – cannabis sales in the U.S. are expected to reach $25 billion by 2025 according to the CRS report, well beyond the $11 billion in sales experienced in 2018 – nor does it fully take into account the extent to which a single cannabis operation can be divided up into multiple activities, permitting some or even most of the non-cannabis facets of the business to take deductions. In any event, the tax environment surrounding any cannabis business poses a unique valuation exercise requiring creativity and a fresh set of eyes, one that is not readily solved with a one-size-fits-all formula.