Section 280E of the Internal Revenue Code was introduced in the 1980s. Its purpose was to prevent drug traffickers from claiming deductions on their illegal income. This section has become a major challenge for legal cannabis businesses. It prevents them from deducting regular costs for producing and selling cannabis products.
The primary challenge posed by 280E is that it only allows cannabis businesses to deduct COGS, which are the direct costs associated with producing and selling their products. Other expenses, such as sales and marketing, are not deductible. As a result, cannabis businesses face a higher tax burden compared to other industries.
The Importance of COGS in the Cannabis Industry
As mentioned earlier, COGS is the only deductible expense category for cannabis businesses under 280E. It is essential for companies to accurately calculate and report their COGS. This will help them to reduce their tax responsibility.
COGS includes all direct costs required to produce and sell a product, such as raw materials, packaging, and labor. The interpretation of 280E often limits the Cost of Goods Sold deductions to packaging and raw materials. This increases the tax burden on cannabis businesses.
Cannabis businesses need to reduce their tax payments. To do this, they should find ways to include their sales and marketing expenses in their COGS calculations.
A Potential Solution: Intellectual Property and Royalty Agreements
One strategy that can help cannabis businesses offset their sales and marketing expenses under 280E is by leveraging intellectual property and royalty agreements. This approach can be applied to manufacturers, cultivators, and vertically integrated businesses in the cannabis industry.
Step 1: Create a Separate Intellectual Property Entity
The first step in this strategy is to establish a separate entity that will own and manage the cannabis business’s intellectual property. Intellectual property refers to trademarks, images, slogans, logos, trade secrets, recipes, techniques, formulations, and patents.
Step 2: Implement a Royalty Agreement
Once the intellectual property entity is established, the operating cannabis business (e.g., manufacturer or cultivator) can enter a royalty agreement with the intellectual property entity. The operating business will pay a reasonable royalty fee to the intellectual property entity for the right to use its intellectual property.
The intellectual property entity will then use the royalty revenue to perform sales and marketing functions for the operating business, effectively transferring these expenses to the intellectual property entity and potentially allowing them to be included in the COGS calculation.
How Taxes Work with Intellectual Property and Royalty Agreements
When implementing this strategy, it is essential to understand how taxes will be impacted. The cannabis business will pay a monthly royalty fee to the intellectual property entity, which will become taxable income for the intellectual property entity. However, the intellectual property entity will also incur sales and marketing expenses, which can be used to offset the royalty income.
By structuring the royalty agreement in this manner, the cannabis business can potentially deduct the royalty payments as part of their COGS, thereby reducing their overall tax burden under 280E.
Determining a Reasonable Royalty Rate
It is crucial to set a reasonable royalty rate for the intellectual property agreement to ensure compliance with tax regulations. A reasonable royalty rate can be determined by considering various factors, including the total projected sales and marketing expenses for the cannabis business and the industry standards for royalty rates.
Typically, royalty rates in other industries range from 1% to 5% of sales. However, given the unique nature of the cannabis industry, higher royalty rates of 8% to 10% may be justifiable.
Potential Tax Savings
By implementing this strategy, cannabis businesses can achieve significant tax savings. For example, a cannabis business generating $20 million in annual revenue with a $1 million annual royalty payment and a 30% tax rate could potentially save $300,000 in taxes per year. For a smaller business with $3 million in annual revenue and a $150,000 annual royalty payment, the potential tax savings could be up to $45,000 per year.
Reducing Exposure and Risks
While this strategy has not yet been tested in tax court specifically for cannabis businesses, there are several ways to reduce exposure and risks when implementing intellectual property and royalty agreements:
- Set a reasonable royalty rate that is in line with industry standards and supported by a well-documented methodology.
- Keep the intellectual property and operating businesses as separate legal entities with separate books, accounting procedures, and business plans.
- Develop well-written standard operating procedures (SOPs) that qualify as intellectual property and can be licensed to other businesses, potentially strengthening the validity of the tax strategy.
In summary, offsetting sales and marketing expenses under 280E can help cannabis businesses reduce their tax burden. By leveraging intellectual property and royalty agreements, these businesses can strategically include these expenses in their COGS calculations. It is essential to set reasonable royalty rates, maintain separate legal entities, and develop well-documented SOPs to minimize exposure and risks associated with this strategy.
By implementing these strategies, cannabis businesses can navigate the complex tax landscape and achieve significant tax savings, resulting in increased profitability and growth.