Section 280E of the tax code presents significant financial challenges for cannabis businesses by limiting their ability to deduct standard operating expenses like rent, salaries, and utilities. This results in companies being taxed on their gross income, not their net income, which can lead to tax rates as high as 70% or more. Navigating 280E is critical for long-term financial health in the cannabis industry. One highly effective solution is implementing an Employee Stock Ownership Plan (ESOP), which offers valuable tax advantages to help offset 280E’s restrictions.
What Is 280E?
Section 280E of the Internal Revenue Code prohibits businesses involved with Schedule I or II substances (Cannabis is currently considered a Schedule 1 Drug) from deducting typical business expenses like rent, utilities, and employee wages. Since cannabis remains a Schedule I substance federally, cannabis businesses are taxed on their gross income, which substantially increases their tax obligations compared to other industries.
The Impact of 280E on Cannabis Businesses
The 280E tax code places an especially heavy burden on cannabis businesses, as they cannot deduct normal business expenses, which are standard for other industries. This causes tax rates to climb to 70% or higher in many cases. Such a tax burden can cripple profitability and limit a business’s ability to grow, hire employees, or reinvest in product development or services. For cannabis businesses, this makes navigating 280E essential for maintaining financial stability and planning for the future.
Most cannabis businesses focus on maximizing COGS deductions since COGS are considered direct costs and not subject to 280E limitations. However, this is only a partial solution.
By selling to ESOP, businesses can eliminate their tax burden entirely. Once the company is 100% owned by the ESOP, it pays zero federal taxes, making 280E irrelevant and providing a significant advantage for long-term financial health and growth.
280E Deductions for Cannabis Retailers
While 280E severely limits what cannabis businesses can deduct, there are certain areas where deductions can still be made. These include:
- Cost of Goods Sold (COGS): Direct costs attributable to producing goods, including raw materials, labor involved in production, and certain packaging are not considered expenses by the IRS, and can be deducted.
- Certain Employee Wages: For employees directly involved in production, their wages may be considered part of COGS.
- Packaging Costs: Packaging expenses that are directly tied to the product itself may be deductible as part of COGS.
- Shipping Costs: Expenses related to shipping cannabis products to customers can also qualify under COGS.
- Inventory Costs: Managing inventory is sometimes deductible, depending on how costs are categorized.
By focusing on COGS deductions, cannabis businesses can reduce taxable income under the 280E tax code. It’s crucial to work with a tax professional who specializes in the cannabis industry to ensure compliance and maximize available deductions.
How Do Dispensaries Pay Federal Taxes Under 280E?
Dispensaries face a particularly tough challenge under 280E, as they are taxed on gross income without the ability to deduct ordinary business expenses like rent, utilities, and salaries. To navigate these constraints, dispensaries must focus on maximizing COGS deductions, which include costs directly related to production and procurement. Examples include cultivation costs, raw materials, and some packaging expenses.
Despite maximizing COGS, the tax burden remains substantial, making it vital for dispensaries to partner with tax professionals specializing in cannabis taxation to help manage federal tax payments and explore potential opportunities to reduce their liabilities within the law’s limitations.
How to Avoid 280E Tax Pitfalls
Except for an ESOP, eliminating the impact of 280E is nearly impossible for cannabis businesses. However, there are several strategies to mitigate its effects:
- Implement Strong Accounting Practices: Ensure precise categorization of COGS versus non-deductible expenses.
- Vertical Integration: Owning every part of the production chain—cultivation, manufacturing, distribution, and retail—can increase the amount of deductible COGS.
- Consult Tax Professionals: Work with experts who specialize in 280E to develop strategies and avoid costly mistakes.
How ESOPs Can Help Create Tax Benefits
For cannabis businesses, an Employee Stock Ownership Plan (ESOP) isn’t just a tax strategy—it’s the only solution that can fully eliminate the burden of 280E. When a company becomes 100% owned by an ESOP, it is transformed into a tax-exempt entity, meaning it no longer pays federal taxes, rendering 280E irrelevant.
While other strategies focus on maximizing Cost of Goods Sold (COGS) deductions to minimize 280E’s impact, they don’t address the root issue. An ESOP doesn’t just reduce 280E’s effects—it eliminates them, allowing profits to be reinvested into growth, employees, or expansion without the heavy tax burden.
Why ESOPs Make Sense for Cannabis Businesses
No other strategy offers the advantages of an ESOP. In the cannabis industry, 280E threatens profitability by preventing businesses from deducting normal operating expenses. But with an ESOP, this issue is completely eliminated. Once a company is fully owned by an ESOP, it becomes a federally tax-free entity, freeing the business from 280E’s grip entirely.
Beyond tax relief, ESOPs transform the workforce. Employees who become owners are more motivated, loyal, and aligned with the company’s success. This advantage is critical in a competitive industry like cannabis. An ESOP not only shields the business from 280E but also fosters a high-performing, engaged workforce, positioning the company for long-term growth and stability.
In short, an ESOP is the only solution to make 280E irrelevant while creating significant tax benefits and turning employees into true stakeholders. It’s more than a tax strategy—it’s a complete financial and cultural transformation.
How MBO Ventures Can Help
Navigating the complexities of 280E and implementing an ESOP requires more than just guidance—it demands expertise from a firm specializing in this space. At MBO Ventures, we’ve successfully structured numerous cannabis ESOPs, helping owners unlock substantial tax savings while maintaining control. We ensure that owners receive fair market value for their business, along with warrants that offer a future opportunity for additional profits.
With our deep experience in cannabis and ESOPs, we’ll help you maximize tax benefits, eliminate 280E’s impact, and position your company for long-term success.
Frequently Asked Questions About 280E
Why does 280E exist?
280E was implemented to prevent businesses involved in illegal drug trafficking from claiming tax deductions. It was originally created to target criminal enterprises.
Is COGS Deductible under 280E?
No, 280E itself is not deductible, but COGS (Cost of Goods Sold) is an allowable deduction under the code, helping cannabis businesses lower taxable income.
Is 280E still in effect?
Yes, 280E is still in effect and continues to impact the cannabis industry by limiting businesses’ ability to deduct standard expenses.
How can cannabis businesses minimize the impact of 280E?
While maximizing COGS deductions is a common approach to reducing the impact of 280E, the most effective solution is to implement an ESOP. By selling the company to an ESOP, cannabis businesses can completely eliminate their federal tax burden, as a 100% ESOP-owned company operates tax-free, making 280E irrelevant. This provides a powerful advantage over traditional methods of tax mitigation.
Are there any efforts to repeal 280E?
Yes, there have been legislative efforts to amend or repeal 280E, but the most significant change could come through federal rescheduling of cannabis. Currently classified as a Schedule I substance, cannabis remains subject to 280E. If cannabis is rescheduled to a lower classification, Schedule III, 280E would no longer apply. However, until such rescheduling occurs, 280E remains a major challenge for cannabis businesses.