Federal Income Tax Challenges for the Cannabis Industry

Although many states have legalized the production and marketing of cannabis and its associated products, it remains a federally illegal Schedule I controlled substance(s).

The information in this publication is provided only for educational purposes and to inform the reader of relevant topics. This is not to be perceived or utilized as formal tax or legal advice. It is up to the reader to seek the necessary and appropriate tax and legal professionals that specialize in these areas for specific guidance. This article is to inform tax practitioners, growers, and others about income tax complexities for those involved in non-federally approved Schedule I or II controlled substances.

Medical and recreational cannabis has been legalized by multiple states (table 1) for its production, sale, and use.¹ But cannabis remains illegal at the federal level, classified as a Schedule I controlled substance. The US Department of Justice (DOJ) defines controlled substances as “Drugs and other substances that are considered controlled substances under the Controlled Substances Act (CSA)”.²

The DOJ categorizes substances as one of five classifications based on

1. whether or not a substance has a current medical use in treatment in the United States;
2. the substances’ relative abuse potential; and
3. the likelihood of causing dependence when abused.²

Schedule I-V Controlled Substances

A Schedule I controlled substance is a substance that has “no currently accepted medical use in the United States, a lack of accepted safety for use under medical supervision, and a high potential for abuse.”² Schedule I substances include cannabis and Peyote, LSD, Ecstasy, heroin, and others.²

A Schedule II/IIN controlled substance has a “high potential for abuse which may lead to severe psychological or physical dependence.”¹ Schedule II substances include methadone, oxycodone, fentanyl, methamphetamine, pentobarbital, and others.²

Schedule III – V controlled substances have less potential for abuse than Schedule I and II/IIN substances with varying degrees of dependency and are more likely to have medical uses within the United States. Some of the substances include: products containing not more than 90-milligrams of codeine per dosage unit such as Tylenol with codeine (Schedule III); Xanax and Valium (Schedule IV). Schedule V substances may include cough medicines than do not contain more than 200 milligrams of codeine per 100 milliliters/100 grams such as Robitussin^® and others.²

Industrial Hemp

Over the past six years the United States has seen significant growth in the production of industrial hemp partly due to the passing of the 2014 Farm Bill. The 2014 Farm Bill allowed for the production, cultivation, and marketing of industrial hemp as a pilot project, as long as the state allowed for the cultivation of industrial hemp.³ States with US Department of Agriculture (USDA) approved pilot programs were allowed to permit individuals to grow industrial hemp even though industrial hemp remained a Schedule I controlled substance because of the Controlled Substance Act (CSA) of 1970. The passing of the 2018 Farm Bill removed industrial hemp from being classified as a Schedule I controlled substance.³

Industrial hemp is differentiated from cannabis by the Tetrahydrocannabinol (THC) content and its purpose. Industrial hemp is grown for its “industrial purposes” and not for the purpose of its intoxicating effect(s). Industrial hemp according to the 2014 and 2018 Farm Bills has a THC level of not more than 0.3 percent.^3,4

Prior to the passing of the 2018 Farm Bill, those not permitted through a state’s USDA approved industrial hemp pilot program could have been considered trafficking a Schedule I controlled substance. Permitted producers of an approved pilot program were able to legally produce and market industrial hemp.

Through the passage of the 2018 Farm Bill, industrial hemp (THC not more than 0.3 percent on a dry matter basis) is no longer considered a Schedule I controlled substance, but a permitting process is still required to legally grow and market the crop.⁴ Presently, states with pilot programs under the 2014 Farm Bill may utilize the previously state approved pilot program(s) until the USDA unveils new regulations that meet the intent of the 2018 Farm Bill. The 2018 Farm Bill still requires a number of criteria to be met but does not allow everyone and anyone to raise industrial hemp. The 2018 Farm Bill has removed industrial hemp as a Schedule I Controlled Substance and therefore industrial hemp should be treated like any other agriculturally produced product for income tax reporting.

A tax practitioner should request the taxpayer to produce a letter, certificate, or other proof that they have been approved or permitted by the state to produce and market industrial hemp. Unpermitted industrial hemp producers may have unintended tax consequences.

Tax Implications

All tax practitioners should perform due diligence with clients that are producing, marketing, processing, handling, etc. any Schedule I or II controlled substance products involved in a revenue generating business that is illegal at the federal level. This may limit the available tax deductions allowed and or require the capitalization of expenses of the business regardless of a states’ cannabis law(s).

The Internal Revenue Service (IRS) generally requires income derived from illegal activities to be reported. Determining taxable income from illegal activities is further complicated as expenses may or may not be deductible depending on the revenue generating activity. This article specifically looks at the regulations for the medical and recreational cannabis industry. Cannabis is still considered a Schedule I controlled substance by the DOJ. Given that the production, processing, and marketing are considered “trafficking” at the federal level, it may be good to recommend the taxpayer work with a tax attorney for purposes of attorney-client privilege.

Tax Implications of Trafficking Cannabis Legalized by States

Trafficking is defined as being in the business, trade, or dealing in illegal activities. Typically, anyone trafficking (production, processing, marketing/sale) of a Schedule I or II controlled substance(s) such as cannabis must report income and pay appropriate taxes to the IRS but may be unable to deduct expenses beyond “cost of goods sold” (COGS). Determining the deductibility of expenses beyond COGS requires the study of a series of IRS codes, laws, regulations, and court cases.

Related Tax Code and Guidance

Taxpayers presently trafficking a Schedule I or II controlled substance such as cannabis should proceed with caution as it relates to their taxes. Many assume that products such as cannabis that have been legalized at the state level can follow general IRS rules for deducting expenses, but these activities remain illegal at the federal level and as a Schedule I controlled substance it is bound by 26 U.S. Code § 280E.⁵ Everyone that is illegally (at the federal level) producing, processing, and handling a Schedule I or II controlled substance(s) should proceed with caution and work with a trusted tax professional such as an Enrolled Agent (EA) or Tax Attorney who specializes in this industry.

Federal Income Tax Code Related to the Sale of Illegal Controlled Class I and II Substances

Originally, anyone receiving income from a controlled Schedule I or II substance was able to deduct expenses associated with that revenue generating activity. Eventually, 26 U.S. Code § 280E was enacted, which does not allow anyone receiving income from trafficking a controlled Schedule I or II substance to deduct any expenses associated with that revenue generating activity.⁵

The 26 U.S. Code § 280E of the Tax Equity and Fiscal Responsibility Act of 1982, September 3, 1982⁵; Pub. L. 97-248, title III, §351(a), 96 Stat. 640– Expenditures in Connection with Illegal Sale of Drugs⁶ states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I or II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.⁶

The Office of Chief Counsel of the IRS did release on January 23, 2015 a memorandum titled “Taxpayers Trafficking in a Schedule I or Schedule II Controlled Substance – Capitalization of Inventoriable Costs”.⁷

The memorandum states that:

A taxpayer trafficking in a Schedule I or II controlled substance determine Cost of Goods (COGS) using the applicable inventory-costing regulations under §471 as they existed when §280E was enacted.⁷

The memorandum cites multiple court cases which has helped define taxation of income and assists in defining COGS, which is described as the adjusted basis (gross revenue – COGS). The COGS is the expenditures that are required:

To acquire, construct, or extract a physical product which is to be sold. The seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold.⁷

The taxpayer can only deduct/capitalize expenses directly attributable to the production or purchase of items purchased for resale but cannot include any of those same items attributable to general business or marketing activities.

In summary

1. Cannabis is still considered a Schedule I controlled substance.
2. Because a state has laws that have legalized cannabis does not make it legal at the federal level.
   • Federal law continues to supersede state law in this case.
3. Industrial hemp with a THC level above 0.3 percent may be considered an illegal Schedule I controlled substance if appropriate legal procedures are not followed and the crop is marketed.
4. Individuals trafficking in a Schedule I or II substance such as cannabis are only able to deduct COGS for federal income tax purposes.
   • Determine if the appropriate accounting method is being used to meet tax code.
   • Determine if an expense meets the definition of COGS.
   • Determine if an expense must be capitalized or can be deducted.

Table 1. State by state legalization of cannabis as of June 25, 2019.²

*On April 17, 2019 a law was signed by Governor Brian Kemp that will allow six private companies, the University of Georgia, and Fort Valley State University to raise cannabis to produce cannabis oil to be used for medical purposes. This new law assists with the original intent of Haleigh’s Hope Act.

References Cited

1. Blake J, Gould S. States where cannabis is legal. Business Insider. New York (NY): Insider Inc; c2019. [accessed 2019 Jul 17]. https://www.businessinsider.com/legal-cannabis-states-2018-1.
2. Diversion Control Division, Drug Enforcement Administration. Springfield (VA): U.S. Department of Justice. [accessed 2019 Jul 17]. https://www.deadiversion.usdoj.gov/Schedules/#define.
3. Agricultural Act of 2014. Pub. L. No. 113-79 (Feb 7, 2014).
4. Agricultural Improvement Act of 2018, Pub. L. No. 115-334 (Dec. 20, 2018).
5. 26 U.S. Code § 280E of the Tax Equity and Fiscal Responsibility Act of 1982. Pub. L. No. 97-248, title III, §351(a), 96 Stat. 640– Expenditures in Connection with Illegal Sale of Drugs (Sep 3, 1982).
6. Tax Equity and Fiscal Responsibility Act of 1982. Pub. L. No. 97-248, title III, §351(a), 96 Stat. 640 (Sep 3, 1982).
7. United States. Office of Chief Counsel. Internal Revenue Service (IRS). “Taxpayers Trafficking in a Schedule I or Schedule II Controlled Substance – Capitalization of Inventoriable Costs; Memorandum,” [No. 201504011] (23 Jan 2015).
8. Georgia’s Hope Act, HB 324, 155th (GA, 2019).
9. Haleigh’s Hope Act, HB 1, 153rd (GA, 2015).