In episode 53 of How Tax Works, Matt Foreman discusses the state of the taxation of Cannabis, how section 280E works, how to mitigate its effects, and why 471(c) isn’t a panacea. 

 

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Hello and welcome to the 53rd episode of How Tax Works. I’m Matt Foreman. In this episode, I’ll talk about the taxation of cannabis, specifically the application of Section 280 CAP E over the Internal Revenue Code. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make.

Matthew Foreman [00:00:43]:
Before we get started, a few administrative things. New episodes every two weeks. The next one will discuss Substance versus Form, Part 3, Economic Substance and Project Soy, which I promise you is a real thing. If you have any questions, comments or constructive criticism, you can email me my FRB email address which you can find via your favorite search engine. Early on, I would say best ones ask or Ask Jeeves, which no longer exists apparently. Apparently it’s gone, which is kind of depressing. Upcoming webinars speak engagements are on the website. Also update on LinkedIn so you can connect with me there.

Matthew Foreman [00:01:16]:
What are we talking about? We’re gonna talk about cannabis and tax and Funyuns. So why is this even an episode? Is the question that I want to lead with. Basically, there was a war on drugs during the Reagan administration and there was a case that allowed a drug dealer to deduct their expenses. And everybody got angry. If you’ve ever watched South Park, this is where the townspeople go, rabble, rabble, rabble, rabble, rabble. If you don’t understand what that means, and then you’re probably better off candidly for not knowing. But, you know, so Congress acted right, and they introduced 280E, which I’ll talk about in a moment. However, time’s change.

Matthew Foreman [00:01:57]:
Okay, and 280E does is it disallows a deduction for ordinary and necessary business expenses associated with and this is quotation marks, trafficking of Schedule 1 or 2 under the Controlled Substance Act. At the time, cannabis was illegal everywhere. There were no medical applications that were approved and you couldn’t use it legally. That was it. It may put things into five schedules. I pulled the schedules, I believe from the DEA website.

Matthew Foreman [00:02:24]:
That’s what my notes say. So if it’s wrong, it is. The five schedules are Schedule 1 and they’re in Roman 1, which I think is really interesting. But anyway, Schedule 1, drugs with no current medical use with high potential for abuse and or addiction. Schedule 2, drugs with some medically acceptable uses but with high potential for abuse and or addiction. These drugs can be attained through prescription. Schedule 3, drugs with low or moderate potential for abuse or addiction but less dangerous than Schedule 1 or 2. These drugs can be attained through prescription but generally are not available over the counter.

Matthew Foreman [00:02:55]:
Drugs 4, drugs with a viable medical use and low probability of use or misuse. Schedule 5, drugs with low potential for abuse lower than Schedule 4. The drugs that are considered the most dangerous by the DEA are known as Schedule 1 substances. These drugs with no current medical use per analysis by DEA and FDA. These substances also carry high potential for abuse and addiction. Again, I took this literally from the DEA website. Okay, so this has been there for a while.

Matthew Foreman [00:03:22]:
Schedule 1, drugs include heroin and this. I’m going into this because I think it’s important to understand context. Schedule 1 drugs include heroin, LSD, marijuana, Ecstasy, Quaaludes and bath salts. Schedule 2 drugs. Examples. Okay. Methadone, Demerol, Vicodin, Oxycodone, fentanyl, morphine and codeine. Okay, so marijuana.

Matthew Foreman [00:03:43]:
Schedule one, fentanyl. Schedule two. Okay. Schedule three, Suboxone, Ketamine and anabolic steroids. Schedule four, Xanax, Soma, Klonopin, Valium, Ativan. I don’t. I honestly don’t know. And Schedule 5, Robitussin, AC and Ezogabine.

Matthew Foreman [00:04:03]:
I don’t know what that is. Sorry if I’m not being helpful here. Those are Schedule 1 to 5. It is really important to note here before I get into 280 Cap E only affects Schedule 1 and Schedule 2. So the sale of, for example Suboxone and Ketamine. Anabolic steroids. No, no, no.

Matthew Foreman [00:04:23]:
280 Cap E. Marijuana. Apparently in the brink of the most dangerous drugs. That’s it. Fentanyl apparently has medical use. I’m. Maybe it does. I don’t know.

Matthew Foreman [00:04:34]:
I’m not that kind of doctor. My doctorate’s in law, so I’m not really a doctor. But, but that. That’s it. And I’m trying not to make a political statement. I’m trying not to take an opinion or put opinion.

Matthew Foreman [00:04:44]:
But I think it’s fairly obvious that I’m viewing things through a 2026 lens and I’m saying that sometimes things have to get changed. So why are we talking about it? Right. I’ll. You know what? There was a recent notice. I’m going to leave it for the end I think it’s better served if I talk about the President’s order at the end. I think a little bit of boring technical detail is more important. So what is the effect of 280Cappy? Right. If you think about taxable income, the way you reach taxable income, and there’s more to it than that, but generally speaking, right? Gross receipts, less cost of goods sold, less ordinary necessary business expenses, that’s your taxable income.

Matthew Foreman [00:05:22]:
So GR Less COGS, less O & N. Right, that’s it. So what happens is you get to deduct your cost of goods sold, but you don’t get to deduct your ordinary necessary business expense. Most people, when they do their. Their books and when they do their tax returns, they’re really not that worried about the difference between ordinary and necessary business expense and cost and goods sold. There’s a lot of, I’ll use the word politely, fluidity between them. And the reason is because they’re both generally deductible.

Matthew Foreman [00:05:47]:
But it is really, really, really, really, really important in the context of cannabis or other things that fall in science schedules one and two, because you want cost of goods sold, you can deduct them ordinary and necessary business expense under section 162, you cannot not permit it. Some people talk about 471C. I will get to that later. So I think it’s really important. So how does this work? Right. What happens? The effective nature of what happens is pretty draconian. That’s the word I use a. Because it sounds cool.

Matthew Foreman [00:06:18]:
It’s definitely an SAT word, but. But also because I think it functionally works okay. What happens is that you essentially just get a really, really, really, really, really high tax rate. That’s what happens. That’s all there is. If you think of A business makes $100 and has $50 of cost goods sold and $50 of ordinary necessary business expenses, its taxable income is zero. Cannabis business, $100, $50 of cost goods sold. You’re paying tax on dollars, but you don’t have any money left at the end.

Matthew Foreman [00:06:48]:
That. That’s the important thing, that that’s essentially function. What happens. I’m exaggerating. Cannabis businesses actually tend to be fairly high in terms of margin, but like any other business, there’s startup costs, not everything works as well as you’d hope, etc. Etc. So you have these tremendously high tax rates that make their margins very small. The other question I’m going to hit before I go into the first music break is people ask me, well, how is this constitutional? When they get out there, they say this is unconstitutional.

Matthew Foreman [00:07:16]:
I can’t believe this. This is the worst thing ever. It’s beating up, you know, small children. It’s stealing a lot of lollipops, et cetera, et cetera. And the answer is it’s constitutional. And I’m sorry, I think there’s, you know, people say, oh, it violates, you know, the Eighth Amendment. Violates this, it violates that. And.

Matthew Foreman [00:07:34]:
And I understand the arguments, but there’s case law that says otherwise. And what any tax practitioner will tell you, or least should tell you, is that if there’s case law, then it’s not worth the litigation, generally speaking, you can fight it. But I will tell you that auditors don’t care. They have case law, and they’ll move on. So you’re stuck spending hundreds and hundreds of thousands of dollars, possibly millions, to litigate a point that’s already been litigated. That’s it. That’s what happens. So it’s constitutional.

Matthew Foreman [00:08:03]:
Sorry, that’s what the law says. I’m not here to make that level of an impassioned argument. That’s it. This is just how tax work. It’s a podcast. So we’re gonna get some music in. Come back in a moment. Talk about section 461C.

Matthew Foreman [00:08:38]:
All right, welcome back. We’re talking about cannabis. So 471C is a rule for inventory. There’s an exemption for small business. You’re eligible for it if you’re eligible for the cash method of accounting. Under 448A3, which is, generally speaking, an AAGR average annual gross receipts of 25 million, which is indexed for inflation. It’s now a bit over 30. I think it’s like 31, 31 million and some change.

Matthew Foreman [00:09:01]:
It goes in, I think, thousand dollars increments, but that’s where it is. So I always just tell people it’s 25 million index for inflation. I’m not that worried about it, because if you’re close, you’re close, and we should do the analysis. Some people are already doing, you know, $100 million of revenue. So it’s not really. Not really relevant. Right. But a lot of cannabis businesses don’t hit $25 million in revenue.

Matthew Foreman [00:09:20]:
You think about, you know, a small dispensary, even one. There’s a lot lot in Manhattan, right. They’re unlikely to really do a huge amount, you know, right away. So it takes a little time. What happens is, is under 471C, you must conform your Financial accounting for the taxpayer. If there’s no financial statements, use book and books and records. And what does it do? Right. I know I’m saying you have to conform your financial accounting for the taxpayer to, to your tax return.

Matthew Foreman [00:09:47]:
But what it does, I’m going to make this abundantly clear. I don’t think 471C works. I don’t think it functions in the way people are. I will explain why. I’ll explain why people think it does, but I don’t think it does what. What the idea is, it allows you to deduct ordinary necessary and business expense. Okay? It allows you to deduct ordinary necessary business expenses if you deduct those ordinary and necessary business expenses under your method for your books and records. Okay? That’s the idea.

Matthew Foreman [00:10:17]:
And people say, oh, that’s great. You can do it. But I don’t. I’m not buying. And I’ll tell you why not. Because people say, oh, you know, we do it for books, therefore we meet it and this and that. First and foremost, I always quote. It’s one of the few lines from Shakespeare I actually know a rose banner, their name, right? What it says is, look, why can your method for books and records overrule the Internal Revenue Code? And I ask these questions to people who say it works.

Matthew Foreman [00:10:44]:
And I say, well, why does that make sense? And they’re like, well, it just does, right? And saying it just does that sounds a little bit like a small child explaining why they get dessert even though they didn’t have any of their dinner. Then you’re with me. You’re understanding it, right? That’s the first one. Second one is it’s overruled. It’s using the General 471C as a General inventory provision, overruling a specific disallowance in 280E. Okay? That’s not how the code works. General rules cannot overrule specific rules. Okay? And people say, oh, what about the economic substance doctrine? That’s a general rule that overrules a specific rule that allows me to do it.

Matthew Foreman [00:11:24]:
I will talk about the economic substance doctrine literally in the next episode. I’ve already talked about it in, in a prior episode. That’s not how the economic substance doctrine works. The economic substance doctrine is actually intended to prevent you from doing very specific things. That comes up in a very specific one. I also think the economic substance doctrine comes in here a bit because the economics should not control, you know, the economics and tax should. Should not be the same in this context anyway.

Matthew Foreman [00:11:52]:
So I think in this one, you know, candidly, cannabis kind of caught astray. You know, they got dinged up in it. That’s how it works. And until cannabis is removed from Schedule 1 and Schedule 2 has to be removed from both, I think that’s just kind of how it is. People don’t like it, and that’s fine. I suspect there’s a significant portion of the Internal Revenue Code that’s liked by at least one. Like, or should say disliked by at least one person. Fine.

Matthew Foreman [00:12:19]:
But that’s just kind of how it is. And I think that in this one, you know, for example, In Treasury Regulation 1.613, a cost of goods sold specifically does not include selling expenses, losses or other items. Not ordinarily in computing cost of goods sold, even unicap. Right. 263 Cap A basically says the same thing. People always say, oh, but this is, this is, you know, you can use it, you can use it. But the idea is you can’t actually move ordinary and necessary business expense into another category to make a deductible unless it’s otherwise properly includable. This was sort of my point, what I said earlier, right? The generally speaking, for most people, most businesses, the difference between cost of goods sold and ordinary and necessary business expense is extremely, extremely academic.

Matthew Foreman [00:13:09]:
They’re both deducted. They’re both deducted. In the current year, they’re deducted functionally. In the same way, when you get to taxable income, it doesn’t really matter, but it really matters for cannabis businesses. It also really matters if your business is selling heroin. I don’t recommend that, it’s illegal and there’s other issues that come along with it, but it’s the same thing. That’s why I say cannabis kind of caught astray. In the 80s it was used very differently.

Matthew Foreman [00:13:31]:
Unclear why. But then today, and I think today, you know, like roughly half the states have it legal. So. So the question always says is that that comes back to. And clients always go to is what, what can I do? You know, what can I do to reduce my tax? I can’t change my business. I see what you’re saying about two 80E and 471C. What can I do? The first thing you want to do is divide your rent, salaries and other expenses between cannabis and non cannabis businesses. Right? This is patience mutual to some extent, although really didn’t do a great job of this.

Matthew Foreman [00:14:04]:
But if you sell, you know, shirts, if you sell glassware, papers, other things like that, there’s beverages, things like that, that don’t include cannabis. You want to split those out. Some people split them up by square footage. Some people split it up by volume, dollar amount of threshold. Some people split it up by you know who’s staffed to sell what. Right. Most states you have to be 21 to sell it. That’s fine.

Matthew Foreman [00:14:28]:
That can help you. Who can sell what. That’s the key. Some people become a C corporation. What they do is you’re taxed a higher level within the corporation but it’s only a 21% tax so it’s really not that atrocious. And then what happens is after the 21% tax, the distribution is only taxed once, right? The pass through. The full income is taxed at slightly higher rates. Pass through but there’s no deduction.

Matthew Foreman [00:14:52]:
So sometimes you can get a better one, you can get a better weight to do it. Most states decouple couple for those who don’t know means they don’t follow federal law. Some states, no states have actually decoupled for from 280E. What they actually decouple from is a little bit more nuanced. What they actually are decoupling from is if basically if this is a state legal sale. So effectively if it’s legal to sell cannabis you don’t get hit by 280, you’re allowed the deduction for state purposes. Now that creates a pretty significant difference between federal and state. So I strongly recommend you model this out.

Matthew Foreman [00:15:32]:
Figure out what the numbers are. If companies have already gone to a C corp and they want to go back. Sometimes an S is an option that’s a direct one. Some people will do f reorg drop and have to have a partnership below and start putting money out that way. There’s different ways to do it, different things to think about about. There’s A case on 199 Cap A. You know, whether you get the pass through deduction. It’s actually a really interesting read.

Matthew Foreman [00:15:55]:
I think you do, you know that that’s how I view it. But I think it’s about, you know, understanding what is your income, how much is deduction, what kind of expenses you have, etc. Etc. So I think that’s a really interesting one and it changes the math. So it’s important to really sit down and do the math, go through, go through the mechanics of it because it’s really, really, really really really really really important. Finally, you know, look, production versus retail. I’m, I’m not going to go through this in detail because I actually think it’s like a 15 minute discussion to get it done right. And I don’t, I don’t want to spend more than one episode on this.

Matthew Foreman [00:16:28]:
I just, I don’t view it as being sufficiently nuanced or necessary to do it. Plus, if I were to do that, it’d be like an episode and a half total. And I’m not doing it. I’m burning through it, going quickly because I think that’s the correct way to cover, cover this topic. So let’s get a little music in my secondbreak. And when we come back, we’re going to come back with what I have titled in my notes. Hope is on the horizon. Beautiful.

Matthew Foreman [00:17:11]:
Hello. We’re closing out episode 53 of how tax Works. So Hope is on the horizon. You know, the president issued an order and basically what it comes down to is the DEA in the order. Right. The DEA is going to accelerate the process of moving marijuana off schedules 1 and 2 for medical marijuana business. That’s it. That’s all it’s going to be.

Matthew Foreman [00:17:41]:
It’s not for everyone. It’s only for medical, which is a good thing because it’ll allow it to be studied more fully. What are the long term effects? Does it actually do some of the health benefits it’s been reported to do by some proponents. We need to understand that, right. As a society need to know what do drugs do, right. How drugs work. But that’s the idea. People said, oh, he’s moving it off, you know, for all marijuana, everything cannabis is to be great.

Matthew Foreman [00:18:07]:
And he did not do any of that. It is merely continuing the Biden administration’s movement to reschedule for state legal cannabis. And this is really important. Okay. The current order is for medical, where it can be used for medical purposes, to study and for treatment. The Biden administration’s was for state legal cannabis. Okay. So if you live in a state where cannabis is still illegal fully, it is still will still be on schedules one or two, which is moderately fascinating in a way.

Matthew Foreman [00:18:41]:
They’re really splitting it up that way. This is, this is the, the end of the war on drugs. Really kind of digging out. So what, what is not going to happen? We’ll say, oh, we need to repeal 280E. I don’t think that happens and I don’t think there’s any real desire to do that broadly. Some of the things that I mentioned, I would strongly, you know, think hard about whether you want to give their people who sell them preferential tax treatment. I think you have a pretty good argument that maybe the answer is no there, that you don’t want to, and I leave it at that. Secondly, you know, from a policy perspective, illegal businesses still have to pay taxes, right? Section 61 does not say only if you’re legal.

Matthew Foreman [00:19:27]:
You can ask Al Capone how that worked out, right? He, he, he went to prison not for any of the really, really awful things he did. He went for tax evasion, which is one of the really awful things to do, but not too real easy, I guess. And I think that, that, you know, for most people, that doesn’t really bother most people. They view things as, look, you’re doing something illegal, you should get more of a penalty. And this is just part of it, right? You still have to do it. I know for a fact that there are some states, federal government, that will add in tax charges for drug dealers. They do it. They’ve done it.

Matthew Foreman [00:20:01]:
They still do it. So that’s kind of fascinating from a policy perspective, might be a little interesting, but that’s, that’s what happens. I do think fully making state legal cannabis legal for or exempt from 280E is going to happen. I do think it’s going to happen within the Next, I’ll say 18 months, but it’s going to take some time and it’s going to take some going back and forth. And I think expecting it very quickly is, is, is unrealistic. I think there needs to be some understanding that it’s just going to take a little bit of time, but that that’s really what you want, you know, that’s what you’re looking for. And I think that’s the key, is to understand that this is going to take a little bit of time. It’s going to take a little bit of working together and that’s fine, but it’ll get there.

Matthew Foreman [00:20:45]:
I do think there are some, generally, I’ll say general inconsistencies on what comes up in what schedule, which is why I sat there for a moment and read it, because I do think it’s important, you know, to most people if you hear about, you know, drugs and things like that. The fact that cannabis, you know, marijuana is considered more dangerous than fentanyl and Suboxone is really, to me, you know, somewhat, I don’t say astonishing, but surprising. I think it’s something that needs to be discussed and, and, and modified, you know, because I think that’s something we need to think about from again, a tax perspective. And I think that’s really important. So that’s really important. All right, well, that was the 53rd episode of How Tax Works, one of the more interesting ones. I hope I heard you. Hope you learned something.

Matthew Foreman [00:21:37]:
We back in two weeks with the 54th episode where I’ll be surprising you with a topic. No, I’m. I’m kidding. It’s Substance versus Form, Part three, the Economic Substance Doctrine and Project Soy. Now for the best song of all time.