Taxation of Illegal Businesses

All for-profit businesses are required to pay federal income taxes on their gross income. This is true even if a taxpayer is operating an illegal business. You might be asking yourself, “Why would an illegal business voluntarily pay taxes?” Well… what about the medical and adult recreational use marijuana businesses?

Although operating a cannabis related business may be legal in your state, it is currently still federally illegal in the United States. If you plan on entering the cannabis market, you should know how the tax code will impact your federally illegal business.

Taxation of illegal business in general

In most illegal businesses, taxpayers may deduct both the cost of production, manufacturing, sales, and administrative activities as long as the activities themselves are not illegal. However, IRC Section 280E prohibits business who are trafficking Schedule I and II drugs from deducting any expenses other than costs of good sold. As of today, cannabis is still a Schedule I drug, which means that a cannabis business is subject to the 280E rules.

How taxation works on illegal business

Deductions for cannabis businesses

Under 280E, the only costs that a cannabis business may deduct against gross income are those costs incurred to produce or purchase inventory. For example, a cannabis farmer could deduct seeds, costs of planting, harvesting, etc. A re-seller of cannabis products would be able to deduct the costs of purchasing inventory from a supplier. These costs would include acquisition costs, transportation, and trade discounts.

All other costs associated with running the business would not be deductible. For example, salaries of the employees, advertising, general and administrative costs are all legal activities, but not allowable as a deduction against gross income.

Affect of UNICAP rules

The uniform capitalization (UNICAP) rules indicate that some of the general costs of operating a business must be allocated to the cost of inventory. However, in the case of a cannabis business, these costs cannot be allocated to inventory because they are not deductible under 280E. This further limits the amount of deductions available as compared to other industries.

State excise taxes

Most states where medical and adult recreational use is legal have imposed significant excise taxes. The IRS has taken the position that these excise taxes are not subject to the limitations under 280E. Thus, cannabis businesses may reduce their gross sales by the amount of excise tax required to be paid in order to generate those sales.

It will be interesting to see what new developments continue to come out relating to legalizing marijuana, particularly in New York State!