The cannabis industry continually grows and is weeding out the cynics in the process. To date, 21 states and the District of Columbia legalized the recreational use of cannabis; meanwhile, 37 states legalized the medical use. As a result, the cannabis industry is estimated to take in more than $25 billion annually within two years. Although cannabis businesses are legal throughout the country, the Tax Code constantly burns them.
Federal law, codified under 21 U.S.C. section 812(b)(1)(A)-(C), classifies cannabis as a Schedule 1 substance, along with heroin, cocaine, and LSD. All cannabis businesses must pay taxes on their income. However, the classification as a Schedule 1 substance stops all cannabis businesses from deducting ordinary and necessary business expenses, charitable contributions, or using the Section 168 depreciation method.
On March 27, 2020, Congress passed the CARES Act to give relief to businesses, and included the Employee Retention Credit. Consequently, this may have resulted in the cannabis industry being on the right side of the Federal tax law for the first time. Cannabis businesses might want to consider amending their 2020 and 2021 tax returns to claim the ERC. Although cannabis businesses cannot deduct ordinary business expenses or claim the qualified research credit, they have the potential to claim the ERC.
Who Is Eligible for the ERC?
Section 2301 of the CARES Act provides that eligible employers may have a credit against employment taxes and health care expenses after March 12, 2020, and, in most circumstances, before October 1, 2021. The ERC is a refundable payroll tax credit that can be as high as $5,000 per employee in 2020, and even as high as $21,000 per employee in 2021. Employers qualify as an eligible employer under three circumstances: (i) Recovery Startup Businesses, (ii) employers that experienced a qualifying decline in quarterly gross receipts; or (iii) business operations suspended under governmental orders.
Recovery Start Up Business
Section 2301(a) classifies a recovery startup business as one that began carrying on any trade or business after February 15, 2020, and before September 31, 2021, with gross receipts not more than $1,000,000.
Gross Receipts
Section 2301(a) also qualifies employers if in 2020, their revenue decline decreased 50 percent in one quarter compared to 2019. The eligible employer remains one until its gross receipts increase to less than a 20 percent decline in revenue in comparison to 2019. An employer qualifies in 2021 until September 30, 2021, if their gross receipts suffer a 20% decline compared to 2019.
Suspension of Operations
Often overlooked, an employer may qualify under Section 3134(c)(2)(A)(ii)(I), if their operation was fully or partially suspended as a result of orders from a Federal, State, or local government, that limit commerce, travel, or group meetings because of COVID-19. Under Notice 201-20, Q/A 14, an employer that voluntarily suspended its operations or hours does not qualify under this prong. This method allows an employer to qualify due to their suspension and modification of business; rather than a decline in its gross receipts.
Section 280E
Historically, dispensaries did not qualify for any deductions or credits due to Section 280E. Subtitle A, Chapter 1, Subchapter B, Part IX of the Code provides “[i]n computing taxable income no deduction shall, in any case, be allowed in respect of the items specified in this part.” Sections 262 to 280H make up Part IX. Each provides specific items that are not deductible in the computation of taxable income.
Relevant to dispensaries, Section 280E provides that no deduction or credit is allowed if a trade or business consists of trafficking in controlled substances. Unfortunately, 21 U.S.C. section 812(b)(1)(A)-(C) classifies cannabis as a Schedule 1 substance, along with heroin, cocaine, and LSD. Although this may change in the future, this section prevents dispensaries from claiming all deductions from their income tax that would otherwise be allowable. For instance, dispensaries cannot deduct ordinary and necessary business expenses under Section 162(a), or charitable contributions. Additionally, dispensaries cannot use a depreciation method outlined in Section 168.
With all this being said, Section 280E should not apply to the ERC. Section 280E only applies to “income tax”. Part IX explicitly provides for items not deductible in the computation of taxable income; it does not apply to the entire Code. Therefore, Section 280E should not prevent dispensaries qualifying for the ERC.
As a result of Section 280E not prohibiting businesses from claiming the ERC, dispensaries may qualify under any one of the three prongs:
- Gross Receipts;
- Recovery Startup Business; or
- Suspension of Operations due to Governmental Order.
Cannabis dispensary owners should look to see if they meet the gross receipt bar. A new cannabis business opened after February 15, 2020, could qualify for the deduction. Further, they should look to see if they will meet the suspension as a result of government order test. Some restricted operations include:
- Capacity limitations restricting number of employees or customers;
- Orders requiring only curbside transactions and delivery;
- Inability to attend cannabis conferences and “cannabis festivals”;
- Social distancing measures affecting employees at cannabis labs; or
- Suppliers suspended their operations, and as a result they could not receive their product in the desired quantities.
Cannabis business owners should recognize that restrictions such as these may make them an Eligible Employer if they can show that the government regulations had a more than nominal effect on their operations. Cannabis businesses must analyze their specific circumstances.
Conclusion
Businesses can still amend their 2020 and 2021 Federal Tax Returns to claim the ERC. They must be cautious about this because the IRS has issued several warnings. The IRS issued the most recent on March 7, 2023, stating that they will audit ERC claims and are on high alert for aggressive ERC promoters.
Cannabis businesses have a right to be wary about claiming the ERC because of their history with the IRS and Tax Court. However, this time the argument is on their side and as a result, cannabis businesses should consider whether they are eligible to claim the ERC.