Does 280(e) Apply to Cannabis Seed Sales?

Does 280(e) Apply to Cannabis Seed Sales?

Anyone in the cannabis industry is (or at least should be) familiar with Internal Revenue Code 26 U.S.C. § 280(e), although it is the bane of our existence.

It 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 and 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.” 

For those not fluent in legalese, what this means is that a cannabis business cannot deduct ordinary and necessary business expenses that would be deductible by a comparable business that sells literally anything else. This creates a massive burden for cannabis businesses because it creates what is known as "phantom income."

What is phantom income?

Basically the assumption by the IRS that a cannabis retailer has income that doesn’t really exist.

Imagine a cannabis retailer has $1,000,000 in gross sales. This retailer spends $600,000 on salable inventory (aka Costs of Goods Sold or “COGS”), some more money on labor, some more on rent and more on various expenses (probably utilities, licensing, seed to sale tracking systems, marketing, etc). In any other business ALL of those expenses would be deductible, however, under 280(e) ONLY the COGS would be deductible, meaning that from a tax perspective, such an enterprise would have $600,000 in income and its federal taxes would be calculated based on that income. 

In reality, however, the business only has an actual income of $300,000 because it had to spend an additional $300,000 on the other things to, you know, actually run the business. The difference between $600,000 and $300,000 is known as “phantom income” because the IRS views cannabis retailers as having income that simply does not exist.

Cannabis farmers have a slightly easier time than retailers under 280(e) because the labor, rent, and utilities expended by cannabis farmers are the actual inputs needed to generate the product they sell. So while labor is not a part of COGS for a cannabis retailer, farm labor IS a part of COGS for a cannabis farmer because the labor is directly related to the generation of the product the farm sells.

So what about breeders who sell cannabis seeds? 

Are their labor, rent, and all other expenses necessary to run their business subject to 280(e)? The short answer is NO! 

280(e) ONLY applies to businesses engaged in the sale of Controlled Substances as defined in the Controlled Substances Act and thanks to the 2018 Farm Bill [link to prior blogs on 2018 Farm Bill], products that contain less than .3% THC are classified as Hemp under the 2018 Farm Bill and are explicitly excluded from application of the Controlled Substances Act. 

Since cannabis seeds do not contain THC (because THC emerges only as a plant matures) they are considered ‘hemp’ under the 2018 Farm Bill and are not subject to 280(e). Therefore, breeders of cannabis seeds are entitled to normal business deductions just like any other business.

Lucky them.