Under Internal Revenue Code (IRC) Section 280E, no individual is permitted to take a deduction or credit on income taxes if the income resulted from carrying on any trade or business if the business consists of trafficking in controlled substances, such as marijuana, under the Controlled Substances Act (CSA). This section of the IRC was designed to prohibit individuals from taking individual tax deductions from marijuana sales. However, how does federal tax law apply to California corporations, s-corps, LLCs for the purposes of deducting expenses?
California Corporations and the Revenue and Taxation Code
The differences between federal law and California state laws have created an unique situation for California marijuana businesses due to the treatment of income and expenses for personal income tax (individuals and partnerships) versus corporation tax law (including statutory cooperatives).
For individuals and partnerships, Revenue and Taxation Code Section 17282 has prohibited taxpayers from taking deductions on any of his or her gross income as a result of income derived from illegal activities, including drug trafficking. However, the taxpayer must be found to have engaged in these activities first due to a criminal or other proceeding in which the state, county, city, or other subdivision was a party.
For corporations, including statutory cooperatives, California has enacted a stand-alone law. A statutory cooperative is a cooperative that has organized and registered as a corporation under the Corporations or Food and Agricultural Code (Id. at Section 12311(b)).
According to California tax law, an entity that is taxed as a corporation per Part 11 of the Revenue and Taxation Code and is also involved in medical marijuana activity is permitted to deduct its ordinary and necessary businesses expenses, along with the cost of goods sold, provided that the entity can substantiate any deductions that it claims with adequate records.
How California Classifies C Corporations, S Corporations, and LLCs
In California, a C corporation refers to an entity that is doing business in California, organized in California, or registered with the California Secretary of State. A C Corporation is business entity that is taxed as a separate entity from its shareholders. The C Corporation pays corporate taxes on its profits while the shareholders are not taxed on the C corporation's profits. The shareholders of a C corporation only report and pay taxes on the income that is paid to them by the corporation.
In addition, California also has specific definitions for corporations that are S corporations or LLCs:
The owners of LLCs that have not made the election for the LLC to be classified as a corporation for federal tax purposes are not required to pay a salary so they can take their earnings as distributions. Therefore, when they report the net income for the LLC, there may be no salary expenses to be disallowed under Section 280E. Additionally, if the owners are involved in the selling, marketing or delivery of marijuana and they do take a salary, this salary expense is disallowed under Section 280E.
However, if the LLC is taxed as a C corporation, the LLC owners are required to pay themselves reasonable salaries, and this salary expense may be disallowed under Section 280E.
California Tax Law Does Not Automatically Conform to Federal Tax Law
In California, individuals are bound by the provisions of Section 280-E. However, this tax law does not automatically conform for corporations. This is due to the fact that California law has not been designed to conform to changes in federal tax law, except under specific circumstances. Instead, California policy makers are required to affirmatively conform to changes in federal tax law.
However, legislative sessions in California do not systematically address nonconformity with federal law and they haven’t in sometime. In fact, the last time that California policy makers agreed to address nonconformities with federal tax laws on an annual basis occurred from the years 1982 through 1992. Beginning in 1992, the California Legislature stopped enacting annual conformity bills that were designed to require policymakers to act on federal tax law changes by a specified date each year.
As a result, several nonconformity issues, such as the nonconformity of California corporations with Section 280-E of the IRC, have gone unaddressed.
AB 2679: California Issues Guidance for California Cannabis Manufacturers
On September 29, 2016 Governor Jerry Brown, signed AB 2679 into law in order to provide guidance for cannabis manufacturers that are currently operating in the state of California. The bill's authors were the same legislators that designed the Medical Cannabis Regulation and Safety Act (MCRSA).
A cannabis manufacturer is any company that uses methods to prepare cannabis or its by-products for commercial retail and/or wholesale, including, but not limited, to the processes of drying, cleaning, curing, packaging, and extraction of the active ingredients of cannabis in order to create marijuana-related products and concentrates. Examples of companies that are considered as cannabis manufacturers are companies that produce marijuana extracts and concentrates.
Although all cannabis businesses are still illegal under federal law, California cannabis manufacturers are particularly at risk due to a state law which made the manufacturing of a controlled substances, such as cannabis, by chemical extraction illegal.
Prior to the passage of AB 2679, there was very little guidance available to cannabis manufacturers informing them of how to ensure that their business operations were compliant with California law. However, AB 2679 has now exempted collectives and cooperatives that engage in the manufacture of cannabis products from criminal penalties, if they meet certain requirements.
Under AB 2679, cannabis manufacturers are required to:
In the same way that the current laws govern California medical cannabis cooperatives and collectives, these new provisions for cannabis manufacturers are designed to be repealed during the year following the announcement that state marijuana licenses are being issued from the Bureau of Medical Cannabis.
Once this occurs, the California Department of Public Health (CDPH) will take on the job of issuing licenses to these cannabis manufacturing businesses per the MCRSA. The CDPH is also responsible for developing the standards that apply to the manufacturing and labeling of manufactured medical marijuana products.
In addition, the CDPH has been tasked with identifying and creating reports of any medical marijuana products that have been misbranded or adulterated. The CDPH is currently holding meetings in order to address concerns regarding cannabis manufacturer licensing.
However, until 2018, which is when the CDPH officially takes over as the regulatory body for cannabis manufacturing, state legislators are hoping that AB 2679 can provide cannabis manufacturers with adequate protection from unnecessary raids from local law enforcement agencies, enabling them to continue with their normal operations.
For those cannabis manufacturers who were waiting for this guidance, the passage of AB 2679 should provide relief and the information that they need to bring their businesses into compliance with California law in preparation for the issuing of cannabis manufacturing licenses in 2018.