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Why Marijuana Companies Struggle to Make a Profit

With 29 states (plus the District of Columbia) that have legalized marijuana in some form, the U.S. is seeing an explosion of pot-related companies. In 2016, there were between 21,000 and 33,000 cannabis businesses in the U.S. Yet many of these businesses have a hard time just making ends meet, let alone making a profit. That's because marijuana companies operate under a tax handicap that most other businesses don't.

Meet IRS section 280E

Section 280E was introduced to the tax code in 1982, during the hottest part of the war on drugs. Congress had discovered a tax court case in which a drug trafficker was allowed to deduct a number of expenses for his various illegal businesses. Legislators were so offended by this case that they passed Section 280E, a provision ruling that illegal businesses cannot deduct any business expenses other than cost of goods sold (meaning expenses related directly to creating the business' product).

Why is this a problem for marijuana companies? Because technically, pot is still a federally banned Class I controlled substance. And that means marijuana dispensaries are subject to Section 280E, resulting in enormously higher taxes for these businesses.

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Why Section 280E is such a problem

Most businesses can deduct just about anything and everything related to the business. Anything from office supplies to worker salaries, from commercial leases to bank fees can be deducted from income before calculating the tax bill. These deductions make a huge difference in how much taxable income businesses have – and therefore how much they end up paying in taxes.

For example, consider the matter of employee compensation. The Bureau of Labor Statistics reports that business expenses for employee compensation averaged $35.28 per hour in June 2017. Imagine a business with 100 full-time employees. Assuming that each employee worked 2,000 hours per year, that business would have paid a little over $7 million in employee compensation over the course of the year. While most businesses can fully deduct that salary expense, marijuana businesses cannot. And that's just one of the numerous deductions limited by Section 280E.

Is there a way around Section 280E?

Faced with such an enormous financial handicap, marijuana businesses have gotten quite clever about finding ways to finesse this bit of the tax code. For example, many marijuana dispensaries establish a second business in the same building that houses the dispensary. The second business provides a related but legal service, such as drug counseling. The dispensary will keep all of its COGS-related expenses under the umbrella of the dispensary business, while funneling all its other expenses through the counseling business.

This approach has met with mixed results on a legal level. In one 2007 tax case, the tax court largely upheld the dual-business approach used by Californians Helping to Alleviate Medical Problems (CHAMP), allocating most of its expenses to the caregiving business and allowing CHAMP to deduct those expenses. However, a similar tax court case in 2015 ended badly for a marijuana dispensary, because the court believed that the second business was strictly a legal fiction created to get around Section 280E. In other words, the core concept behind this two-business workaround has passed muster, but marijuana companies need to be extremely careful about how they implement it.

What does this mean for investors?

As long as marijuana is considered a controlled substance on the federal level, U.S.-based marijuana businesses are operating under a serious handicap. It would be safest to hold off on investing in such companies as long as the current situation stands. After all, Section 280E isn't the only hurdle that marijuana companies face -- although it could be the most problematic.

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