Legal cannabis businesses are obligated to pay federal income tax under the same tax code as illegal drug traffickers because cannabis is an illegal drug under federal law. Because this tax code is crippling small businesses across the legal side of the industry, many have decided to battle the IRS in court to change it. This section on cannabis law provides advice for taxpayers trafficking in a Schedule I or Schedule II Controlled Substance.
Issue #1: How does a taxpayer trafficking in a Schedule I or Schedule II controlled substance determine cost of goods sold for the purposes of § 280E of the Internal Revenue Code? (§ 280E 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 the 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.)
Conclusion: A taxpayer trafficking in a Schedule I or Schedule II controlled substance determines cost of goods sold using the applicable inventory-costing regulations under § 471 as they existed when § 280E was enacted. (§ 471 states: (a) General rule – Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.
(b) Estimates of inventory shrinkage permitted – A method of determining inventories shall not be treated as failing to clearly reflect income solely because it utilizes estimates of inventory shrinkage that are confirmed by a physical count only after the last day of the taxable year if—(1) the taxpayer normally does a physical count of inventories at each location on a regular and consistent basis, and
(2) the taxpayer makes proper adjustments to such inventories and to its estimating methods to the extent such estimates are greater than or less than the actual shrinkage.
Issue # 2: May Examination or Appeals require a taxpayer trafficking in a Schedule I or Schedule II controlled substance to change to an inventory method for that controlled substance when the taxpayer currently deducts otherwise inventoriable costs from gross income?
Conclusion: Yes, unless the taxpayer is properly using a non-inventory method to account for the Schedule I or Schedule II controlled substance pursuant to the Code, Regulations, or other published guidance.