Depreciation Allowed for Cannabis Companies on Tax Returns
CannaBlog by Calvin Shannon, Principal
Bridge West CPAs and Advisors to the Cannabis Industry
How much depreciation is allowed for cannabis companies? The answer depends on several factors:
- For retail cannabis companies, depreciation is generally not allowed, with potentially some small exceptions
- For cultivation and extraction facilities, limited depreciation is allowed
The reason for these limitations is Internal Revenue Service (IRS) code §280E, which prevents cannabis companies from taking any deductions, even for depreciation. However, §280E allows taxpayers to reduce gross receipts by cost of goods sold (COGS) when calculating taxable income.
Depreciation is further detailed in the Office of Chief Counsel IRS Memorandum Number 201504011, which references §1.471-11(c)(2)(iii). We would like to emphasize that depreciation related to assets necessary and incident to inventory production are allowable as inventoriable costs, but only to the extent such depreciation is reflected as an inventoried cost in the taxpayers’ financial reports, internal books, and records. These records must also be consistent with Generally Accepted Accounting Principles (GAAP).
For retail cannabis stores, depreciation of leasehold improvements, cash registers, and other assets, e.g., display cases, would be considered non-deductible selling and administrative expenses under §280E. The timing of the depreciation deduction is slower for cannabis businesses than for companies operating outside the cannabis industry. For them, immediate expensing of capital assets using bonus depreciation and Section 179 rules are allowed, but for cannabis companies, the timing is more complex. The IRS provided guidance in their January 2015 Memorandum 201504011, which points taxpayers to the regulations under IRS code §471. This section allows for depreciation under GAAP, but prohibits accelerated approaches to recognizing depreciation, such as bonus depreciation and §179. These strategies are not consistent with GAAP and are therefore disallowed for taxpayers subject to §280E.
Some gray area on the limits of depreciation for cannabis stores has recently been clarified in relation to accelerated bonus depreciation under §168K, which relates to indirect cost calculations under §263A. In the 2022 case Lord v. Commissioner, the tax court explained that §168 depreciation methods involve §167 depreciation deductions, and §167 deductions are not available to businesses selling a controlled substance. For the Lords’ two separate businesses with gross receipts of well over $10 million and COGS of almost $7 million, this amounted to $375,000 of undeclared tax liability, along with accuracy-related penalties.
This tax court case highlights yet again the core tax difficulties facing cannabis businesses. Even when cannabis is legal at the state level, federal restrictions on the sale of controlled substances, prohibited by §280E, means reducing tax liability for cannabis retailers is much harder to secure and potentially risky without extremely robust GAAP adherence. Because §280E restrictions apply even more strictly to the sale of cannabis, this also explains why cannabis extraction and cultivation facilities have some increased leeway in applying depreciation.
The case also highlights an all-too common, but legally fatal misconception about the nature of tax courts and the tax code itself. While the Lords argued that certain aspects of the IRC were unconstitutional, specifically, §280E, the tax court swiftly rejected this. Generally, the burden of proof for tax debts rests with those notified of a deficiency, while the Commissioner’s determinations are presumed correct. The Memorandum Opinion even explained that the Lords did not actually claim, let alone prove, that the burden of proof should have shifted to the prosecution. Even though it still likely wouldn’t have done much for them, it exemplifies a common misunderstanding about the true nature of tax court proceedings. All taxpayers sign under penalty of perjury to heed extremely tight accounting practices, and taxpayers selling cannabis much raise those practices to an even higher level, with or without an abundance of case law to go by.
The 2021 San Jose Wellness court case further demonstrated the acute focus the IRS places on improper deductions made by cannabis companies. Like the Lords case, the main point of contention with San Jose Wellness was the strict limits under which depreciations for COGS are allowed under §280E. What happens for most cannabis companies is that they feel enormous pressure to find allowable tax breaks, because they cannot deduct the “ordinary and necessary” deductions normally afforded to businesses under §162.
As a result, they’ve understandably been reading any potentially allowable deductions with overly optimistic eyes, perhaps further encouraged by a lack of case law about it. They’re also being simultaneously encouraged by favorable state laws, but placed on thin ice by federal tax actors, giving them an enormous pressure to reduce their tax liability, but perhaps a higher pressure to heed GAAP in their reporting.
In addition to filing depreciations outside the allowable limits of §280E, San Jose Wellness also calculated significant deductions on the basis that they believed they were charitable contributions. Again, the crux of this attempted deduction was whether the deduction could be somehow defined outside the bounds of §280E. Perhaps this had at least somewhat higher chances of success, as corporations have long been allowed to deduct charitable contributions, even when highly promotional of the business.
San Jose Wellness argued that their charitable contributions were not business expenditures and were not “carrying on” their cannabis business specifically, thus meeting the requirements for legal deductions under §280E. Yet the court ruled that the charitable contributions were carrying on their business, and they went on to explain that charitable contributions can be defined as business expenditures (the inverse of which was another of San Jose Wellness’s arguments).
It would seem that no matter what, the nature of almost any deduction – whether depreciations or charitable contributions – simply doesn’t matter when it’s related to a controlled substance. When it comes to §280E, cannabis businesses must exercise the highest caution possible to ensure their deductions are specifically allowable within the excruciatingly tight bounds of controlled substances. For all but cultivation and extraction facilities, or retailers depreciating certain packaging and storage equipment, the safest bet is to place your efforts most fully on reducing gross receipts by COGS.
We Can Help!
Bridge West CPAs & Advisors to the Cannabis Industry continues to follow new congressional decisions and will share updates regarding any changes to the amount of depreciation allowed for cannabis businesses. Since 2009, our team of experienced cannabis accounting and tax advisors has been serving over 600 cannabis license holders and businesses nationwide. We have guided hundreds of U.S. and international cannabis businesses through a very challenging business and regulatory environment. From minimizing the effects of IRS 280E, to inventory management, and preparing audited financial statements, our services address the industry’s most unique and ever-evolving issues. If you have any questions or would like to schedule a complimentary consultation, please contact us.