Chapter 2 - § 2.3 TAXATION

• Jurisdiction: Colorado

§ 2.3 TAXATION

§ 2.3.1—Overview

In addition to the considerations previously discussed in this chapter, the RMB owner must consider what form of entity will be most appropriate from a tax standpoint, and must elect a form of taxation that makes the most sense for the RMB and for the owners themselves. While the IRS prescribes specific default tax rules applicable to certain entities, the RMB can elect different tax treatment that will be most advantageous for the company and its owners. This section will explore rules applicable to the taxation of a few different forms of entities and will highlight the pros and cons of each.

§ 2.3.2—Section 280E

Before determining the most appropriate tax treatment for the entity, however, the RMB owner must be aware of tax rules specific to the regulated cannabis industry. What has undoubtedly been one of the biggest challenges for the RMB since the passage of Amendment 64 is taxation, and, more specifically, the IRS's viewpoint on the tax treatment of the RMB. The IRS requires RMBs to report all income, no matter the source of such income.⁵⁹ Section 280E of the Internal Revenue Code, however, prohibits the RMB from taking advantage of otherwise standard deductions and credits for any illegally derived income.⁶⁰ Additionally, RMBs must file an annual tax return to report any income, and because the industry is an almost exclusively cash-based business, the RMB is expected to timely file specific reports and returns to the IRS that are not necessarily required by other types of businesses. ⁶¹

Section 280E has one of the most interesting histories of any other section of the Internal Revenue Code. Congress enacted Section 280E in 1982 to deter deductions made by illegal drug traffickers in furtherance of their illegal businesses.⁶² One of the most famous cases prompting the passage of 280E is Edmondson v. Commissioner of Internal Revenue in 1981.⁶³ In this case, the taxpayer in question (Edmondson) was an entrepreneur, self-employed in the trade of selling amphetamines, cocaine, and marijuana. The IRS Commissioner determined that Edmondson was deficient in the payment of his income taxes due to the failure to report the income derived from his enterprise, to which Edmondson replied with a number of expenses actually incurred in furtherance of his business, including automobile mileage, business trips to California, which included airfare, food, and entertainment, a scale for measuring product, packaging, telephone expenses, and rent for his principal place of business (which also served as his personal residence).

The Commissioner of Revenue disallowed Edmondson's travel and entertainment expenses for failure to comply with the IRS's substantiation requirements, but agreed that a portion of Edmondson's home, being his only place of business, was an "ordinary and necessary expense" of his business.⁶⁴ In addition, Edmondson's remaining expenses, including the purchase of a scale and packaging, telephone, and automobile expenses, were all held to be made in connection with Edmondson's trade or business, and were "both ordinary and necessary."⁶⁵ Soon after the Commissioner delivered this opinion, the IRS enacted § 280E.

The IRS has consistently held that the permissibility of the business activities of the RMB at the state level has no effect on the application of § 280E on all income derived from the cultivation and sale of cannabis in contravention of the federal cannabis laws.⁶⁶ While the IRS views the RMB's business activities as illegally trafficking in controlled substances, § 280E does permit the RMB to reduce its gross receipts by deducting its "properly calculated" cost of goods sold (COGS).⁶⁷ According to the IRS, the costs of acquiring or producing the cannabis that the RMB sells may reduce the company's gross receipts and thereby reduce the company's taxable income. The RMB owner must also take into consideration the allocation of its business activities, which may also affect the company's ability to deduct properly calculated business-related expenses.⁶⁸ Where a business owner's characterization of business activities as separate and distinct is not artificial or unreasonable, the IRS will permit the owner to allocate the deduction of certain expenses...