An Exclusive Guide to Navigating California Cannabis Dispensary Tax [For Owners]

In 1996, California became the first US state to legalize medical cannabis. Then, in November 2016, the Adult Use of Marijuana Act legalized recreational cannabis in the state. 

So today, cannabis is legal in California for both medical and recreational purposes for use, sale, and cultivation. And we can say that California is a marijuana-friendly market. 

Despite the legalization, popularity, and growth of the industry, owners of recreational and medical cannabis dispensaries face tax-related challenges, thanks to federal laws regarding the sale of marijuana.

The state levies a 15 percent excise tax and sales tax which can reach as high as 8.25 percent. Combining these with other types of taxes, cannabis dispensaries end up paying huge money in taxes.

The Tax Dilemma for Cannabis Dispensaries in California

According to federal law, cannabis is still considered a Schedule I controlled substance. But, in 2013, the Justice Department issued a Cole Memo, which prevents federal prosecutors from enforcing federal marijuana laws against those complying with a “strong and effective state regulatory system.” 

That’s why states can run legitimate cannabis businesses. But when it comes to cannabis taxes, they have to follow federal rules.

Under Internal Revenue Code section 280E, legitimate marijuana businesses are denied all ordinary and necessary deductions against their sales income. 

Types of Business Expenses Scrutinized under Section 280E

• Wages, salaries, and benefits to employees
• Utility costs such as electricity, internet, and telephone service
• Health insurance premiums
• Advertising and marketing costs
• Rent or mortgage payments for the property where the business is conducted.
• Repairs and maintenance
• Payments to contractor

…and more.

Moreover, the prohibition of deductions under Code Sec. 280E also disallows the following:

• all the deductions for depreciation under Code Sec. 167
• charitable contributions under Code Sec. 170
• state and local business tax under Code Sec. 164

As a result, cannabis dispensaries in California end up paying staggeringly higher than normal tax rates, exceeding over 70 percent.

Now, the Good News!

State-licensed cannabis dispensaries in California can deduct the COGS from their taxes.

All About Cost of Goods Sold (COGS)

COGS is not a deduction – it is subtracted from gross receipts when determining a taxpayer’s gross income. It is the cost of acquiring inventory through purchase or production, as per the Code Sec. 471 inventory valuation methods.

COGS typically include:

• General and administrative costs
• State excise tax
• Purchasing cannabis
• Storage of cannabis
• Depreciation of cannabis

…and more.

These adjustments allow cannabis businesses to save on taxes and collect meager profits. So, you may want to maximize the expenses you can allocate to COGS. 

Please note that as per Section 263A, you can allocate more indirect costs to inventory than do the Section 471 rules. But the IRS prohibits marijuana businesses from using Section 263A. They must instead use the Section 471 rules as they existed at the time of enactment of Section 280E in 1982.

This means that Section 263A cannot be used to capitalize indirect costs that would be considered non-deductible under Section 280E, which disallows deductions for businesses trafficking in controlled substances, including marijuana.

Section 471, on the other hand, provides the general rules for tax accounting in connection with inventories. It allows businesses to include in COGS both the direct costs of products and certain indirect costs, such as handling and storage costs.

Ways to maximize COGS in a marijuana dispensary

• Increase the space for inventory storage, increasing related expenses that you can put into the cost of goods sold.
• Increase labor allocated to inventory management.

Running Separate Lines of Cannabis Business

If a cannabis dispensary runs multiple separate, legal business activities that are not subject to Section 280E, it may be able to allocate some of its expenses to those other business activities and thereby reduce its overall California cannabis tax liability. This is known as the “Separate Lines of Business” strategy. 

For example, a dispensary might also sell non-cannabis merchandise, offer educational classes, or provide therapeutic services. If these activities are truly separate, they might not be subject to the same restrictions to tax cannabis sales.

However, it is important to note that the IRS scrutinizes these arrangements closely, and simply claiming separate lines of business is not enough. The businesses must be truly distinct, with separate bookkeeping. The non-cannabis business must be substantial and profitable on its own.

Also, the IRS and the courts look at factors such as the degree of economic interrelationship between the activities, the business purpose which is (or might be) served by carrying on the various activities within a single entity, and the similarity of the activities. 

This is a complex area of tax law, and cannabis businesses should consult with a tax professional to ensure they are in compliance with all applicable rules and regulations.

Quick tips to maximize your ability to deduct the expenses to other business lines:

• Charge market-rate prices for the goods and services in other business lines.
• Maintain proper accounting records that clearly reflect income and expenses between the lines of business.
• Keep the logistics of each business separate.

C Corporation – the Right Corporate Structure for Your Cannabis Business

C corporations can be a beneficial business structure for cannabis businesses that run other separate business lines. This is because C corporations are taxed at a flat rate, which can result in tax savings. This means that the tax rate remains the same regardless of how much your cannabis businesses earn.

Other key benefits of C corporations are:

Separate entity: A C corporation is a separate legal entity from its owners. This means that the corporation’s profits are taxed separately from the owner’s personal income. This can result in tax savings if the corporation’s tax rate is lower than the owner’s personal tax rate.

Tax strategies for cannabis companies: C corp structure allows cannabis businesses to benefit from more flexible tax planning. For example, a C corporation can retain earnings to lower its taxable income. This can be beneficial for cannabis companies, which often face high tax rates due to federal restrictions.

Running separate lines of businesses: If a cannabis dispensary also runs other separate lines of businesses, a C corporation can be beneficial. This is because each line of business can be treated as a separate entity for tax purposes. This allows cannabis retailers to take advantage of different tax rates and deductions for each line of business.

Takeaway

Although the IRS and tax court impose challenges on cannabis dispensaries in California, you can lower your taxes by allocating more expenses to COGS, having non-marijuana business lines, and becoming a C corporation.

Seeking professional advice from accounting and tax professionals can make it easy to navigate the process. These experts offer a wealth of resources and guidance, helping you make informed decisions for your cannabis business. Remember, your dispensary can thrive in this dynamic industry with the right strategies and guidance.