California Income Tax and Internal Revenue Code (IRC) Section 280E
For federal income tax purposes, IRC Section 280E prohibits deductions for expenses incurred by operating “any trade or business…that consists of trafficking controlled substances (within the meaning of schedule I and II of the Controlled Substances Act).” Marijuana is a schedule I controlled substance, and the IRS uses section 280E to disallow cannabis businesses from deducting ordinary and necessary business expenses. However, IRC Section 280E does not prevent cannabis businesses from taking deductions for costs of goods sold (COGS).3
California generally uses federal taxable income as the starting point to determine state taxable income. With regards to IRC Section 280E, however, California takes a middle-of-the-road approach and (unlike for federal income tax purposes) allows deductions for a cannabis business filing a corporate franchise tax return. Because California’s personal income tax conforms to IRC Section 280E,4 a cannabis business operating as a sole proprietorship and taxed as a partnership is treated less favorably than its corporate counterpart. Additionally, in some circumstances, California’s laws are harsher than Section IRC 280E. For example, if a court finds that a cannabis business is engaged in criminal profiteering or related activities, the business may not deduct any expenses, including COGS.5
Sales and use
For the privilege of selling tangible personal property at retail, California imposes a sales tax on retailers.6 The seller is ultimately liable for the tax, but can seek reimbursement from the purchaser.7 Therefore, cannabis retailers are subject to the sales tax for retail sales of cannabis and cannabis products. The sales tax does not apply to sales of medicinal cannabis if customers can provide valid, state-issued medical marijuana identification cards (MMID).8 Cannabis cultivators may be able to reduce their sales tax liability on certain capital investments, such as farm equipment and machinery, while manufacturers and other cannabis businesses engaged in certain research and development may be eligible for a partial sales tax exemption.9
Cannabis businesses may also be liable for local sales and use taxes. California generally caps local tax rates, but the state allows for an enhanced cap for local sales tax imposed on cannabis products.10 For example, the city of Berkeley is limited to imposing a 2 percent sales and use tax rate for non-cannabis products but, at one point, imposed a 10 percent sales and use tax rate on cannabis products.
The Excise Tax and Cultivation Tax
On January 1, 2018, California began imposing a 15 percent excise tax upon cannabis purchasers.11 This tax is based on the cannabis’ average market price when purchased at retail. A sale’s average market price depends on whether the purchaser bought the cannabis through an arm’s length or nonarm’s length transaction.12 Retailers, such as cannabis dispensaries, are required to collect the excise tax from their customers and pay it to their cannabis distributors. The distributors then must report and pay the cannabis excise tax to the CDTFA.
California also implements a cultivation tax upon all harvested cannabis that enters the commercial market.13 Cannabis cultivators must pay this tax to either their distributor or their manufacturer. The rate of cultivation is: $9.25 per dry-weight ounce of cannabis flowers, $2.75 per dry-weight ounce of cannabis leaves, and $1.29 per ounce of fresh cannabis plant.14 The flower category includes all dried flowers of the cannabis plant, whether trimmed or untrimmed, while the leaves category includes all other parts of the dried cannabis plant. The fresh category includes all parts of the plant, so long as the cultivator weighs the unprocessed cannabis within two hours of harvesting.
Moving forward
As the industry continues to grow at a rapid pace, so will the taxes that follow the increasing dollars. While states and localities are eager to cash in on the newly legitimized industry, they often lack the resources and knowledge to properly administer the laws and regulations. Cannabis businesses should carefully consider engaging tax counsel to not only ensure the proper administration of the tax rules but also to help with the interpretation of the ever evolving cannabis laws in these states.
- Cannabis businesses must obtain a cannabis tax permit if they are distributors or microbusinesses licensed to act as distributors.
- The California Department of Food and Agriculture is responsible for licensing cannabis cultivators, while the California Department of Public Health provides licenses to cannabis manufacturers. Cannabis distributors, testing facilities and retailers must obtain their licenses from the Bureau of Cannabis Control.
- COGS are costs incident and necessary to production, such as direct material costs, direct labor costs, utilities, maintenance, rent (real estate and equipment) and quality control.
- See Cal. Rev. & Tax. Code § 17201(c).
- See Cal. Rev. & Tax. Code §§ 17282, 24436.1.
- See Cal. Rev. & Tax. Code § 6051.
- Id.
- See Cal. Rev. & Tax. Code § 34011(f).
- See Cal. Rev. & Tax. Code § 6377.1.
- Cal. Rev. & Tax. Cd. § 7251.1 Higher local rates are achieved by separate propositions enacted by the localities; see also Cal. Rev. & Tax. Code § 34021.5.
- See Cal. Rev. & Tax. Code § 34011.
- See Cal. Rev. & Tax. Code § 34010(b).
- Cannabis “enters the commercial market” when it has completed and complied with the Medicinal and Adult-Use Cannabis Regulation and Safety Act’s quality assurance review and testing procedures. See Cal. Rev. & Tax. Code § 34010(m).
- See Cal. Rev. & Tax. Code § 34012.
Client Alert 2018-160
