On November 8, 2016, California voters approved the Control, Regulate and Tax Adult Use of Marijuana Act (Prop 64), which legalized the recreational use of cannabis by adults who are 21 years and older. In response to this ballot initiative, the California legislature passed Senate Bill (S.B. 94), which amended Prop 64 by streamlining the requirements for licensing and regulating medical and adult use of commercial cannabis. Under the new system, California cannabis businesses must register with the California Department of Tax and Fee Administration (CDTFA) for sellers’ permits and cannabis tax permits1 if applicable to their type of business. Cannabis businesses must also obtain the appropriate cannabis license(s) for their activities.2 On January 1, 2018, retail sales of recreational cannabis began, and California taxes relating to these sales went into effect. As the legal cannabis market grows in California, cannabis businesses must be aware of the various tax implications facing the industry.
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