It’s Complicated: A Closer Look at Cannabis Sales and 280E

Keith Staats, JD Executive Director, Illinois Chamber Tax Institute
Deciphering Today's State & Federal Tax Law

In Illinois, sales of recreational and, to a lesser extent, medical cannabis are subject to a plethora of state and local taxes. And although sales of both are legal in the state as of 2020, they still remain illegal under federal law, adding more complexity and scrutiny to their taxation.

Here, I’ll be taking a closer look at this complicated relationship, specifically as it relates to taxable income and Section 280E of the Internal Revenue Code (IRC).

The general rule under the federal income tax law is that all income is subject to state and federal taxation, even when it results from illegal activity. As a result, taxpayers in the cannabis business space—including growers, distributors, and retailers—are subject to federal income taxation on their income.

Taxpayers involved in a cannabis business that earn income attributable to Illinois are also subject to Illinois income taxation. For example, in the case of an individual, federal adjusted gross income is the starting point for determining net income subject to Illinois income taxation. For corporations and partnerships, they begin with federal taxable income when determining their income subject to Illinois income taxation.

IRC Section 280E further complicates matters. In determining federal taxable income, Section 280E states that no deduction or credit is allowed for any amount paid or incurred during a taxable year in carrying on any trade or business if it consists of illegal trafficking in controlled substances (Schedules I and II) of the federal Controlled Substances Act (CSA).

Notably, under the federal CSA, marijuana is considered a controlled substance. Therefore, even though sales of recreational and medical marijuana are legal in Illinois, businesses in the legal marijuana trade in Illinois are denied these federal deductions. Such denied deductions include ordinary business expenses, such as wages paid to employees, rent payments, depreciation, charitable contributions, etc.

Although Section 280E denies these business expense deductions, it doesn’t deny the adjustment for the cost of goods sold. This is because the cost of goods sold is an exclusion from income—not a deduction. However, close attention should be paid to the requirements for the proper determination of cost of goods sold. For example, taxpayers in the cannabis space are required to determine costs using the applicable inventory cost regulations under IRC Section 471, as these regulations existed when Section 280E was enacted in 1982.

Under current Illinois law, the business expense deductions disallowed at the federal level may not be deducted at the state level for purposes of determining Illinois net income subject to Illinois income taxation. For example, Section 203(h) of the Illinois Income Tax Act provides that only the deductions set forth in Section 203 may be taken into account for purposes of determining income subject to Illinois income taxation.

Earlier this year, Rep. La Shawn K. Ford (D) introduced House Bill (HB) 998, which would amend the Illinois Income Tax Act to create an Illinois income tax deduction for taxpayers engaged in the legal marijuana business in Illinois in an amount equal to the amount of the deduction denied at the federal level by Section 280E. However, the legislation didn’t move forward during the 2023 spring legislative session.

From a tax policy standpoint, Section 280E was enacted when marijuana sales were illegal at both the state and federal level in an apparent attempt to limit the profitability of the drug trade. In addition to criminal penalties, those engaged in illegal marijuana sales would be subject to income taxes on their profits (i.e., another way to punish those dealing in illegal drugs).

The tax policy calculus is a bit different, however, with respect to taxpayers in the legal marijuana trade (at the state level). By forbidding deductions allowed to every other legal business, Section 280E increases the costs of doing business in the marijuana trade. While this results in increased federal and state income taxes, those increased costs to the business in the form of higher income taxes are passed along to consumers in the form of higher prices. Therefore, it’s my estimation that the burden of the tax is borne by Illinois consumers who purchase legal marijuana.

As Illinois HB 998 was introduced in the 2023 spring legislative session, it would’ve amended the Illinois Income Tax Act to allow the deductions at the state level that are denied at the federal level. This would place the Illinois income tax obligations on Illinois companies in the legal marijuana trade where they would be if Section 280E wasn’t part of federal law. Since HB 998 didn’t gain any traction, Illinois cannabis businesses will maintain their relationship status with Section 280E as “it’s complicated.”

Related Content:

• The Green Rush: What CPAs Should Know Before Considering Cannabis Clients: As the cannabis industry grows, more—and more complex—opportunities for CPAs arise. Before rushing into serving this unique client base, here are some challenges and risks CPAs and their firms should consider.
• Illinois’ Cannabis Industry: What Accountants Need to Know: As more states move to legalize marijuana, accounting professionals must stay ahead of the curve to help serve this unique, complex niche.