Death by Deduction

Business may be booming for many New Mexico cannabis companies, but a sometimes overlooked federal tax code can create difficulty in making ends meet. Thanks to a decades-old legal battle between a Minnesota drug dealer and the Internal Revenue Service, the federal government prohibits state-sanctioned cannabis companies from deducting regular business expenses when it comes time to pay Uncle Sam.

Most businesses can generally deduct a portion of costs such as payroll, tools or supplies from their taxable incomes. Cannabis businesses, however, are prohibited by the IRS from deducting anything but the costs of goods sold, meaning they are taxed on most of their revenue, regardless of whether it was later spent on the business.

John Grisham, an Albuquerque-based certified public accountant and partner with the national firm Carr, Riggs & Ingram, tells SFR the tax code known as 280E has taken New Mexico cannabis business owners by surprise for years, but more so since the state started issuing adult-use business licenses in late 2021. A lot of the shops, he says, won’t be “able to cope.”

That was the case for Ben Snelgrove, who recently sold off his Eldorado dispensary after both federal taxes and state regulations left him “dancing from one foot to the other” trying to keep his shop alive. He tells SFR 280E had a big impact on his ability to make money, especially since he could only deduct the price he paid for wholesale cannabis and not other costs such as rent and advertising.

“If you went on a month-by-month basis, just the inability to be able to deduct that expense, and be able to claim that and get at least some of it back, that pretty much ate into anywhere from 25% to 30% of my overall profit margin, after overhead,” Snelgrove says.

Grisham says he and his firm represent a significant portion of what are known as the “legacy” cannabis companies that cropped up long before New Mexico shifted from medical cannabis to full legalization. The firm is selective about taking on industry newbies because many have never owned a business before, let alone one with the nuanced legality of cannabis.

“They are shocked by this idea that they’re going to owe a lot of tax. They just think it’s going to be raining money at some point,” Grisham says.

The old-school companies not only have the knowledge and experience to navigate obscure tax codes, but are also largely vertically integrated, meaning they grow, manufacture and sell their own products. The tax code, which essentially makes it illegal to deduct expenses related to federally illicit drugs, does allow some wiggle room, especially for those that grow their own products. The cost of cultivation and wholesale purchases, for example, can be deducted from a company’s taxable income.

One industry leader who has long been a vocal critic of both the state’s medical and recreational cannabis market says companies that control their own production lines have an advantage out of the gate.

Duke Rodriguez, president and CEO of Ultra Health, estimates it’s “mathematically impossible” for retail-only spots to stay afloat without writing off a sizable chunk of operational expenses. Rodriguez says the tax code significantly impacts even behemoths like Ultra Health, which is among the top highest earning cannabis businesses in the state.

“The liability [280E] has created for us on income taxes is probably, let’s just say, greater than $10 million a year,” Rodriguez tells SFR.

The tax code causing headaches in states with legalized weed goes back several decades to Minnesota, where Jeffrey Edmondson tried to deduct expenses such as rent, business travel and long distance phone charges from the income he made selling amphetamines, cannabis and cocaine in 1974. After the IRS denied those deductions, a federal tax court ruled Edmondson was indeed allowed to write off the costs of selling illegal drugs.

“We hold that one-third of [Edmondson’s] rental expense of $2,360, or $787, constitutes an ordinary and necessary expense of petitioner’s trade or business and is to be allowed as a deduction,” the 1981 court decision reads, while also identifying a whole host of other expenses as deductible.

Congress enacted 280E a year later, which cleared up that “no deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business…consists of trafficking in controlled substances.”

US Rep. Earl Blumenauer, D-Oregon, and others are again trying amend legislation to exempt cannabis from 280E. But for now, Grisham says, companies that spend the lion’s share of their income on fancy build-outs and customer service staff to set their business apart from the rest are probably still feeling the sting of tax day.

“It all costs a lot of money,” he says. “So their bottom line might show that they’re not making a ton of money, but when you have to pay tax on all those expenses that aren’t deductible, that tax burden is more than what their net profit is.”