The Corporate Tax Cut Might Have Done More for Marijuana Suppliers than Repealing Section 280E Would Have
As most readers will know, state licensed marijuana businesses pay a comparatively high effective federal tax rate, because a special provision of the federal tax code (section 280E) bars them from deducting all but their cost of goods sold (COGS) when calculating their federal tax liability. In other words, these businesses may not deduct their ordinary operating expenses (like legal fees, advertising, and so on) from their income. As a practical matter, this means that marijuana businesses wind up paying more than 35% (the old federal corporate tax rate) on their net income, calculated as revenue minus all expenses (COGS and operating).
Professor Benjamin Leff provides a nice example to illustrate the dramatic effect Section 280E could have on a state licensed marijuana business. (Leff’s example is discussed on pages 397-398 of the book; his full article can be found here).
To simplify the example somewhat, imagine a retail marijuana shop that sold $3 million in marijuana during 2017. It paid $2.6 million for the marijuana, and shelled out another $300,000 for advertising and other operating expenses, leaving it with a net profit of $100,000. However, because those operating expenses are not deductible, the shop would have to pay federal taxes on $400,000 of its revenues. Under the old corporate tax rate (35%), the shop’s tax bill would be $140,000 – in other words, it would actually lose money. If other shops have comparable cost structures (a big if), the industry would not be viable in the long-run.
However, now that Congress has dramatically cut corporate taxes, the same shop’s tax liability has plummeted. To be sure, it still cannot deduct those operating expenses—i.e., its taxable income is still $400,000 in the eyes of the IRS—but it now pays only 21% on that income, or $84,000. The shop is suddenly profitable ($16,000), notwithstanding Section 280E.
Of course, the corporate tax cut is not a complete fix for Section 280E. Marijuana businesses will still be at a comparative disadvantage vis-à-vis other state licensed businesses, which might make them comparatively less appealing investments. However, the dramatic tax cut should lessen considerably the burden that Section 280E imposes on the marijuana industry. Perhaps most significantly, the tax cut makes it considerably less likely that federal taxes would put marijuana suppliers out of business.
Indeed, I think the tax cut may have helped the industry even more than repeal of Section 280E would have. To illustrate, consider a business that has a healthier (and to my mind, more realistic) gross margin than the one hypothesized by Professor Leff above. In particular, imagine a shop with $3 million in gross revenue and $300,000 in ordinary expenses, but only $2.2 million in COGS. Now suppose that the shop could ask a magical genie to do one or the other (but not both) of the following:
- Repeal Section 280E, or
- Lower the corporate tax rate for everyone from 35% to 21%
Which option would maximize the shop’s after tax profit?
If the Genie repeals Section 280E, the shop will net $325,000 after taxes. But if the Genie instead lowers the tax rate for everyone, the shop will net $332,000 after taxes. In other words, a marijuana shop might pay less in federal taxes today (under the new 21% rate) than it would have had Congress instead repealed Section 280E and left the old rate (35%) in place.
Of course, these are just hypothetical figures (albeit ones based on some data). The actual results for any given business will depend on four key variables, including:
- The business’s Operating Expenses (OE)
- Its Gross Profit (GP) (i.e., its gross revenues minus COGS)
- The original tax rate (r1), and
- The revised tax rate (r2)
If my calculations are correct (no guarantees there), then whether the firm gains more from repeal of Section 280E or the reduction in the tax rate depends on the answer to this equation:
r1 * (OE / GP) ? r1 – r2
If “?” is >, the business would gain more from repeal of Section 280E. However, if “?” is <, the business would gain more from the tax cut. Here’s the basic logic: the higher are a business’s operating expenses (as a percentage of gross profit), the more it should worry about Section 280E. If “?” is =, the business would be indifferent to the two options.
Enough math for a day . . .