Cannabis, 280E, and Delta 8: A Discussion of Tax Issues Unique to Selling Cannabis

Highlights from the December 9, 2021 webinar hosted by Christopher T. Marrie, CPA, CCIFP, Principal and National Director, HBK Cannabis Solutions.

• HBK Cannabis Solutions has been working with cannabis businesses throughout the United States and abroad since 2018. It is a dedicated, all-in group of professionals counseling clients as the industry has evolved and governments’ positions change or remain steadfast.

• The history of governance over the industry indicates that you need to consider all possibilities anytime there is a new aspect of the cannabis industry, as is the situation with Delta 8 sales.

• Cannabis exists in two species: hemp and marijuana

- The Farm Bill of 2018 distinguished the two as:

— Hemp is defined as less than 0.3 percent THC, not pschyo-active, but high in CBD. It falls under compliance with the Farm Bill and is completely legal

— If it doesn’t meet that criterion, it is considered a controlled substance. Delta 8 was excluded from the Farm Bill, and has been addressed differently by different branches of government.

• The Controlled Substances Act categorizes Schedule 1 substances as having high potential for abuse, no current accepted medical use, and lacking accepted safety for use under medical supervision.

• Delta 8 THC has been specifically listed by the Department of Justice (DOJ) as a Schedule 1 controlled substance.

• Tax implications:

- As taxpayers, any trade or business is allowed to deduct ordinary and necessary expenses to conduct business. But that is not the case for the cannabis industry. IRC Section 280E regarding trafficking in controlled substances, even if legal in a state, denies deductibility for tax purposes of all but direct costs of inventory. Applicability and enforcement have expanded over the years.

- 280E has a particularly severe negative impact on retailers due to their required investments in operations, including employees. A retailer could end up cash-flow negative but still with a substantial tax liability. The impact is more severe for S corporation pass-through businesses.

- Hemp in not covered by 280E if the business has implemented an official agricultural pilot program allowing cultivation of “industrial hemp” or any part of the cannabis plant with less than 0.3 percent THC in dry weight.

• The CDC received more than 600 reports of adverse reactions to Delta 8 in 2021.

• The Drug Enforcement Agency (DEA) has issued its opinion that Delta 8 is a Schedule 1 controlled substance. Some states are outlawing it and others are considering legislation to change their position. The DEA and DOJ positions will clearly dictate the level of enforcement by the IRS.

• In November 2021, the DEA clarified its position on Delta 8, acquiescing that Delta 8 is covered by the Farm Bill if you are compliant with all other aspects of the Bill. Derivatives of Hemp are also covered protected by the Farm Bill assuming they’re produced exclusively from cannabis materials. But for most Delta 8 products, CBD is extracted and put through a conversion process, a synthetic conversion, so you are not using exclusively cannabis material. As well, Delta 8 remains listed by the DOJ as a Schedule 1 controlled substance.

• IRS enforcement relative to Delta 8 has been very aggressive and highly antagonistic to the taxpayer. They are taking a rigid, hard-line position in enforcing this aspect of the tax code. They’ve been selective about who they take to court so as to ensure favorable rulings. We are not optimistic that the IRS will act in good faith interpreting the DEA position.

• The IRS has been under-funded in recent years, but there is $88 billion in IRS funding in the Build Back Better bill, $45 billion of which is dedicated to enforcement. We are confident that a big part of that enforcement will target cannabis businesses.

• If you’re selling Delta 8, first understand the ramifications, what the IRS might do, and be prepared for subsequent audits. Comply as much as possible with the 280E code as written and proactively segregate any aspects of your business at risk from the rest of your business. Understand what the potential tax liability and penalties might be in case there is enforcement.

• The greatest concern is for standalone retailers. Two types of businesses are selling Delta 8. One is a compliant CBD dealer now selling Delta 8 products; for them, adjustments from the IRS could be substantial. The impact could be more onerous on people in completely non-cannabis retail businesses, such as convenience stores, that have entered the Delta 8 space.

• If you’re going to continue selling Delta 8 products, we recommend that you segregate that from your other business. Our recommendations include:

- A different sets of books and insurance policies

- Different locations

- Separate management and employees

- Businesses that operate independently of each other

• Implement procedures, processes and controls that demonstrate you’ve made every effort to segregate the businesses.

• Legal sellers of CBD products must also segregate Delta 8 sales as much as possible to insulate themselves from the potential of a substantial adjustment in taxes for your entire business.

• Until there is more clarity on what is or isn’t Schedule 1, we will continue to operate in an area of confusion.

• Approach any new CBD products that come to market by being prepared for the worst.

About the Author(s)

Chris is a Principal in the Naples, Florida office of HBK CPAs & Consultants and National Director of the HBK Cannabis Solutions. He has been with the firm since 1998, and has extensive experience working with closely held companies and their owners. He specializes in working with clients in the medical and adult-use cannabis industries and the industrial hemp industry, providing financial consulting, assurance, and business advisory services to clients located throughout the U.S. and abroad. As National Director of HBK Cannabis Solutions, Chris is responsible for the growth, strategic direction, and day-to-day operations of HBK’s cannabis industry practice.

Chris has presented at cannabis industry conferences, prepared and presented continuing professional education on accounting and other financial aspects of the cannabis industry, and served on various panels as a subject matter expert on the medical and adult-use cannabis industries and the industrial hemp industry.

Chris has worked with clients in the cannabis industry on a wide range of projects, including:

  • Audits and reviews of financial statements for both vertically and horizontally integrated cannabis businesses under various financial reporting frameworks, including U.S. GAAP and IFRS
  • “Carveout” audits and other attest engagements required by cannabis regulators in various states
  • Implementation of SKU-based standard costing systems compliant with both U.S. GAAP and the requirements of IRC Sec. 471 and IRC Sec. 280E
  • Transaction advisory services for both acquirers and acquirees in the cannabis industry
  • Analysis of compliance under various royalty and licensing agreements for intellectual property owned by cannabis businesses
  • Entity structuring specific to businesses operating in the cannabis industry
  • Hill, Barth & King LLC has prepared this material for informational purposes only. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.