California is likely to see a boon to its weed economy in the coming years, with the industry expected to topple $6 billion by 2020. But for many looking to cash in on green, tax code 280E is a major buzzkill.

The tax code 280E specifically targets illegal drug traffickers. Regardless of whether your cannabis enterprise is legal under state law, the federal government still deems marijuana a Schedule I controlled substance, so it's taxed accordingly. Under 280E, cannabis industry insiders who run businesses that touch the plant — dispensary owners, growers, product manufacturers — can deduct “cost of goods sold,” but no other “ordinary and necessary” costs related to running a business, such as payroll, rent and electricity.

Growers are least affected by 280E, since the majority of their expenses — paying trimmers and buying soil, nutrients and other necessities for cultivating cannabis — go into the cost of goods sold, namely, the actual bud. Dispensary owners, on the other hand, struggle the most with 280E.

“It's been tough. You can only deduct for buying cannabis wholesale,” says Oliver Summers, who operates a mom-and-pop dispensary in Sun Valley. “The trick is, we're not really buying stuff for the shop. We don't really buy anything except for the Staples run, or the Smart & Final run.” The idea is to keep all non–bud-related expenses to a minimum.

The 280E tax code came about in 1982 following the Edmondson v. Commissioner court case, in which Jeffrey Edmondson, a “self-employed” amphetamine, cocaine and pot dealer, asserted his right to make tax deductions for “ordinary and necessary” business expenses. Congress' response was 280E, in order to make sure other drug traffickers couldn't do the same.

So while state-compliant marijuana businesses can hardly be considered “traffickers,” federal tax law still applies as if they were. “With [28] states and the District of Columbia now allowing some form of legal marijuana, 280E is applied to state-regulated cannabis businesses more often than it is to the types of illegal drug dealers that the provision was intended to penalize,” according to the National Cannabis Industry Association.

For some, 280E is a deterrent to entering the cannabis industry, since it ultimately decreases profits and fosters uncertainty among entrepreneurs and investors guessing at what the future may hold for federal tax treatment of cannabis sales, says professor Benjamin Leff, who teaches about federal tax law at American University, Washington College of Law. “The uncertainty may be a deterrent, although there is so much non-tax uncertainty in the future federal treatment of the cannabis industry (like will the Department of Justice start arresting people), the tax uncertainty seems minor to me,” he says.

Up until now, 280E has done little to keep the cannabis industry from rapid growth. And business owners and consultants have found ways to mitigate the effects of 280E, especially for dispensaries.

Since cost of goods sold is deductible, including the costs of producing cannabis, if a dispensary is vertically integrated, and grows as well as sells, any costs that are allocable to growing operations are deductible, Leff explains. “So, shifting costs to growing operations may reduce the impact of 280E. Also, because 280E only impacts the business of trafficking in controlled substances, a seller who also operates another business can allocate expenses to the other business.” If shared expenses among the dispensary owner's multiple businesses are properly allocated to the non-cannabis part of the business, the impact of 280E is reduced, he adds.

Nick Richards, a partner at Dill and Dill, tax counsel for Vicente Sederberg, one of the largest cannabis law firms in the country, and former IRS trial attorney, offers a few other solutions to dealing with 280E: “Reducing your 280E footprint and controlling your 280E exposure.”

The first tip means cutting retail expenses as much as possible, while bolstering expenses related to the actual cannabis. “For example, if you are a retailer and have a nice big plush store with a large waiting area and it's 10,000 square feet, if you can cut that retail space to half that size, you reduced your 280E footprint in half, you reduced your expenses in half, your electrical bill in half, and your employee costs as well,” he says. Another expense comes from packaging the cannabis, he adds. If you acquire marijuana in bulk and you do the packaging at your retail store, you might not be able to deduct those costs. But if you buy it prepackaged, you can.

Controlling 280E exposure, on the other hand, might mean putting a C corporation around your 280E footprint, says Richards. “280E creates a phantom income. If you're a business owner and you are in a flow-through business like an LLC, all the business taxes flow through to you personally,” he explains. No matter what, you have to pay for all those expenses you can't deduct. “Investors don't want to be in a flow-through cannabis company, [but] a C corporation is a limited investment,” Richards says. In a C corporation, investors can lose only as much money as they put in but not more. So while, in the case of a regular LLC, the taxes would be on your personal tax return and everything would flow straight to you because of the 280E liability, he says, a C corporation limits that liability. “The challenge is that a C corporation also pays tax, so there's the potential for a double tax,” says Richards.

Since 280E applies to both Schedule I and Schedule II drugs, marijuana would need to be Schedule III or below, or totally descheduled, in order for 280E not to apply to the cannabis industry. And while historically many in the cannabis industry have had a poor understanding of 280E, more and more people are coming forward in the past couple years who want to voluntarily pay their taxes and understand how to be as compliant as possible, says attorney Tiffany Wu with Harris Bricken/Canna Law Group. “If you want to get a local permit or state license [under California's new adult use and medical marijuana regulations], they may look to your tax compliance,” she says. “If you want to move forward into the regulated market, getting those paid ahead of time is better in the long run.”