How Delta-8 Companies Can Mitigate Impact of 280E IRS Audit

The Drug Enforcement Administration (DEA) has taken the position that Delta-8 tetrahydrocannabinol (THC) and other cannabinoids synthetically derived from cannabidiol (CBD) are categorized as Schedule I substances under the Controlled Substances Act (CSA). Arguably, the DEA is misinterpreting the 2018 Farm Bill, which authorized the production of hemp and removed hemp from the list of controlled substances. The 2018 Farm Bill defines hemp as “the plant Cannabis sativa L. and any part of that plant, including the seeds thereof and all derivatives, extracts, cannabinoids, isomers, acids, salts, and salts of isomers, whether growing or not, with a delta-9 tetrahydrocannabinol concentration of not more than 0.3 percent on a dry weight basis.” As such, Delta-8 THC should be considered hemp and, in turn, not a controlled substance. However, it is very likely that the IRS would adopt the DEA’s position with respect to Delta-8 THC and other cannabinoids synthetically derived from CBD. This means that Internal Revenue Code (IRC) Section 280E (“280E”) would apply to businesses selling Delta-8 THC.

Generally speaking, any taxpaying business is allowed to deduct ordinary and necessary expenses to conduct business. However, this is not the case for businesses in the cannabis industry. 280E states that “[n]o 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 (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” If Delta-8 THC is categorized as a Schedule I substance, then 280E applies to businesses selling Delta-8 THC; and, notably, 280E does not allow deductions other than cost of goods sold (COGS).

Most, if not all, companies selling Delta-8 THC are not filing tax returns that apply 280E. The risk associated with this is that if the IRS audits your company, they may find that you have not been properly calculating your taxes and subsequently require that you pay back-taxes and penalties.

Here are steps Delta-8 companies should be considering to mitigate the impact of an IRS audit:

• If you sell other non-CBD-derived cannabinoids that are clearly “hemp” under the 2018 Farm Bill, consider creating two separate entities: (1) one entity for sales/expenses on non-CBD-derived cannabinoids; and (2) another entity for sales/expenses of CBD-derived cannabinoids. This way, the expenses related to non-CBD-derived are fully deductible and not subject to 280E. You should work with your accountant to allocate as many expenses as possible to the entity selling non-CBD-derived cannabinoids.
• Regardless whether you are selling non-CBD-derived cannabinoids, you should work with an accountant to classify as many expenses as possible to COGS. This require documentation that supports the expenses as COGS.

The above recommendations are not legal or tax advice. There are various issues you should consider when trying to mitigate the impact of an IRS audit. We highly recommend that you work with legal counsel and tax counsel to examine these issues.