The IRS has decided not to automatically challenge cannabis business owners’ claims for the section 199A deduction for qualified business income.
Speaking February 10 at an American Bar Association Section of Taxation meeting, Luke Ortner of the IRS Office of Chief Counsel (Small Business/Self-Employed) confirmed that decision, but he explained that when calculating the factors for determining whether a taxpayer is eligible for the deduction, section 280E still comes into play.
Section 280E denies deductions or credits for the business expenses of any trade or business that traffics in controlled substances, including state-legal cannabis businesses, other than for the cost of goods sold. Meanwhile, section 199A, enacted by the Tax Cuts and Jobs Act, provides for a deduction of up to 20 percent of passthrough income for qualified business owners.
Many tax professionals have argued since the passthrough deduction’s enactment that cannabis business owners should be eligible for it, pointing out that while section 280E states that no deduction is allowed for amounts “paid or incurred” during the tax year, the section 199A deduction isn’t paid or incurred. The American Institute of CPAs requested guidance on the issue in 2018, but the IRS hadn’t addressed it publicly until now.
Ortner pointed out that taxpayers with income above the thresholds of section 199A(b)(3)(B) and (d)(3) must have sufficient W-2 wages to support the deduction, but under the section 199A regulations, only amounts included in determining taxable income qualify. So for cannabis businesses, any wages not included in COGS aren’t qualified.
“To the extent that 280E might prohibit you from using those W-2 wages in calculating your cost of goods sold, 280E will impact your 199A deduction,” Ortner said.
As tax attorney Daniel Rowe observed in an April 2019 Tax Notes article, that means that cannabis producers will be more likely to qualify for the deduction than pure retailers.
Ortner couldn’t say whether the IRS would issue formal guidance on the availability of the passthrough deduction to cannabis business owners.
Domestic Production Activities
Jennifer Benda of Holland & Hart LLP pointed out that the IRS previously conceded that cannabis businesses were eligible for the section 199 domestic production activities deduction, which was enacted in 2004 and repealed in 2017.
That concession was noted in a footnote in a March 2022 Tax Court memorandum opinion, Lord v. Commissioner, T.C. Memo. 2022-14. Benda represented the petitioners in that case, a married couple with ownership interests in two medical marijuana businesses.
The same framework for determining the section 199 domestic production activities deduction for cannabis businesses — that is, using the costs that aren’t disallowed by section 280E to determine the eligibility factors for the deduction — has carried over to the section 199A deduction, Benda said.
Speaking at a separate session February 11, Benda pointed to the IRS’s little-known position on the domestic activities production deduction as evidence that it sometimes takes a long time for the agency’s positions on cannabis issues to make their way down the ladder.
“What I’ve experienced . . . is that they’ve taken positions, they’ve changed their minds, and then it takes a long time for those positions to trickle down so that they’re actually being applied throughout the IRS,” Benda said.
The IRS launched a marijuana initiative in 2021 to provide more training and job aids to examiners and promote consistency in the cannabis area, and Benda said she hopes that initiative leads to more effective coordination across the agency.