State Tax Break for New Jersey Cannabis Companies

On May 8, 2023, Governor Phil Murphy signed into law A3946, which effectively decoupled New Jersey from Federal Internal Revenue Code (“IRC”) section 280E. The bill, which has been making its way through the New Jersey legislature since May 12, 2022, states, “For cannabis licensees, New Jersey gross income under subsections b. and k. of N.J.S.54A:5-1 shall be determined without regard to section 280E of the Internal Revenue Code.” This section is intended to apply to all cannabis licensees in the State of New Jersey who are subject to corporate income tax. The law takes effect immediately and shall apply to all taxable years beginning on or after January 1, 2023.

The impacts of this change will provide a much-needed boost to cannabis businesses operating in New Jersey. IRC 280E causes those affected to calculate their taxable income based on their gross profit (revenues less cost of goods sold) and allows them no relief for amounts paid or incurred for selling, general or administrative expenses. At a glance, this means that costs, such as marketing, freight-out, retail employee salaries, and interest, are completely removed from the equation when calculating taxable net income. Companies subject to IRC 280E can often experience effective tax rates as high as 80%- 100% (with some publicly traded MSOs reporting even higher effective rates).

By decoupling, New Jersey is signaling to the legal cannabis industry that it is invested in its success and is willing to forego a small amount of tax revenue in the short term for the long-term tax revenues a successful industry can provide. New Jersey cannabis businesses will save up to 11.5% of their federally disallowed expenses for C Corporations and up to 10.75% of their disallowed expenses for pass-through entities (i.e., the highest marginal tax rate depending on entity type).

In addition to decoupling from Federal section 280E, the bill also provides a more subtle benefit for state-licensed cultivators and manufacturers. These taxpayers will now be eligible to take tax advantage of the New Jersey Research and Development tax credit. New Jersey law allows for credit in an amount equal to 10% of qualified research payments during the privilege period. These amounts are determined using the same rules set forth in IRC section 41. Federally, state-licensed cannabis operators are not allowed to benefit from this tax credit, nor the amortization expenditure available under the new IRC 174. The ability to utilize this credit on the state level will provide a much-needed reduction in tax so that New Jersey businesses can continue to flourish.

Codified in 1982, Federal IRC §280E states, “No 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.” Practically speaking, this means that taxpayers trafficking in a Schedule I or II narcotic – such as cannabis – cannot take into account any selling or administrative expenses when calculating Federal taxable income. These expenses may make up 50% or greater of all expenses for a business. 

When IRC §280E was introduced in 1982, the Treasury Department did draft regulations to interpret the law or advise on practical application. The War on Drugs was a major public policy initiative, and the public was overwhelmingly behind it. As was published in the Senate Committee Report: “There is a sharply defined public policy against drug dealing with allowing drug dealers the benefit of business expense deductions at the same time that the U.S. and its citizens are losing billions of dollars per year to such persons is not compelled by the fact that such deductions are allowed to other, legal, enterprises. Such deductions must be disallowed on public policy grounds.” [1]

For years, §280E went unchallenged in the courts and has to this day remained unchanged in the Internal Revenue Code. Even with the 1996 passage of Proposition 215 in California, the first major regulatory change in the United States to allow for medical cannabis to be legally bought and sold, no regulations or changes in Federal tax policy were passed. In 2012, when Colorado and Washington became the first states to vote to legalize cannabis for adult use, there was still no change. It was not until January 2015 that the first published guidance came from Washington in the form of CCA 201504011. This legal memorandum, which is outside of the scope of what can traditionally be relied upon by tax practitioners, aimed to give tax accounting guidance to the growing state-legal cannabis industry. Unfortunately, the CCA fell well short of the direction needed by an industry that daily walks the fine line between Federal prohibition and State-sanctioned, legal activity.

Today, despite the flat tax rate of 21%, which is applied to corporations, and the relief under IRC section 199A for pass-through entities, IRC section 280E still forces most state-legal cannabis operators to be taxed out of existence. The law is harsh, and despite many states decoupling, has a dire impact on the cannabis industry. Efforts to have cannabis rescheduled, or IRC section 280E modified, continue to fail despite growing support. 

Author: Ray Owens, CPA | [email protected]

[1] Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, p. 264 (Dec. 31, 1982).