The 2018 Farm Bill - What it Means for Hemp Farmers' Tax Bill

Ben Condon, CPA

Ben Condon, CPA Covers the Income Tax Implications for Hemp Farms after the new 2018 Farm Bill

The Agriculture Improvement Act of 2018 (the 2018 Farm Bill) has officially been signed into law.  One of the major components of this legislation of industrial hemp.  This blog post will mainly focus on what the tax implications of this legalization and contrast tax differences of a federal legal hemp business versus a federally illegal business subject to section 280E. 

Why Hemp? For traditional farmers, rising costs and imports of foreign low-priced produce have made it difficult to turn a profit. There is currently a glut of recreational cannabis producers in Oregon driving down the wholesale prices so low most producers can afford to continue to operate. Cannabis cultivation is also heavily regulated including the canopy size a grower can use.  As a result, the switch to hemp is logical choice. 

280E No Longer Applies

Previously, hemp related businesses were often subject to section 280E, and therefore could not take any business deductions or credits, and the only cost recovery is via cost of goods sold. This is no longer the case, now hemp producers can tap into the favorable farm tax rules, which we'll dive into. 

No Need to Track Inventory

For farms with less than $25 million in gross receipts over the past three years, there's no need to track inventory.  What does that mean? It means there's no add-back to taxable income for ending inventory.  If a farm has not sold off all of its year's harvest prior to year end, it still can deduct all of the costs into it took to produce it. Previously, when hemp was a controlled substance, the act of growing hemp (and still for cannabis) was deemed manufacturing, not farming, which requires an add-back of ending inventory at year end. 

Expanded Use of Cash Method of Accounting

Again, farms with less than $25 million in gross receipts over the past three years can use the cash method of accounting. What does this mean? With the cash method available, and no requirement to track inventory, It means that a farms will have a great ability to manage their taxable income by purchasing supplies, fertilizers, equipment, ect. in preparation for the next year's harvest and take those deductions in the current year.  

Bonus Depreciation and Sec. 179 Expending

Until January 1, 2024 eligible equipment is available for immediate 100% bonus depreciation.  This now applies to certain used property too, previously, property needed to be brand new for use to be eligible.  

Sec. 179 provides for the full immediate deduction similar to 100% bonus depreciation, and has generous dollar limits up to $1 million can be immediately deducted in 2018 (with several limitations and thresholds).  Sec. 179 is available for single-purpose horticultural structures. 

Greater Access to Banking and Borrowing

Most businesses take the ability to bank for granted. Without the ability to bank, businesses are at risk of theft and record keeping can be very cumbersome. With banking bookkeeping is made easy, your cash is kept safe and counted at all times, and you're able to send and receive large sums of money safely and securely.   Also, without banking, the ability to borrow or obtain a line of credit was nearly impossible. 

Farms with a solid business plan and history of earnings should theoretically now have access to borrowing. Borrowing or leveraging can allow a business to expand with little capital and can greatly increase the return on investment if done effectively. 

Recipe for Success 

With the ability to borrow and by employing the favorable tax rules listed above, a hemp farm has the ability to expand rapidly virtually income tax-free by reinvesting its earnings into the various immediately deductible items.  That is, of course, until its average gross receipts exceeds $25 million per year, not a bad place to be. 

Analysis & Key Takeaways from the Harborside Health Center's Unfavorable U.S. Tax Court Case Decision

In a landmark case between the IRS and Harborside Health Center ("taxpayer"), the U.S. Tax Court held the following judgments--all against the taxpayer and in favor of the IRS: 

1) The Government’s dismissal with prejudice of a civil forfeiture action against taxpayer does not bar deficiency determinations.

The tax court held that a previously dismissed civil forfeiture case against the taxpayer did not preclude the taxpayer from income tax deficiencies. The taxpayer argued a Res judicada defense, essentially a double jeopardy defense for monies. Res judicata--or claim preclusion--is an affirmative defense that bars suits on the same cause of action, and it does apply to tax litigation. The court held that civil forfeiture and income tax deficiencies aren't one in the same, and therefore monies that were successfully defended from a civil forfeiture claim weren't protected from a tax deficiency judgement.  

2) I.R.C. section 280E prevents taxpayer from deducting ordinary and necessary business expenses. 

Despite various grammatical arguments from the taxpayer, the court held that the taxpayers business "consists of" trafficking a controlled subject, and therefore can only claim cost of goods sold, and no deductions or credits. 

26 U.S. Code § 280E - Expenditures in connection with the illegal sale of drugs      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. 

3) During the years at issue taxpayer was engaged in only one trade or business, which was trafficking in a controlled substance. 

The taxpayer argued, similar to the CHAMPs case, that the revenue derived from non-cannabis items (clothing, paraphernalia, etc.)  constituted another trade or business not subject to Sec. 280E.  

In a previous court case commonly referred to as "CHAMPs," the court held that CHAMPs was involved in two separate trade or business, one being a cannabis dispensary, the other being a wellness center and were able to take deductions related to their wellness center. The divisions between these two business were much more clear (separate entrances, products & services, and lines of revenue).   

In this case, the Court argued that selling paraphernalia is akin to a bookstore selling stationary in addition to books, and that doesn't rise to the level of two trade or businesses, and further held the sale of paraphernalia is no different than the sale of the cannabis itself.   As a result, the taxpayer was disallowed all deductions, even the percentage allocated to the sale of non-controlled substances. 

4) Taxpayer must adjust for COGS according to the I.R.C. section 471 regulations for resellers.

This is the most painful opinion of the case and puts to rest any and all argument that IRC Sec. 263A can be applied to cannabis retailers, and the answer is "NO." It is written in a way that also makes the section's application to non-retailers highly doubtful as well, although they won't get hit quite as hard as retailers. 

The Court held that the taxpayer must follow the section 1.471-3(b), Income Tax Regs (relevant passages below). Essentially, the taxpayer can only deduct the actual purchase price of inventory from its vendors, and there shall be no absorption of any other costs (storage, intake, etc.) except for freight in.   Even activities such as making pre-rolls do not rise to the level of producer, and any cost associated would be completely disallowed under 280E. 

§ 1.471-3 Inventories at cost.

Cost means:

(a) In the case of merchandise on hand at the beginning of the taxable year, the inventory price of such goods.

(b) In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods. For taxpayers acquiring merchandise for resale that are subject to the provisions of section 263A, see §§ 1.263A-1 and 1.263A-3 for additional amounts that must be included in inventory costs. (Emphasis added, as Sec. 263A doesn’t apply to cannabis businesses.)

Key Takeaways:

• This court erased any notion about applying 263A to cannabis dispensaries, they cannot. 
• Cannabis dispensaries can only deduct their cost of goods sold at cost, and any and all below the line deductions are completely disallowed regardless of any paraphernalia sales. 
• S-Corporations are no longer a viable tax efficient entity for cannabis dispensaries as any W-2 reasonable shareholder compensation will be 0% deductible by the company and 100% taxable to the employee, shareholder, plus payroll taxes on top of that, OUCH! 
• This will spell the end for some struggling dispensaries, and consumers will no doubt feel price increases passed on to them. 
• This will (or in my opinion should) increase the political pressure on law makers to repeal 280E or at a minimum modify the final sentence to state "prohibited by Federal law AND the law of any State." 

Full U.S. Tax Court case can be found here.