2016-Issue 20 – This edition of Tax Advisor Weekly examines the unique tax issues that affect regulated cannabis businesses. Introduced by the Reagan Administration, Section 280E of the Internal Revenue Code prohibits businesses selling cannabis from deducting otherwise ordinary business expenses from their gross income. However, with the industry rapidly expanding at the state and local levels, many predict that it is only a matter of time before Congress acts to explain this archaic Code section.
Today, the cultivation and sale of cannabis remains illegal under federal law (Controlled Substances Act 3), but a number of newly enacted laws demonstrate that states are willing to support this emerging industry.
Prior to 1982, when Section 280E was enacted, the tax code permitted businesses to deduct otherwise ordinary business expenses from gross income associated with the “trafficking” of controlled substances. In 1981, the Tax Court allowed an illegal business to recover the cost of the controlled substances obtained on consignment and also claim certain business deductions, such as packing, telephone and automobile expenses (Jeffrey Edmondson v. Commissioner, T.C. Memo. 1981-623).
Congress believed that it was against public policy to allow those who illegally trafficked in controlled substances to receive the same tax benefits as legitimate businesses. In 1982, Congress enacted Section 280E, which reversed the holdings in Jeffrey Edmondson v. Commissioner. As defined in Internal Revenue Code, Section 280E reads as follows:
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 Substance Act) which is prohibited by Federal Law or the law of any State in which such trade or business is conducted.
Section 280E penalizes “traffickers of controlled substances” by denying deductions from gross income for business expenses. However, drug dealers do get a deduction for the cost of goods sold because it would be unconstitutional for Congress to deny them this deduction, since the 16th Amendment does not permit Congress to impose a tax on gross receipts. As one might imagine, the denial of ordinary business deductions greatly impacts those doing business within the cannabis industry. Many argue that Section 280E is applied to state-regulated cannabis businesses more often that it is to the types of illegal drug dealers that the provision was originally intended to penalize. The table below demonstrates the obvious disparity in effective rate of tax resulting from the application of Section 280E for a cannabis business compared with that of a normal business. In fact, despite large sales figures, many cannabis businesses are actually in the red because of the high amount of income taxes being paid.
In 2010, lawmakers in Arizona, California, Colorado and Massachusetts drafted a letter to the IRS requesting that it stop enforcing Section 280E in states that have legalized medical cannabis sales. In response, the IRS explained that under the 16th Amendment of the United States Constitution, Congress is ultimately authorized the power to lay or collect taxes on incomes.
As a result, legal cannabis businesses have had to change the way they traditionally do business. For example, a common method dispensaries use to limit the burden of Section 280 is by diversifying the services offered by the business.
In a 2007 case, Californians Helping to Alleviate Medical Problems Inc. v. Commissioner of Internal Revenue, a California not-for-profit corporation (known as “CHAMP”) that was taxed as a regular corporation for federal purposes opened the door to this diversification method. The company’s mission was to provide a variety of “caregiving” services to its patients. CHAMP charged a membership fee that included limited amounts of medical cannabis, support groups, counseling, massages, yoga and a number of other ancillary services.
The IRS argued that all of CHAMP’s activities consisted of trafficking in cannabis. However, the court ruled that because CHAMP was able to demonstrate that it had incurred expenses related to the separate “caregiving” services (justified under Section 162 and appropriately substantiated), the organization was allowed to deduct such expenses as incurred.
Legislative Reform Gaining Momentum
The CHAMP case was a significant win for the medical cannabis industry, and as the industry has evolved, and as states have loosened their laws to allow legal cannabis businesses to operate, pressure has begun mounting for federal action.
In 2013, the U.S. Department of Justice released a memorandum that provided guidance to federal prosecutors relating to cannabis enforcement under the Controlled Substance Act (CSA). The memo instructed Department attorneys and law enforcement to focus on the following priorities in enforcing the CSA against cannabis-related conduct (Guidance Regarding Marijuana Related Financial Crimes, February 2014):
- Preventing the distribution of marijuana to minors;
- Preventing revenue from the sale of marijuana from going to criminal enterprises, gangs and cartels;
- Preventing the diversion of marijuana from states where it is legal under state law in some form to other states;
- Preventing state-authorized marijuana activity from being used as a cover of pretext for the trafficking of other illegal drugs or other illegal activity;
- Preventing violence and the use of firearms in the cultivation and distribution of marijuana;
- Preventing drugged driving and the exacerbation of other adverse public health consequences associated with marijuana use;
- Preventing the growing of marijuana on public lands and the attendant public safety and environment dangers posed by marijuana production on public lands; and
- Preventing marijuana possession or use on federal property.
Under this guidance, law enforcement must consider whether the cannabis-related issue implicates one or more of these priorities when considering prosecution under the CSA. Additionally, this memo has no impact on federal law, as the possession, cultivation and sale of cannabis remains illegal (under federal law), and states have no power to prevent the federal government from enforcing its own laws.
Although this memo has no impact on federal law, it is obvious that the federal government has taken a step back on its enforcement related to the possession, cultivation and sale of cannabis. As a result, federal cannabis policy has provided states with the freedom to implement statutes and enact legislation from a civic and business perspective.
As cannabis continues to become more popular in our society, certain states are jumping at this revenue opportunity and legalizing medical or recreational use, although it remains illegal under federal law. At the time this article was written, four states and the District of Columbia had legalized the sale of recreational cannabis, with an additional 24 states permitting the sale of medical cannabis. With the state and federal governments not on the same page, businesses that produce and sell cannabis are left in an unclear tax scenario.
We are going to look at several states where recreational cannabis has been legalized to examine the tax impact on the respective state from a revenue and regulatory perspective.
Colorado, where a billion-dollar-a-year legal cannabis industry has emerged since 2014, continues to exceed initial tax revenue projections. According to the Colorado Department of Revenue, the state sold $996 million worth of recreational and medical cannabis in 2015, a 70 percent increase over 2014. Collections from recreational cannabis were $56 million in 2014 and $133 million in 2015, and are likely to exceed $140 million in 2016. Of the revenue collected, 15 percent is allocated to Colorado’s school districts ($13.3 million in 2014 and $35 million in 2015), leaving the remainder to be dispersed between law enforcement and general state funds. The state’s cannabis tax is structured as:
- A 15 percent excise tax on the “average market rate” of wholesale cannabis, plus
- A 10 percent state tax on retail cannabis sales, plus
- The state sales tax of 2.9 percent, plus
- Local sales taxes, plus
- Local cannabis taxes such as a 3.5 percent tax in Denver.
When added, Colorado’s effective tax rate on recreational cannabis totals to 29 percent. In 2015, Colorado’s cannabis tax revenues were twice those of alcohol taxes, and some predict that they may even quadruple by the end of 2016. However, as the industry continues to evolve, many of the current tax rates and structures in place will likely need to be revisited by lawmakers. One example of this includes Colorado’s reduction in its state cannabis tax, which is expected to drop to 8 percent beginning July 1, 2017, due to concerns related to the competitiveness of the black market.
The Washington State Liquor Control Board, which oversees the state’s cannabis industry, reported that dispensaries sold over $257 million worth of cannabis in its first year, of which the state collected $70 million in tax revenue. Looking forward, Washington estimates that sales will average over $2 million a day, which could mean excise tax revenue may hit $270 million for 2016.
In January 2016, Oregon collected $3.48 million in taxes on $14 million in sales, exceeding initial revenue projections by a factor of three. The state plans to distribute the tax revenue, with 40 percent going to schools, 20 percent to mental health and drug services, 15 percent to state law enforcement, 10 percent to cities, and 5 percent to the Oregon Health Authority.
Seeing the success that states are having from a revenue generation standpoint could spur the federal government to act. A recent study published by the Tax Foundation estimates that if every state imposed retail cannabis tax, total annual collections could range from $5.3 billion at a 15 percent rate to $8.8 billion at a 25 percent rate. With all this revenue potential, many argue that it’s only a matter of time until the feds budge, whether it is from a legal perspective through the decriminalization of cannabis and removing it from the Schedule I list of controlled substances or from a tax perspective by reforming Section 280E.
Coincidentally, on June 6, 2016, in San Francisco, Harborside Health Center, the country’s largest medical cannabis dispensary, was in Tax Court arguing against the application of Section 280E of the Internal Revenue Code to state-recognized cannabis dispensaries. A decision on the case is not expected until early 2017, but the case has potential landmark implications for the industry.
Alvarez & Marsal Taxand Says:
The cannabis industry is still in its early growth stages and faces a number of legal and fiscal challenges both at the state and federal level. Despite the success many states are having from a regulatory perspective, it is clear that the federal government isn’t in any hurry to overhaul its stance on cannabis. So long as Section 280E is around keeping its pockets full of income tax revenue from legal cannabis businesses, there is little chance for proactive legislative change. It is going to take litigation such as the CHAMP, and potentially, Harborside cases to impact policy moving forward.
Written by Chad Thompson
Peter Gaudyn contributed to this article.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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