In spite of federal restrictions, the cannabis industry in the United States is rapidly expanding and is expected to grow to $80 billion over the next 10 years. The legal status of marijuana in a particular jurisdiction is governed by a patchwork of laws, regulations, and agency guidance at the federal, state, and local levels. Many states have now decriminalized possession of marijuana and authorized medicinal use of cannabis; and an increasing number are creating legal frameworks for the sale of recreational cannabis. For federal purposes, though, parts or derivatives of the Cannabis sativa L. plant are listed as Schedule I substances under the Controlled Substances Act – meaning production and sale is heavily restricted. This has left the marijuana industry with a complex tax compliance landscape. There are a few key areas for businesses and tax professionals to consider when wading into the marijuana market.
Income Taxes and IRC §280E
It’s a well-established principle of tax law that taxpayers must declare income from unlawful activities, including trafficking in controlled substances. In 1981, the Tax Court held that these taxpayers could also deduct their expenses from that income. In order to reverse this ruling, Congress passed IRC §280E in 1982, providing:
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.
Since cannabis is considered a Schedule I controlled substance at the federal level, state-legal marijuana businesses often find out at tax time that they cannot deduct many common expenses like insurance, wages, taxes, or rent. Importantly, however, costs of goods sold (COGS) are not limited by IRC §280E – taxpayers can still reduce their gross income by subtracting these amounts. Thus, how a cannabis industry taxpayer calculates COGS is crucially important to its resulting tax liability. Several bills in recent years have proposed exceptions to IRC §280E for businesses that are legally operating under state law, or have proposed changing the scheduling of cannabis under the Controlled Substances Act. None has garnered sufficient support to pass.
The impact of IRC §280E is not limited to the federal level – most states conform to the federal restrictions as well. However, states like Colorado and Hawaii, with a robust legal framework for cannabis businesses, are increasingly providing state-level deductions for the disallowed expenses.
Navigating State Sales and Excise Taxes
Marijuana businesses also need to consider their state sales tax and excise tax liabilities. Cannabis falls within the usual definitions of “tangible personal property,” which means that in states that impose a sales or use tax, cannabis sales are presumed to be subject to tax. Most states lack clear guidance on the treatment of cannabis for sales tax purposes, and the sophistication of the industry is quickly surpassing the guidance that does exist.
While most states provide exemptions for prescription drugs, medicinal marijuana typically does not qualify because medical marijuana programs often dispense marijuana under a doctor’s recommendation or certification rather than prescription. However, a state may have provided a separate exemption for medicinal marijuana sales. It’s also unclear whether exemptions and reduced rates apply to products like marijuana edibles.
In addition, a growing number of states also impose an excise, gross receipts, or other similar taxes on marijuana or marijuana businesses at some point in the product’s supply chain. Colorado, for example, imposes a Retail Marijuana Excise Tax on the first sale or transfer of “unprocessed retail marijuana” by a “retail marijuana cultivation facility” to a retail marijuana store or a facility that manufactures marijuana products. The calculation of the tax is different based on the product sold – bud, bud allocated for extraction, trim, immature plant, wet whole plant, etc. – and all parties must keep extensive documentation. To make it even more complex, local jurisdictions can impose excise and sales taxes as well.
On top of all of this, cannabis businesses have another challenge in state tax compliance – due to federal restrictions, they often encounter difficulty with obtaining banking services. This means that when it comes time to remit tax payments, they have to do so in cash. Many states have additional requirements for paying taxes with cash and potential penalties for failing to remit payments electronically. A few states are starting to explore workarounds for these banking problems, including using a state-run banking system or a “closed-loop” gift-card-like payment system.
The marijuana industry extends far beyond the retail store and customer. Companies in agriculture, pharmaceuticals, industrial equipment, packaging, and more are involved in the cannabis supply chain. Each of these industries will deal with unique tax challenges. For example, marijuana processing may qualify as “manufacturing” for some state purposes, but not for others; marijuana cultivation could constitute “farming” or “agriculture” or be excluded from those definitions. The complexity will only increase as the lines between drug, food product, agricultural product, lawful, and unlawful are increasingly blurred.
About the Author Melissa A. Oaks is a Proposition Manager for Indirect Tax at Thomson Reuters. Prior to this role, Melissa was the Managing Editor of State & Local Tax for Checkpoint Catalyst, where she specialized in complex nexus, apportionment, and e-commerce issues. Before joining Thomson Reuters in 2013, Melissa practiced law in New York. Melissa is a graduate of Cornell University and Columbia Law School and earned an LL.M. in Taxation from NYU School of Law. Twitter: @melissaaoaks
For more information on how ONESOURCE and Checkpoint can help you keep up with the changing regulatory environment, visit our ONESOURCE and Checkpoint pages.