By Stephanie Carr • September 04, 2019•Ms. JD, Writers in Residence
Notorious Prohibition-era gangster Al Capone reportedly bragged, “They can’t collect legal taxes from illegal money.” Capone learned the hard way that this isn’t true when he was sentenced to prison for tax evasion. Relatedly, marijuana remains illegal at the federal level but revenue from marijuana sales are taxable. Cannabis businesses that fail to understand and plan for these taxes are at high risk for an IRS audit, a massive tax bill, or even tax evasion charges for failure to report. Tax attorneys interested in cannabis law are needed to help these entities understand, plan and prepare for taxation. The following are recommended areas of review for practitioners looking to crack the tax code.
Section 61 of the Federal Income Tax Regulations provides that gross income is all income from whatever source derived, including gains from illegal activities. Gross income is gross receipts minus the cost of goods sold (COGS). However, section 280E of the Internal Revenue Code disallows deduction or credit for any amount paid or incurred in carrying on any trade or business that consists of trafficking in controlled substances – such as marijuana. Thus, gross revenue from marijuana sales are taxable but few business deductions are allowed on federal tax returns; the COGS may be deducted but ordinary and necessary expenses related to the sale are not.
The United States Tax Court has issued several decisions regarding the application of I.R.C. §280E to marijuana sales. In November 2018, the Tax Court rendered an especially lengthy decision on this topic upon petition by a medical marijuana dispensary. Patients Mutual Assistance Collective Corp. v. Comm'r of Internal Revenue, No. 14776-14, 2018 WL 6271696 (T.C. Nov. 29, 2018). Patients Mutual notably addresses what it means for a business to "consist of" trafficking. It also offers guidance for calculating COGS. Practitioners should carefully review this and other Tax Court decisions regarding I.R.C. §280E to help clients maximize deductible costs, account for beginning and ending inventories, and assess whether different business lines should be broken into separate entities to maintain general business deductions.
Several states have legalized the sale and use of marijuana and issued related tax laws. In states where marijuana is legal, attorneys should research whether the state has imposed a marijuana income, sales and/or excise tax, and whether tax rates differentiate for marijuana flowers versus leaves. Practitioners should be prepared to explain how tax consequences differ at the state level for cultivators, manufacturers, distributors and retailers. Finally, it's important to check whether state laws in place, or being considered by the legislature, to permit cannabis business deductions from state taxes. For example, California House Bill AB 37 (Jones-Sawyer), which passed with unanimous support and is headed to the State Sentate for consideration, would allow cannabis businesses to deduct business expenses from their state personal income tax.
Cannabis clients also need attorney guidance on whether an S corporation or C corporation structure is the most tax-efficient for their business – which could vary depending on whether the client is a cultivator, manufacturer, distributor or retailer. The Tax Cuts and Jobs Act of 2017 changed the top corporate tax rate from 35 percent to one flat rate of 21 percent, which could make a C corporation more enticing to certain clientele.