Following the November 2020 elections, 15 states and Washington DC have legalized adult use of recreational marijuana. Beyond that, a continuously growing number of states allow their residents to purchase legal medicinal marijuana, and many have also decriminalized adult recreational marijuana use. However, marijuana remains a Schedule I substance to the Controlled Substances Act and is therefore illegal on all accounts at the U.S. federal level; thus, creating a number of issues for businesses in the cannabis industry duly operating in states where marijuana has been legalized. Not only is it difficult for cannabis companies to avail themselves of alternative banking solutions, but there are also obstacles in place preventing these companies from taking advantage of notable tax deductions.
Chief among these hurdles is Internal Revenue Code (IRC) Section 280E
Section 280E is only a few lines, but carries significant impact for the cannabis industry. The law reads as such:
“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 or 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.”
More simply, the law denies cannabis businesses any U.S. federal income tax deduction for ordinary and necessary business expenses, despite being duly licensed as a legal business in their state of operation. U.S. Congress enacted the law in the 1980s following a court case which disallowed a convicted cocaine trafficker from claiming deductions from ordinary business expenses under federal tax law. While the law intends to target illegal drug dealers, it simultaneously generates considerable problems for cannabis companies legally operating in their respective states because marijuana is a Schedule I substance.
In 1970, President Richard Nixon signed the Controlled Substances Act (CSA). The CSA is part of the Comprehensive Drug Abuse Prevention and Control Act, a federal drug policy to regulate the manufacturing, importation, possession, use and distribution of certain narcotics, stimulants, depressants, hallucinogens, anabolic steroids and other chemicals. Under the CSA, there are five schedules at the federal level used to classify drugs based on their abuse potential, accepted medical applications in the U.S., and safety and potential for addiction.
The DEA defines Schedule I drugs, substances or chemicals as those drugs with “no currently accepted medical use and a high potential for abuse.” Examples of Schedule I drugs include:
Typically, the ability to deduct ordinary business expenses means that a business is subject to federal tax on its net income (i.e., gross receipts minus expenses). However, the definition of Section 280E and the classification of cannabis as a Schedule I substance severely hinder legal cannabis companies from taking advantage of tax deductions for actual economic expenses incurred in the ordinary course of business, which results in a significantly higher effective tax rate as compared to other businesses. In fact, businesses within the cannabis industry are left with tax liabilities of up to 70% of their income. Section 280E has increased scrutiny on the most common business expenses, including:
Importantly, Section280E affects all state-legal businesses that engage in the cultivation, sale or processing of the cannabis plant. For example, cultivators, medical dispensaries, marijuana retail stores and infused product manufacturers, as well as concentrates and cannabis oil manufacturers, all feel the economic effects of Section 280E on their businesses.
While Section 280E greatly restricts the tax deductions of state-legal cannabis businesses, there is still a small bit of reprieve. Current IRC provisions permit state-legal cannabis businesses, such as marijuana growers, producers, wholesalers or retailers, to deduct the Cost of Goods Sold (COGS) in computing their US federal income tax liability, despite the application of Section 280E. This was upheld through Olive, 139 T.C. 19 (2012) as well as through Chief Counsel Advice (CCA). COGS generally entails inventory costs, including the cost of the product itself, shipping the product and certain other directly related expenses, depending on whether the cannabis business constitutes production or resale. Currently, the IRS does not allow any other amount as a deduction or credit for amounts paid or incurred with respect to cannabis business operations.
More than half of the states in the U.S. legally allow some form of marijuana sale or consumption, whether that be medicinal or both medicinal and recreational. As such, there is a considerable amount of legal businesses dealing with the excessive tax burden of Section 280E. In response, companies are turning to the courts to challenge the status quo.
Alpenglow Botanicals LLC is a medical marijuana dispensary in Colorado – a state where medical and recreational marijuana is legal. The business elected to deduct ordinary business expenses beyond COGS on their federal tax returns. However, following an audit of Alpenglow’s tax returns between 2010 and 2012, the IRS denied the deductions and charged the company over $50,000 for those taxes not paid. Alpenglow argued that the IRS exceeded its authority because rejecting the deductions due to Section 280E regulations implicitly determined that Alpenglow trafficked in an illegal drug, despite the fact that that marijuana is legal both recreationally and medicinally in Colorado.
Subsequently, the taxpayer sued for a refund in district court and lost. Then in 2018, the Tenth Circuit sided with the IRS. Alpenglow did not give up. They pushed the case all the way to the highest court in the land, the United States Supreme Court, with a February 2019 Petition for Writ of Certiorari.
However, the U.S. Supreme Court issued a denial of certiorari, declining to hear the case. The Supreme Court offered no explanation for denial, which to some signaled that the Court agreed with the Tenth Circuit judgment that the IRS was simply enforcing existing law.
As such, Section 280E remains a thorn in the side of cannabis-related businesses.
Before the Alpenglow pushback against the 280E enforcement, there was a case featuring Harborside Health Center, one of the nation’s largest state-licensed marijuana suppliers. Similarly to Alpenglow, the case originated from an IRS audit of Harborside’s federal tax returns for 2007-2012. Despite paying federal taxes for those specified years, the IRS claimed that the company’s tax payments were severely deficient by tens of millions of dollars. The IRS defended their findings citing two reasons. First, the IRS determined that Section 280E applied to Harborside and therefore the company was not eligible for the millions of dollars in business expense deductions. Second, the IRS explained that Harborside implemented the incorrect calculation method for cost of goods sold, thereby resulting in a lowered federal tax liability.
The case, formally known as Patients Mutual Assistance Collective Corporation, dba Harborside Health Center v. I.R.S., reached the United States Tax Court where the court ultimately sided with the IRS on both issues. First, in regard to the Section 280E concern, Harborside argued that it did sell marijuana, but that it also sold other items like t-shirts and yoga classes. According to the taxpayer, these other activities and products pushed the company outside the restrictions of Section 280E. However, the court rejected this narrow scope of the tax code. The court further rejected the argument, deeming the non-marijuana products and services as merely “incidental.” Finally, the court considered whether or not Harborside was a producer or reseller for purposes of calculating COGS and ruled against in that regard as well.
The case, while unsuccessful for the company, did provide some clarity for cannabis-related businesses. For instance, the case confirmed that a disallowance such as under Section 280E may apply to all the credits and deductions of activities that constitute a single trade or business although the business engages in activities not subject to disallowance.
In what is considered by some to be the most pro-marijuana Congress in U.S. history, cannabis industry legislation appears to be gaining momentum. The Strengthening the Tenth Amendment Through Entrusting States (STATES) Act, originally introduced in April 2018 by Sen. Cory Gardner (R-CO) and Sen. Elizabeth Warren (D-MA), sought to amend the CSA of 1970 to exempt individuals and corporations in states who are in compliance with U.S. state, U.S. territory and the District of Columbia laws from federal enforcement. The original banking ordinances from the STATES Act were later added to the Secure and Fair Enforcement (SAFE) Banking Act, which passed in the House in 2019 but unfortunately failed to make it to the Senate floor to be put to vote. [insert link to law and also to the SAFE Banking Act article]. After initial failure to move forward, Sen. Warren in the Senate and Rep. David Joyce (R-OH) and Rep. Earl Blumenauer (D-OR) in the House of Representatives again introduced the STATES Act in April 2019. Despite Congressional and industry group support, the bill has failed to progress any further.
The U.S. House again included the legislative language of the SAFE Banking Act in the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act in response to COVID-19 relief. However, the HEROES Act likewise failed to make it to the Senate floor.
The tide may again be turning, however, with the December 4, 2020 passage in the House of the Marijuana Opportunity Reinvestment and Expungement (MORE) Act, which if passed would deschedule marijuana from the CSA, expunge marijuana convictions, and create programs to help communities reap the financial benefits of legislation. The passage of the MORE Act is the first time in US history that pro-marijuana legislation was passed by a US federal Congressional body and signals that representatives at the federal level have some understanding and are sympathetic to the challenges specific to the growing cannabis industry.
With the introduction of the Biden Administration and a potential shift of bi-partisan power in the U.S. Senate, there is some optimism in regards to cannabis legislation that either decriminalizes the substance at the federal level, which would in turn provide state-legal marijuana businesses access to traditional banking and be free of the economic burden of Section 280E.
Baker Tilly takes pride in being a business leader working with those in the cannabis industry to handle all accounting, tax and business consulting needs. Our cannabis industry Value Architects™ have unrivaled experience and dedication to working with cannabis clients and understand the uniqueness of the industry and the depths of the concerns without federal protections. Please reach out to ask questions and develop insightful strategies for the short-term and long-term needs of your business.