The cannabis industry has been fighting an uphill battle with the federal government since the first city in the first state approved the legalization of medical marijuana (California on 11/5/1996 effective date 11/6/1996). While there have been great inroads on a state level, with more than half the states approving some form of legalization, there has been little movement on the federal level. Only recently the DEA again refused requests to move marijuana off the list of Schedule 1 drugs (where is sits in good company with Heroin, LSD, and MDMA, among others). Why is this important to taxes? Why indeed…
IRC Section 280E1 is currently the bane of the cannabis tax world. Rather than go into a blow-by-blow rendition of how the cannabis industry has been hamstrung by 280E, let me cut to the chase: the future of the cannabis business needs to effectively eliminate the hazards of this Internal Revenue Code and be able to file taxes, claim expenses, and carry on business like any other legitimate business. We are not going to be successful in eliminating 280E, since it does work for its designed purpose, but what we need to do instead, is to move cannabis out of the crosshairs of this code provision.
Actual results of 280E and Related Sections on the Cannabis Industry
Today, when a canna-professional filed their business tax return with the federal government, they see their profits fall away faster than a blunt at a Phish concert. Each line of the return seems to bring new levels of stress and depression. If you are a dispensary / retail distributor, or a retail delivery service, you are more limited than those in the growing and production tiers of canna-business. Those handling product ready for distribution, and relaying that product to end users, are, by definition, trafficking an illegal substance – and boom, 280E has you. You cannot write off your wage expense, your rent expense, your gasoline or delivery related expenses. You have only what few things you can claim under “Cost of Good Sold” or COGs. If you were selling or delivering vodka, could you claim these expenses? Absolutely! Seem fair? Absolutely not!
If you’ve done your due diligence and hired a bookkeeper or accountant with knowledge of how the canna-business fits (or doesn’t fit), in the world of taxation, then congratulations, you’ve done more than most, and have done the right thing to find legitimate ways to minimize your exposure to 280E. Unfortunately, you are still getting hit, and hit hard. This is the world of canna-business and where taxes are today, but fear not, there is hope.
Recent Developments That Have “Helped”
The hardest hit, during the transition between the reality of illegal and legal cannabis, are two fold – those who came into the canna-business once medicinal use was decriminalized on a state level, and those who came in once recreational use was legalized on a state level. The first wave of tax returns audited, were those filed under the new medical marijuana business – I say “new” in deference to the status of state laws. The second wave came when there was a hope, if not a realistic hope, that state decriminalization would result in softer IRS review.
In 1996, California was the first state to offer a nod to medicinal marijuana. City ID cards were issued, once a doctor’s prescription was written, and dispensaries started to pop up. Subsequently, these dispensaries started filing income tax returns with the state and the federal government. With such a small hole carved, there was some temperance of expenses being claimed. However, in 2002, a California dispensary / healing center filed a tax return with the federal government that would serve as the basis for judicial review of the use of IRC Section 280E.
As the IRS started coming for the canna-professionals, the cannabis industry started pushing back by way of Tax Court. When a tax debt is realized, a path to Tax Court and a way into the judiciary system is also realized. The 2002 return filed by Californians Helping to Alleviate Medical Problems, Inc., became the seminal case from the US Tax Court and is commonly referred to as the CHAMP2 case. In it, the Court found two discrete businesses operating under the CHAMP banner, only one of which was tied to the sale/distribution of cannabis. As such, the “ordinary and necessary” business expenses tied to the care-giving arm of CHAMP were accepted by the IRS, while those same expenses – wages, rent, materials, etc. – were disallowed under the cannabis arm of the business. This was a breakthrough case for the cannabis industry as, at last, there were some guidelines as to what the IRS would consider as acceptable deductions, and those that will not be accepted. There is no bright line to speak of with regard to what will be and won’t be accepted by the IRS, but it did offer a better road map on how to address and utilize the deductions represented in the CHAMP filing by the Tax Court.
Colorado, The Centennial State, passed proposition 64 in November of 2012 and thereby legalized recreational use of cannabis. While medical use had been legal in that state since 2000, the decriminalization of recreational cannabis was a very new step for any state to undertake. During the first year or two, Colorado based canna-businesses were filing their state and federal tax returns like any other business: claiming labor costs, packaging, utilities, advertising, and other “ordinary and necessary” business expenses. Neither the business owners, nor their tax preparers, were ready for the onslaught of federal tax audits that would soon be undertaken. Some argue that they should have known, given the IRS treatment of dispensaries in the 10+ years prior, but Colorado was ready to push the IRS yet again, but this time the IRS pushed back. There was no case law or statute that would support the Colorado filed return position, so they were hit and hit again with audits from the IRS. A fate they still face approximately every 2 years. (Just because you have been successful in defending an audit in 2013, it doesn’t mean you won’t be put on the defensive again in 2015.). Despite the level of legalization created by Colorado, the IRS and federal government saw no reason to allow additional write offs just because the state would allow them.
While CHAMP and a handful of other cases helped to start to fill in some of the gray areas of what expense the IRS may consider as deductible, there is still a long way to go before we know how the IRS will approach each and every deduction claimed on a return filed by a canna-business. Uncertainty is the word of the day.
Path to Success
Given the “search & destroy” mission the IRS undertakes with each new audit of a canna-business, we have to look outside the “creative accounting” tactic to secure a healthier tax life in the canna-world. There are currently two “likely” paths to reach this goal: 1. The DEA would move cannabis off of Schedule 1, or 2. Congress would carve out a safe haven for the cannabis industry and clarify their intent by specifically moving canna businesses outside the scope of 280E. But how likely is it that either of those paths going to be forged?
During the summer of 2016, the DEA just concluded a review of the evidence and offered to help facilitate the move of cannabis off of Schedule 1. It found that they believed there was not enough evidence to offer sufficient support of the medicinal uses of cannabis. Despite the litany of research conducted on this point throughout the world, the vast majority of which confirms the medical value cannabis offers, the DEA looked only to work done within the United States. Most of the US research cites anecdotal evidence in support of their conclusion that cannabis is, in fact, medically beneficial. The DEA chose to disregard this research as insufficient. While this was certainly not the result the canna-business was hoping for, the DEA did crack open the door enough to acknowledge that additional research was needed and, once done, it would reconsider the request to move cannabis off Schedule 1. This is a promising result, but it seems likely that it would take at least two years for enough concrete evidence to be realized before the DEA picks up the charge again. Still… this is the most likely scenario for a way to move canna-business out of the site of IRS Section 280E.
The other possibility is for Congress to recognize the value the cannabis industry brings to Americans, and to specifically carve out an exception to 280E for the industry. Assuming the other states continue to legalize cannabis, it may send a message to Congress that the time is now to move cannabis away from its neighbors on Schedule 1, such as LSD, and MDMA. This path is not remarkably likely, given the pending change in administration, but it is certainly within their power to make this adjustment. This leads us to an interesting questions – how will the next administration deal with cannabis?
Concerns with the Incoming Administration
The only sure thing we can say about a Drumpf administration when discussing cannabis is, we don’t know, but it doesn’t look good. Jeff Sessions has already been nominated as US Attorney General, and there has not been much of a push back from Congress – at least Republican Congress. In April, Sessions was quoted as saying, “[marijuana is] not the kind of thing that ought to be legalized.” While we don’t know what Donald Drumpf will do or not do with regard to cannabis, he may just opt out of any proactive directive and let his Attorney General set policy. That said, there is a strong argument to be made that such thing should be left to the states, but even if that does, in fact, turn out to be the policy embraced, it does not change anything with regard to federal taxes and the cannabis industry it seems likely that we can hope for little or no backsliding, but advancements in finding relief from unfair taxation of the cannabis industry.
Conclusion
We’ve concluded our tour of where we are in the world of canna-tax, but you’re probably wondering what’s next: frankly, I am too. What I can say is that there has been a constant push on the IRS, from all aspects of the cannabis industry, to try to find a path for appropriate taxation. Until such time as the DEA or Congress offers solid help, the industry is best served by following the path to the Courts and the judiciary. We must be diligent in our fight to find ways of including more and more “ordinary and necessary” business expenses in our accepted federally filed tax returns. We need to stay strong in our resolve to work with our Congressional Representatives by helping them make responsible choices with regard to cannabis, and we must take advantage of the opportunities presented to us. More and more medical professionals are conducting studies on the benefit of cannabis, and once the DEA readdresses this issue, we must be ready to supply the proof they say they need to move cannabis off Schedule 1 or to deschedule cannabis completely. It is only through all these means that we will realize our goal – to be respected and treated as the legitimate business that are afforded the ability to file reasonable tax returns and pay only our fair share, not a dollar more.
1§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.
2(Added Pub. L. 97–248, title III, §351(a), Sept. 3, 1982, 96 Stat. 640.)
CALIFORNIANS HELPING TO ALLEVIATE MEDICAL PROBLEMS, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent, 128 T.C. No. 14.
This article is part of Cannabis 2020, an initiative that brings together thought leaders from across the cannabis ecosystem – cultivators, policy experts, lawyers, patients, doctors, scientists, advocates, and entrepreneurs, among others – to each share a big “push the envelope” idea they would like to see become reality by 2020. Want to share your big idea? Get in touch.