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Jim has spent his career advising individuals, non-profit organizations, closely-held businesses, and Fortune 100 companies on tax law, including federal and multi-state tax controversies. A frequent blogger and speaker on local, state, and federal tax issues, Jim's current focus is on the ever-changing cannabis industry and the regulations governing it.

E-commerce Taxes for cannabis businessesMore non-cannabis companies are getting into the business of manufacturing or selling their products to cannabis growers, retailers, and consumers. Some of these ancillary cannabis businesses sell their products online using third-party marketplaces like Amazon. Ancillary cannabis businesses using marketplace providers may be required to collect sales tax from their customers and pay income tax. This post discusses some of the sales tax issues these ancillary cannabis businesses face.

Sales Tax Compliance. A business that sells to an out-of-state customer is generally not required to collect sales tax on shipments to that customer unless it either owns property or employs people in the customer’s state. Less contact is required for a state to impose state income tax from an out-of-state seller. A business may be subject to a state’s income tax merely by selling products to customers located in that state. For example, a business that owns inventory located in California must collect sales tax from its California customers and pay income tax to California. A business with no physical connection to Oregon other than selling to Oregon customers is subject to the Oregon income tax. This is the bad news.

Sales through Marketplace Providers. Business that sells their products on-line often use marketplace providers like Amazon.  These marketplace providers typically list products on their website, processes the sales transactions, and ship the product from its own fulfillment center. Though the product is physically in the possession of the marketplace provider, the selling business still has legal title to the product. Because the selling business holds legal title to the inventory, the selling business is responsible for collecting sales tax from the customer. A state may collect past taxes at any time from a business that does not comply with state tax law. On audit, it is common for a state to ask for 10 years of back taxes. To encourage sales and income tax compliance, the Multistate Tax Commission, a quasi-governmental agency, is offering tax amnesty for past due taxes in 24 states. This is the good news.

State Tax Amnesty. Under the tax amnesty program, most participating states will automatically forgive all prior year income and sales tax liabilities (including penalties and interest) of businesses that sold through marketplace providers if the selling business agrees to collect sales tax and file income tax returns going forward.  A few participating states will consider tax amnesty on a case-by-case basis.

Medical marijuana is still illegal in many of the participating states. However, the following medical marijuana states are offering to forgive past income and sales tax, penalties, and interest: Arkansas; Connecticut; District of Columbia; Florida; Louisiana; Massachusetts; Minnesota; New Jersey; and Vermont. The State of Colorado, will forgive a business’s prior year’s sales/use tax liability; however, a business with more than $500,000 of sales to Colorado residents must pay Colorado income tax from 2013 onward.

To qualify for this tax amnesty, a business must meet the following requirements:

• Not be registered in the state;
• Sell through a marketplace provider such as Amazon;
• Have no other physical contact with the state;
• File an application no later than October 15, 2017.

Every ancillary cannabis business that has ever sold any of its products through an online marketplace provider should analyze — and soon — whether it might be able to benefit from this tax amnesty.  Furthermore, every ancillary cannabis business that has ever sold online and shipped directly to its customer, should examine its compliance with state sales and income tax law.

Cannabis taxesThe United States Court of Appeals for the Ninth Circuit recently ruled on its second tax case regarding IRC §280E.  Decisions from the Ninth Circuit are significant as they apply to the cannabis-friendly states of Alaska, California, Nevada, Oregon; and Washington. In Canna Care vs. the Commissioner, the Court of Appeals upheld the United States Tax Court’s ruling denying a California dispensary’s operating expense deductions under IRC §280E.

Background

Canna Care Inc. was a medical marijuana dispensary prohibited under California law from earning a profit on the sale of cannabis.  On audit, the IRS applied IRC §280E to deny the deduction of all operating expenses, including substantial officer’s salaries and automobile expenses. Canna Care appealed the tax assessment to the U.S. Tax Court. Canna Care made the following three arguments before the U.S. Tax Court:

  • That medical marijuana is not a Schedule I controlled substance;
  • That Canna Care was not “trafficking” for purposes of IRC §280E because its activities were not illegal under the California Compassionate Use Act of 1996;
  • That the Tax Court decision in CHAMP was incorrect.

The Tax Court denied all three arguments and upheld the tax assessment against Canna Care. First the Tax Court reiterated that medical marijuana is a Schedule I controlled substance. Second, the Tax Court held that the sale of medical marijuana is always considered trafficking under IRC §280E, even when permitted by state law. Thus, operating expenses associated with the sale, manufacturing or production of cannabis are always disallowed under IRC §280E.

Third, the Tax Court held that the CHAMP had been correctly decided. Canna Care’s argument that its sole business was providing charitable work like the taxpayer in CHAMP was without merit. The Tax Court held that because Canna Care’s only business was selling cannabis, none of its operating expenses could be deducted under IRC §280E. The Tax Court noted that Canna Care arguably had a second trade or business selling clothing and could have argued these expenses should be deducted. As that fact was not stipulated in its petition, the Tax Court could not consider that issue on the merits.

Appeal to the Ninth Circuit Court of Appeals 

Canna Care appealed to the Ninth Circuit Court of Appeals. None of the arguments before the Tax Court were made on appeal.  Instead, Canna Care raised three new arguments, two of which were unique to Canna Care’s facts and likely not applicable to most other cannabis businesses.

Canna Care’s primary argument was that IRC §280E violates the Excessive Fine Clause of the 8th Amendment of the United States Constitution. In oral argument before the Ninth Circuit Court of Appeals, Canna Care argued that IRC §280E was enacted by Congress to punish drug dealers, and as such, it imposes a fine on cannabis dispensaries. Canna Care noted that its income tax liability was 1000% of its net income and a 1000% tax rate for engaging in an activity allowed under California law constituted a grossly disproportionate fine on such activity. The tax rate impact under IRC §280E is especially disproportionate when compared to the tax rate of other business – both legal and illegal. Accordingly, Canna Care’s income tax liability imposed under IRC §280E constitutes an excessive fine in violation of the 8th Amendment.

In oral argument, the three-judge panel offered several observations:

  • A tax deduction is granted by the legislative grace of Congress. Congress has clear constitutional authority to deny a tax deduction. Why is IRC §280E outside Congress’ legislative authority?
  • IRC §280E was enacted in 1982, well before enactment of the California Compassionate Use Act of 1996. This means that anyone getting into the cannabis industry was and is on notice of its the burdensome tax liabilities cannabis companies face.  Given such notice, why does application of IRC §280E constitute an excessive fine under the 8th Amendment?
  • Why isn’t Congress the appropriate branch of government to address IRC §280E?

The Ninth Circuit Court of Appeals dismissed Canna Care’s appeal and upheld the Tax Court’s holding. Because the arguments presented were not raised in the lower court, The Court did not address the merits of each argument.

Assess Risk & Preserve Refund Claims

When filing their tax return, a cannabis businesses must understand the impact IRC §280E has on its tax liability. Equally important, cannabis businesses must understand the risk of not applying IRC §280E when filing their tax return. The immediate tax savings must be weighed against the risks and the costs of later having to defend the position in court.

Though it is difficult to challenge federal statutes on constitutional grounds, the constitutional arguments do have some merit. A cannabis business that challenges an IRS assessment under IRC §280E should raise all arguments early in the process to prevent a court from later dismissing arguments on procedural grounds.

Because the Ninth Circuit Court of Appeals did not rule on the merits of the 8th Amendment claim. it is possible a federal court could some day rule that IRC §280E is unconstitutional. To preserve a potential refund claim, all cannabis businesses should consider filing protective refund claims. A protective refund claim keeps the refund statute of limitation open beyond the standard three-year period. After October 15, 2017, a cannabis business cannot recover tax paid for tax year 2013. However, if a court were to hold after October 15, 2017 that IRC §280E is unconstitutional, a cannabis business that filed a 2013 protective refund claim can recover its taxes paid for that year.

It is likely more cases will be filed challenging IRC §280E.  A cannabis business should take stock of its current tax return filings applying IRC §280E and craft a strategy to defend its position.

Oregon cannabis lawAs the marijuana industry grows and consolidates, marijuana businesses are forced to consider more complex business structures to meet their business needs. Such business structures must reduce costs, increase operating efficiency, and most importantly, strictly comply with federal and state law.

One strategy for cannabis retailers, especially those with multiple outlets, is to establish an employee leasing company. If the retailer has three stores, for example, each organized as an LLC, its owners may organize a fourth LLC to lease employees to the stores. This leasing company will then contract with, and act as paymaster for, each store LLC. In this arrangement, the employees who work at each store LLC are not store employees; rather, they are leased employees who receive their W2s from the leasing company. Accordingly, the employee leasing company is solely liable for employment tax.

Employee leasing companies offer two key benefits: consolidation of costs and employee retention. Without the leasing company, each retailer in the example above is required to manage the compliance costs of accounting, employment taxes, workman’s compensation, and medical benefits. By consolidating these functions, the employee leasing company should be able to reduce these compliance costs.

Employee leasing companies also benefit employees by making the marijuana retailer a more attractive employer. As leasing company employees, they receive their W2s from a non-cannabis company, it may be easier for them to sign leases, acquire mortgages and take on other formal obligations. In addition, the consolidated purchasing power of the employee leasing company should provide more robust employee benefits at a lower price.

State law on employee leasing companies varies considerably. Some states scarcely address the concept; others regulate extensively. A good example of the latter is Oregon. In Oregon, employee leasing companies must be licensed by the state’s Workers Compensation Division. The completed application is detailed, takes a few months to process, and entails a $2,050 licensing fee (paid every two years). Once licensed, the leasing company is jointly responsible for the hiring company’s entire workforce—including non-leased employees—which requires special procedures and insurance.

In a payroll leasing arrangement, the leasing LLC will have service agreements with each store LLC. Such agreements must reflect an arm’s-length market rate. Many methods are used to determine an arm’s length market rate but all are based on the facts and circumstances of your business. One common methodology is “Cost-Plus.” In a Cost-Plus arrangement, the employee leasing company compiles its costs and adds an arm’s-length market profit. The IRS carefully examines on audit, arm’s-length charges between affiliated entities.

Finally, employee leasing companies cannot be used as a device to avoid taxes, circumvent the correct application of Code §280E, or to launder money.

The use and benefits of an employee leasing company are not limited to retailers; producers, processors, and manufactures may also benefit from using an employee leasing company. But before you establish an employee leasing company for your cannabis business(es), it is critical you have an operational strategy in place and reasonable projections of the costs. It is even more critical that you understand 280E and structure your entities to comply fully with that. Only after having done all this will you be in a good position to evaluate whether an employee leasing company is best for your cannabis business.

California Cannabis Taxes
California Cannabis Taxes: taxes on taxes

California’s Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) will make dramatic changes to cannabis taxation in California in the following ways.

Marijuana Excise Tax (Effective January 1, 2018). MAUCRSA changes the structure of California’s Marijuana Excise Tax. Under prior law, a 15% excise tax was imposed on the gross receipts of any retail sale by a dispensary or other person required to be licensed to sell marijuana and marijuana products directly.

In contrast, MAUCRSA imposes a 15% excise tax on “the average market price” of any retail sale by a cannabis retailer. Potentially, there are two average market prices. The first is based on good faith negotiation in the open market, in which case the average-market-price is wholesale cost plus a mark-up determined every six months by the  California State Board of Equalization. The second is based on a “non-arm’s length transaction,” in which case, the average market price is the gross receipt from the sale.  Ignoring the irony that the good faith arms-length negotiation includes a mark-up determined by the Equalization Board, this distinction is crucial in determining how the tax is collected and remitted. Though the cannabis consumer is ultimately subject to the Marijuana Excise Tax, it is the Distributor that must collect the Tax from the Retailer and, in turn, remit the funds to the Equalization Board.

For “arms-length” transactions, the Distributor must collect the tax from the retailer “on or before 90 days after … the sale [from the distributor] to the retailer.” For non arm’s length transactions, the Distributor must collect the tax from the retailer when the retailer sells cannabis product to the consumer, but in no event more than 90 days after the Distributor’s sale to the Retailer.

The Marijuana Excise Tax is in addition to sales and use taxes imposed by California’s state and local governments and it is included in gross receipts for purposes of computing sales/use tax. This essentially creates a tax on a tax.

Cultivation Excise Tax (Effective January 1, 2018).  Under MAUCRSA, California’s Cultivation Excise Tax will be imposed on the cultivator after the cannabis is harvested and enters the commercial market. For cannabis flower, the tax is $9.25 per ounce. For Cannabis leaves, the tax is $2.75 per ounce. The Equalization Board has the authority to create a tax stamp/tax container system whereby proof of tax payment is evidenced by either a stamp or a pre-approved container.

The Cultivation Excise Tax is collected on the “first sale or transfer” of cannabis by the cultivator to the manufacture. What constitutes a first sale is not defined in the statutes. For a transfer of cannabis product to a distributor, this tax is collected when the cannabis “enters the commercial market.” When Cannabis “enters the commercial market” is defined as the time when the cannabis or cannabis product has completed all required inspection and testing. The cultivator is subject to the Cultivation Excise Tax, but is relieved of that burden so long as a manufacture or distributor provides detailed documentation. Under MAUCRSA, the Equalization Board has the authority to prescribe a substitute method and manner for collecting and paying the Cultivation Excise Tax and it is likely the collection and payment process will be fine-tuned.

Finally, a county may impose a tax on the privilege of engaging in a wide variety of cannabis activities, including cultivating, manufacturing and sales. Under MAUCRSA, counties have some latitude to structure their tax including: the tax rate, method of apportionment, and manner of collection. The county tax may be imposed in addition to the various other local ordinances taxing cannabis.

Anyone who knows California knows it is serious about tax collection in general and MAUCRSA’s treatment of cannabis excise taxes is no exception. Strict record-keeping and compliance is going to be essential for all participants in California’s cannabis market.

Cannabis tax lawyer
Sweat equity: it’s complicated

When our lawyers set up legal structures for cannabis companies, the choice of legal entity is one of the most important things we must consider. Many cannabis businesses use limited liability companies. For tax purposes, an LLC is typically treated as a partnership or as a disregarded entity. In both of these cases, the tax liabilities pass through to the partner/members. However, an LLC may check-the-box to be taxed as a corporation. In that instance, the LLC is subject to tax, whereas its partner/members do not pay tax. Once an LLC is formed, the next important decision is how to fund the LLC.

In this two-part series, we will outline some of the tax traps and opportunities in the initial funding of your LLC. Part I will discuss opportunities in capitalizing your businesses with equity and creating an ownership relationship with the business. Part II will discuss opportunities and risks in funding a cannabis business using debt and creating a debtor/creditor relationship with the business.

The Benefits of Contributing Property. Generally, the contribution of “property” in exchange for a membership interest is tax-free. Members often contribute cash, land, and equipment to a cannabis business in exchange for an interest in a partnership/LLC. This is a classic tax-free contribution. What is often overlooked is that intellectual property may be property for purposes of a contribution. Industrial processes, formulae, designs and “know-how” in the right circumstances are considered property and can be contributed to a partnership tax free. However, this approach should only be taken with careful consideration, analysis and documentation.

The most straight-forward contribution is a contribution of cash in exchange for a member interest in a Partnership/LLC. A member may contribute cash in exchange for a membership interest in an LLC. Such a contribution is typically tax free under federal partnership tax law. If an LLC elects to be taxed as a C corporation, a member may contribute cash in exchange for a deemed “stock interest”. Again, such contribution is typically tax-free. Many companies start with extremely small cash contributions, like $1.00 for each member. However, there is some risk there to equity holders, since some courts have pierced the corporate veil against undercapitalized entities. Nonetheless, there is no minimum amount of cash required to form a valid partnership or corporation for tax purposes. In determining the appropriate dollar amount of contribution, a cannabis business’s founders should use common sense and good business judgement.

Sweat Equity may be Painful but is not Prohibited. Investors often can bring valuable experience and “know-how” to a cannabis business and want to contribute such “know-how” in exchange for an ownership interest in the LLC. In general, a mere promise to contribute services in exchange for a membership interest is subject to tax. This is generally considered a “capital interest” in the partnership. Capital interests are defined by the IRS as ownership interests where the member has a right immediately following the contribution, to its share of the liquidation value of the partnership/LLC. To illustrate, imagine one member contributed $1,000,000 in cash to a new company, and the other member agrees to do all the work for the company, and they split the LLC up 50/50. Even if the business doesn’t generate any revenue, the member contributing sweat equity is going to be on the hook for $500,000 on that year’s tax returns. This is because if the LLC liquidated the next day, that member would be entitled to receive the $500,000 as a liquidating distribution. Although the guidance in this area can be complex, it is based on a simple, maxim – “You can’t get something for nothing (in tax)”

One way to get around this is for a member to receive a “profit interest” instead of a a standard equity interest. A profit interest is defined as an interest where the new member would not receive any value if the partnership were to be immediately liquidated after the contribution. Note however, that this treatment has some strict limitations and requires careful drafting of an operating agreement.

In capitalizing a cannabis business, founders all bring different skills and resources to the new venture. All founders should carefully consider the mechanics of offering equity interests to each new member. As we will discuss in Part II, the use of debt financing brings additional, flexibility, risks and opportunities to funding a new cannabis venture.

Cannabis tax lawyer
New tax law will impact cannabis businesses

Our cannabis business lawyers are often called on to help clients choose the most effective legal entity for operating their cannabis business. In making this choice, we consider many factors, including the tax impact to investors. See Cannabis Companies and Phantom Income and How To Open A Cannabis Business: For-Profit vs. Not-for-Profit, that is the Question.

Our  cannabis clients usually choose to operate as a limited liability corporation (“LLC”). For federal tax purposes, a LLC with more than one member is treated as a partnership unless the LLC elects to be taxed as a corporation.  Accordingly, any change to partnership tax law applies to LLCs as well.

One important consideration for LLC Partners/Members is identifying who is authorized to represent the partnership in the event of an IRS audit. Under current law, Partners/Members appoint a Tax-Matters-Partner or “TMP.” Though the TMP is the contact point for dealing with the IRS, the TMP function is ministerial.

For tax years beginning in 2018, Congress significantly changed the way the IRS audits partnerships and LLCs taxed as a partnership. Under current law, the IRS must collect tax directly from each Partner/Member. In general, each Partner/Member may defend the audit adjustment as he or she sees fit. The new law requires the IRS collect tax directly from the partnership. In essence, the IRS now has “one-stop-shopping” to collect tax. But there is more. To collect tax from the Partnership/LLC, the new law requires each Partnership/LLC have a “partnership representative.”

There are two significant issues regarding appointment of a partnership representative (“PR”). The first is that the partnership representative (PR) has more power than the TMP. The PR has the sole authority to deal with the IRS and to bind each Partner/Member to the consequences of the PR’s decisions. In other words, the PR ultimately will decide how much tax each Partner/Member will pay as the result of an audit. An odd quirk of the law is that the PR does not even have to be a partner/member of the LLC.

It is important for Partners/Members to choose their PR carefully and in choosing a PR, Partners/Members should consider the following:

  • Who should be the PR?
  • Should election of the PR require a unanimous vote or something less?
  • Should the PR have unlimited authority or should such authority be limited under the partnership agreement or the operating agreement?
  • If the authority of the PR is going to be limited, what will be the scope of the PR’s authority?
  • What will the mechanism be to resolve deadlocks?

These above considerations can and should be addressed when drafting new partnership/operating agreements. Current partnership/operating agreements should be amended, however, the timing on when to do so is dependent on each Partnership/LLC’s specific situation. Because the new law will start applying beginning in 2018, Partnerships/LLC’s have a bit of time to address this issue, however, if you are mending your partnership agreement or operating agreement for other reasons, now is the time to make your PR decisions.

And here is the second issue: the IRS can select your partnership representative if you fail to do so yourself. This portion of the new law is controversial and raises many legal issues, many of which remain unclear. But what is clear is that you can avoid this harsh result by having your partnership/LLC choose its PR in a timely manner. Choosing a PR is one of many tax issues that must be considered when drafting a partnership agreement or operating agreement and as 2018 approaches, this is just one more issue cannabis businesses will need to address.

Another day, another (tax) dollar.

The U.S. Tax Court again addressed IRC §280E in the recent case Canna Care, Inc. v. Commissionerdisallowing all of the California’s dispensary’s “operating deductions” under IRC §280E. Unlike prior cases, the Tax Court in Canna Care does not address the computation of COGS, but rather the deduction of regular business expenses, such as salaries.

Cannabis taxation is not fair.
Cannabis taxation is not fair.

Overall, this case does not change the holdings in CHAMP or Olive. [For those of you that need a quick refresher, CHAMP held that where CHAMP was essentially engaged in two separate businesses, one legal (caregiving) and one illicit (dispensing MMJ), it was entitled to deduct COGs for the caregiving portion of its business; Olive applied CHAMP to less favorable facts, holding that where Olive’s primary business was selling marijuana, and its other services amounted to mere “amenities,” Olive was unable to claim any deduction.] What’s notable about Canna Care is the taxpayer’s direct attack on the application of IRC §280E.

Like the taxpayers under scrutiny in both Olive and CHAMPS, Canna Care was a medical marijuana dispensary. Canna Care was organized as a California mutual benefit corporation, and as such, was considered a non-profit entity under California law. Canna Care took care in emphasizing that it operated at a deficit. However, the Tax Court noted that the officers and directors were paid salaries that “far exceeded the salaries paid to any other employee,” an indicator that Canna Care was perhaps not so altruistically motivated. In addition, the Tax Court noted that corporate funds were used to pay for officer’s automobiles. Importantly, Canna Care highlighted to the Tax Court its involvement with the community including: involvement in cancer and diabetes walks; the hosting of regular meetings for Americans for Safe Access, a medical marijuana advocacy group; and, the offering of prayer and counseling services. Even that community emphasis was not enough to save Canna Care.

Taxpayer advanced three arguments, all of which were rejected by the Tax Court.

First, that medical marijuana is not a Schedule I controlled substance.  The Tax Court indicated that Taxpayer “advanced numerous arguments” as to why medical marijuana should not be considered a Schedule I controlled substance.  The Tax Court did not elucidate any of these arguments and summarily rejected them.

Second, that Canna Care was not “trafficking” for purposes of IRC §280E because its activities were not illegal under the California Compassionate Use Act of 1996.  Taxpayer cited the Cole Memo as well as the 2014 FinCEN Memo as support.  The Tax Court, citing both Olive and CHAMP rejected this argument.  In summary, the Tax Court held that the sale of cannabis is always considered trafficking for purposes of IRC Sec. 280E, even when permitted by state law.

Finally, that CHAMP was incorrectly decided.  Canna Care argued that CHAMP really was not involved in two trades or businesses but one.  Canna Care argued that the taxpayer in CHAMP was not allowed to perform “caregiving services” under California Law; therefore, the taxpayer in CHAMP was merely a single entity doing charitable work.  Canna Care argued it was a charitable entity similar to the taxpayer in CHAMP, and therefore was entitled to a full deduction of operating expenses.

The Tax Court disagreed, stating that “CHAMP did not involve a determination as to whether the taxpayer qualified as a caregiver for purposes of California law.”  The Tax Court noted that the critical determination in CHAMP was that taxpayer was engaged in two separate trades or businesses. The Tax Court noted that Canna Care stipulated that it was in the business of distributing medical marijuana. The Tax Court noted that Canna Care received income from the sale of books and T-shirts. However, the evidence presented did not allow the Tax Court to determine what percentage of income was derived from sale of books versus the sale of cannabis. As such, the Tax Court held that Canna Care was engaged only in the sale of medical marijuana.  Therefore all operating expenses were disallowed under IRC § 280E.

The Tax Court did not outline the taxpayer’s numerous arguments in any detail, so it is difficult to dismiss those arguments out of hand. We can safely say, however, that this case clarifies several points.

  • First, the argument that the sale of cannabis is not trafficking for purposes of IRC 280E will be difficult to sustain.
  • Second, CHAMPS and Olive are the current templates in determining whether an expense is deductible under IRC §280E. Good works or community involvement are not sufficient, by themselves, to support a tax deduction outside the application of IRC §280E.  In order to be deductible, such activity must be considered a separate trade or business entered into with a profit motive.
  • Third, the case once again highlights that the essence of a successful IRC §280E argument is the substantiation and development of facts. Because the taxpayer had, in the court’s view, insufficient evidence to carve out two separate trades or businesses, the taxpayer was unable deduct any operating expenses.
  • Finally, so long as IRC § 280E is on the books, the cannabis industry will suffer. The industry would be well-served to support aggressively the passage of the Small Business Tax Equity Act of 2015 or other legislation repealing IRC §280E.  I believe it can, and must, be done.

Until today, the cannabis industry had little to look forward to when discussing IRC §280E and its draconian application. See Marijuana Taxation: 280E Ain’t Getting Better Anytime Soon and Marijuana Taxes: The IRS on Section 280E. Now Washington State producers, processors and retailers have some good news to consider regarding their 2014 tax return: IRC §280E does not apply to the three-tier Washington Marijuana Excise Tax (“MET”) as in effect through June 30, 2015.

Marijuana Tax LawsThis is because on July 31, 2015, the IRS Office of Chief Counsel issued an internal memorandum (“July Memo”) outlining how taxpayer’s should account for the State of Washington MET. The July Memo is not precedential but it does reveal how the IRS views the MET. Though in the July Memo, the IRS is taking an approach that seemingly sidesteps its own analysis offered earlier this year, their conclusion is favorable to Washington producers, processors and retailers and may offer an outline on how other states’ marijuana excise taxes could be treated for federal tax purposes.

It has been a long time since I have been able to put “IRS,” “favorable” and “marijuana” in the same sentence.

IRC §280E prevents a cannabis producer, processor or retailer from deducting costs incurred in conducting a trade or business unless those costs are considered a Cost of Goods Sold (COGS). As a consequence, marijuana businesses are required to determine what expenses are included in COGS. Until this July Memo, the IRS has offered no guidance regarding how any specific state’s marijuana excise tax would be treated for purposes of COGS or IRC §280E.

In the July Memo, the IRS interpreted IRC §164 addressing the deductibility of taxes. Specifically, IRC §164(a) identifies the following six types of federal, state and foreign taxes allowed as a deduction:

  • Real Property Taxes
  • Personal Property Taxes
  • Income and Profit Taxes
  • GST Taxes
  • Environmental Taxes
  • Motor Vehicle Taxes

IRC § 164(a) states that any taxes not described above, are deductible if paid or accrued …”in carrying on a trade or business” and further provides that “[n]otwithstanding the preceding sentence, any tax (not described in the first section) …paid or accrued … in connection with an acquisition or disposition of property, shall be treated … in the case of a disposition, as a reduction in the amount realized on the disposition”

The July Memo states that the MET is imposed “in connection with the disposition of property” and so for federal tax purposes, the amount of gross receipts is reduced by the amount of MET with the same economic consequences as if a deduction were allowed. Significantly, the Memo concludes that the MET is neither a cost to be considered included in COGS nor a deductible expense. Accordingly, IRC §280E and the regulations and guidance regarding COGS do not apply.

Beginning July 1, 2015, HB 2136 reconfigured the MET into a trust-fund tax imposed on the retail purchaser so that taxpayers no longer need to consider the deductibility of the MET for federal tax purposes.

In light of the July Memo, each state’s excise tax should be reviewed to determine the federal tax treatment under IRC §164. Such analysis may prove to be difficult. To encourage the development of the cannabis industry in their state, policymakers should consider restructuring the state’s excise tax in the form of a trust-fund tax to reduce uncertainty regarding the federal tax implications of their marijuana excise tax. 

The Superior Court for Spokane County recently held that Washington’s sales tax does not apply to sales of medical marijuana. Late last month, the Washington Department of Revenue (“DOR”) appealed that decision to the Washington State Court of Appeals.

Background on the Case. Rhonda Duncan operated a medical marijuana dispensary called The Compassionate Kitchen. In 2009, Duncan did not collect sales tax from patients to whom she sold cannabis products. At some point, Duncan paid sales tax on all 2009 transactions involving medical marijuana. But after a 2011 raid by federal authorities, Duncan filed a refund claim with DOR for the sales taxes she previously paid. DOR denied the refund claim and Duncan lost all subsequent appeals in DOR’s Appeals Division. In July of 2014, Duncan filed an appeal with the Board of Tax Appeals (BTA). In October of 2014, the BTA also denied Duncan’s refund claim.

Medical Marijuana and Prescription TaxesThe Issues. The BTA examined whether sales of medical marijuana are exempt from sales tax under RCW 82.08.0281, which exempts from sales tax those “sales of drugs for human use dispensed … to patients pursuant to a prescription.” More specifically, the BTA examined the statute to determine whether a “statement signed by a … physician,” confirming that “the patient may benefit from the medical use of marijuana,” qualifies as a “prescription” as defined by the statute. The statute defines prescription as “an order, formula or recipe issued in any form … by a duly licensed practitioner authorized by the laws of this state to prescribe.”

Duncan presented a highly technical statutory argument to the BTA. Specifically, Duncan claimed that the statute is unambiguous and that the phrase, “authorized by the laws of the state to prescribe” refers not to the actual substance being prescribed (i.e., the cannabis), but instead to the “genus of the person prescribing” (i.e., the physician).

The BTA disagreed with Duncan’s arguments and held that, by its plain meaning, the statute defines a “prescription” as an order issued by a practitioner authorized to prescribe the specific drugs referenced in the order. The BTA determined that Duncan’s reading of the laws ignores the ordinary meaning of the term “prescribe.” The BTA held that “Practitioners do not ‘prescribe a prescription; they prescribe medications,’” and further held that any other reading of the statute is either “circular or vague.”

Even if the statute is ambiguous, the BTA references in its decision Senate Bill 6515’s Final Report from 2004, which modifies the definition of “prescription,” mandating that prescription drugs exempt from sales tax “must be prescribed by a person whose license authorized him or her to prescribe the item or drugs.” Where federal law renders cannabis a Schedule I illegal substance, no physician can lawfully prescribe it. They can only “recommend” it to qualifying patients. The BTA’s basic logic is that where physicians cannot lawfully prescribe cannabis to patients, any sale of cannabis for medical use cannot qualify for a sales tax exemption for prescription drugs under state law. On appeal from the BTA decision, the Spokane Superior Court ultimately disagreed with the DOR and sided with Duncan’s arguments.

What Happens Now?

As a result of the Spokane Superior Court decision, we’re likely to see many medical marijuana businesses try to demand sales tax refunds from DOR for amounts paid throughout the proceeding years. But this is easier said than done.

A seller is entitled only to a refund of tax directly paid to the state.  A seller is not entitled to a refund of tax that it merely collected from its customers. In that case, the purchaser (not the seller) is entitled to a refund. Accordingly, the refund of sales tax collected from medical marijuana patients must be returned to those patients.

A refund claim for excise tax is limited only to amounts paid (for example, tax, interest, and penalty) four years from the beginning of the calendar year in which a refund claim is made, so these claims are also time sensitive. Any refund claim filed with the Washington State Department of Revenue must also be substantiated to the satisfaction of the Department. The DOR will deny unsubstantiated claims.

Finally, if you are a medical marijuana business planning to use the Duncan case as a defense to having to collect and pay sales tax to DOR in the future, it is critical that you realize there are going to be severe limitations on such a defense. Duncan paid sales tax to DOR and is seeking a refund of tax paid. Medical marijuana businesses that have failed to collect and pay sales tax will still have to answer to DOR unless and until the Duncan case is resolved through the appeal.

Because marijuana remains illegal on the federal level, transporting it across state lines is a federal crime. It is therefore understandable then that most marijuana companies consider their state tax obligations to be limited to just one state. However, as the cannabis industry expands, out-of-state investors need to consider the state income tax impact of their investment activity.

One example is licensing. After talking with a number of marijuana companies that are licensing their product across state lines, it is clear that marijuana companies engaged in such licensing arrangements rarely realize that they also have state tax issues outside their own resident state.

Marijuana and TaxesA number of dispensaries and producers have entered into licensing agreements with out-of-state retailers and producers to leverage their marijuana branding outside their own state. In addition, a number of marijuana businesses will soon be up and running in states like Illinois and Oregon, both of which currently allow non-residents to invest in their emerging cannabis marketplaces.

Licensors and other investors need to be aware that the income they receive from a cannabis enterprise is probably subject to income tax in the state from which they receive that income. This is because the law has evolved to permit a state to impose income tax on businesses that have continuous and systematic economic contact with that state (or its residents). This contact is called “economic nexus” and does not require a company to have a physical presence in the state such as an office or employees. Oregon and Illinois both apply an economic nexus standard.

Oregon regulations provide that a licensor of intellectual property (such as a logo) would be subject to income tax because the logo is used by an Oregon licensee/retailer. For example, a Colorado processor of a cannabis-infused brownie that licenses to an Oregon bakery the right to use their logo and recipe would be subject to Oregon income tax. The Colorado processor is subject to Oregon income tax even if the processor has no other connection to Oregon. Oregon casts a very wide net to subject a business to income tax; its regulations suggest that even licensing and regulation by an Oregon administrative agency, such as the Oregon Liquor Control Commission, could subject a business to income tax.

Illinois regulations explicitly state that the following licensing arrangements subject companies to Illinois income tax:

Entering into franchising or licensing agreements; selling or otherwise disposing of franchises and licenses; or selling or otherwise transferring tangible personal property pursuant to such franchise or license by the franchiser or licensor to its franchisee or licensee with the State.

As in Oregon, the Colorado processor would be subject to Illinois income tax solely by virtue of its licensing agreement with an Illinois medical cannabis cultivation center.

Because each state’s tax laws are unique, you must look at the laws of each state in which you planning to do business or are doing business. Other factors regarding income tax need to be considered as well before investing in a cannabis enterprise. For example, though Oregon allows a deduction for expenses, those same expenses are disallowed for federal tax purposes. In addition, states such as Illinois and Oregon will often tax related legal entities as one business enterprise. As the cannabis industry grows, participants in this marketplace will also need to consider the state income tax consequences of their activities outside their resident state.