qualified opportunity zones cannabisQualified Opportunity Zones, which provide a tremendous benefit to investors and low income communities, are the hot new topic in the real estate investment world. The cannabis industry is buzzing about investment opportunities in these zones, but we remain hesitant to recommend them without reservation. Congress disqualifies certain businesses from participation in Qualified Opportunity Zones, and we have seen some indications Congress is considering disqualifying cannabis businesses as well.

Qualified Opportunity Zones were created under the relatively new federal tax law, known as the “Tax Cuts and Jobs Act.” That law authorized each state to nominate certain low-income communities as “qualified opportunity zones.” A list of qualifying census tracts can be found here.

To take advantage of the benefits of these zones, taxpayers must invest in a Qualified Opportunity Fund, which is an investment vehicle organized as a corporation or partnership for the purpose of investing in qualified opportunity zone property that holds at least 90 percent of its assets in qualified opportunity zone property.

The benefits to investors include (1) a deferral of tax on capital gains from the sale of existing property that are reinvested into a Qualified Opportunity Fund, (2) subsequent basis increases on deferred capital gains reinvested into a Qualified Opportunity Fund, and (3) the elimination of capital gains tax on growth attributable to gain reinvested in a Qualified Opportunity Fund held for at least ten years.

The State of California explains that Opportunity Zones will support new investments in environmental justice, sustainability, climate change, and affordable housing, and has created a website to educate investors about various opportunities.

This brings us to cannabis. Commercial cannabis activity, outside the industrial hemp context, is federally prohibited. As such, marijuana businesses are treated as criminal enterprises in the eyes of the feds. We’ve previously written extensively this. (See here, for example). Marijuana’s criminality colors how all federal agencies, including the IRS, treat cannabis businesses.

We have written extensively about Section 280E and its implications for taxation of cannabis businesses (See here, here, here and here). Section 280E disallows deductions and credits for any amount paid or incurred 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.

The benefits provided in connection with Opportunity Zones are not deductions or credits, but deferrals. The new Opportunity Zone clause provides a list of business activity that is disqualified from tax benefits, which includes “any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.” The disqualified list does not include cannabis businesses.

Because the statute omits “cannabis activity” or “marijuana activity” from the list of disqualified businesses, some contend that marijuana qualifies as an opportunity zone business. However, many tax practitioners worry that cannabis businesses being omitted from the list of disqualified businesses was an oversight that Congress will fix in a technical corrections bill. The list of disqualified businesses isn’t limited to illegal businesses — even if Congress is inclined to relax criminal marijuana laws, it hasn’t shown any indication that it wants to provide tax benefits to marijuana businesses. The final regulations governing Opportunity Zones have not yet taken effect.

Cannabis businesses that invest in Opportunity Zones hoping to benefit from the tax benefit need to weigh the risk that Congress will pull the rug out from under them by adding marijuana businesses to the list of disqualified businesses. If marijuana businesses are able to avoid that fate, however, Qualified Opportunity Zones could provide a great opportunity for investors and low income communities.

cannabis management company 280EOn December 20th, U.S. Tax Court issued its opinion in Alternative Health Care Advocates et al. v. Commissioner of Internal Revenue. The long opinion details various issues related to the specific case, but we will concentrate on one relatively small piece of it. How would the Tax Court treat income paid from a marijuana retailer to a management services company for that retailer?

In this case, Alternative Health Care Advocates provided medical marijuana to individuals in California under California law. Another company, Wellness Management Group, Inc., provided management services to Alternative Health Advocates. These services included hiring employees and managing HR for those employees, paying wages for those employees, paying advertising expenses, paying rent, etc. Wellness did not provide services of that nature or any nature to any other business entity. Wellness made money by collecting fees for its services from Alternative Health Care Advocates.

Under Section 280E of the Internal Revenue Code, businesses that are engaged in trafficking controlled substances cannot take regular business deductions, so they end up paying taxes on their gross receipts less their allowed cost of goods sold (COGS). If an expense doesn’t fit into the category of COGS, a company that is considered to be “trafficking” would have to pay taxes as if the expense hadn’t been incurred in the first place. This is how the effective tax rate for marijuana businesses can be outrageously high.

Marijuana businesses set up management companies for a few reasons. Tax avoidance under 280E can be one of them, but trying to set up a management company structure to avoid 280E-related tax problems can be complex and can backfire. Instead, most of the value of the management company model comes from the ability of the management company to get banking and enter into regular electronic transactions with third parties, including running payroll services.

But the model backfires if the management company is considered to be trafficking, because a management company introduces new transactions to the system involving the same pot of money. Imagine that a marijuana retail company generates $1 million and has $500,000 in 280E non-deductible expenses. That company standing alone would pay tax on the full $1 million. Now imagine that a management company is set up to handle the $500,000 in expenses and charges the marijuana company $500,000 to do so. The marijuana company now has $1 million in revenue and a non-deductible $500,000 bill to the management company and pays taxes on $1 million. The management company receives $500,000 from the marijuana company and pays salary and other expenses that also equal $500,000. If the management company is treated like any other business, the transaction is a wash and ends the same way as if there were no management company. If the management company is deemed to be “trafficking” however, then the marijuana business will find itself paying tax on both entities for the same revenue. The $500,000 paid to the management company ends up being taxed twice.

Unfortunately, the Tax Court decided that Wellness’s management activities were “trafficking” as much as Alternative Health Care Advocates’ activities were. In response to the taxpayers’ arguments that disallowing the 280E deductions for both businesses was inequitable, the Tax Court simply stated that the tax consequences were a direct result of the organizational structure the taxpayers put together.

Here are the takeaways for existing businesses, especially management companies. First, it’s worth noting that this case will likely be appealed, so keep an eye on that. Second, businesses have to plan their transactions involving management companies as if management company revenue is subject to 280E. Some management companies that offer broader services to a variety of different businesses may have some additional arguments that they are not engaged in “trafficking.” But if your management company is just a stand-in for your operating marijuana company, the Tax Court has indicated that it will approve of the IRS considering you to be trafficking as well. This case is one more reminder that Section 280E presents an ever-present obstacle to the ongoing health of marijuana businesses. Advocates must continue to concentrate their efforts to finally get Congress to repeal Section 280E.

As we wrote on Tuesday, the midterm elections were monumental for cannabis: Michigan voters approved of a proposal legalizing recreational marijuana for adult use, Utah and Missouri will soon establish medical marijuana regimes, and Texas Representative and marijuana antagonist Pete Sessions lost to a Democrat.

All in all, Tuesday was a good day at the state and national level. But cannabis wasn’t just on the ballot at the state or national level—many cities had measures on that would regulate cannabis in one form or another. This post discusses some of the more impactful ballot measures that won and lost in California.

california elections cannabis marijuana

To start, dozens of cities and counties in California had cannabis taxation measures, which is a good sign for the expanding market. Oakland voters, for example, approved of Measure V, which amends the local code to allow cannabis manufacturers and cultivators to deduct the value of raw materials when calculating gross receipts for tax purposes. Fresno voters approved of Measure A, which adopts a cannabis business license tax. As noted above, numerous cities had tax measures on the ballot—and they are quite literally all over the map.

El Dorado County had a number of cannabis measures on its ballot. Measures P, Q, R, and S each passed, allowing the retail sale, delivery, distribution, and outdoor/indoor cultivation of commercial cannabis for recreational and medicinal purposes. Interestingly, El Dorado County’s Measure N (a tax measure), didn’t pass.

Los Angeles County’s well-publicized Measure B, which would have established a municipal bank, failed. This was a closely watched measure in the cannabis industry, as many had hoped for a local bank in which to bank their earnings. Because the California effort to charter a state bank has cooled, local businesses may have limited options until a federal fix occurs.

Elsewhere, the City of Malibu passed Measure G, which will now allow retail sales of commercial cannabis and deliveries. Before, Malibu only allowed medicinal sales. But wait before delivering into Malibu from other cities; you’ll need a regulatory permit from the City of Malibu to do so. No word yet on what that application process will look like.

As noted above, these are just a few of the measures that were adopted (or not) on Tuesday. California, like many other places nationally, is certainly moving toward a more open marijuana landscape.

Today let’s talk about Matthew Price, the Oregon marijuana businessman headed to jail for tax crimes. This story got a lot of coverage when it broke last month, partly because it was the first known tax-related prosecution for a licensed pot business owner, and partly because Price was fairly well known in Oregon. He once sat on an Oregon Liquor Control Commission (OLCC) rules advisory committee for cannabis retail, and he owned three dispensaries. Seems like he was off to a pretty good start.

Well, not any longer. In addition to the seven-month lockup, Price was ordered to pay the I.R.S. $262,776 in restitution on the nearly $1 million in taxable income he raked in from 2011 to 2014. He will probably never be allowed to participate in the OLCC program again, given the agency’s recent tightening of the screws, and its authority to bar anyone with a federal conviction “substantially related to the fitness and ability of the applicant” to obtain a license.

cannabis marijuana tax IRS

Generally speaking, marijuana businesses are liable for lots of tax under IRC 280E. As cannabis business lawyers, we work with CPAs and others to attempt to mitigate our clients’ tax liability, but at the end of the day, that liability is always there. Tax obligations do not end at the federal level, of course: Most states have income tax programs, and all states with legal cannabis programs seem to collect additional taxes on the sale of marijuana. In Oregon, for example, that sales tax must be escrowed by OLCC retailers and paid to the state Department of Revenue. As to Matthew Price, the news reporting was silent on whether he was also shirking those payments.

Having advised state-legal cannabis businesses since 2010, we have seen a lot of monkey business when it comes to tax. We have seen bad lawyers advise clients not to pay taxes, on the theory that tax programs violate business owners’ rights against self-incrimination. We have seen businesses attempt to claim “non-profit” status and avoid taxes in that manner, despite the impossibility of receiving an I.R.S. exemption. And we’ve seen lots of “management company” schemes, most of which are nonsense. At the end of the day, a baseline level of tax is unavoidable.

Interestingly and appropriately, the judge in this case didn’t seem to treat Price differently because his income derived from cannabis sales. It was reported that federal prosecutors petitioned the judge to go hard on Price, in order to send a message to the marijuana industry. The judge wasn’t having that:

The fact that the product involved here is marijuana is utterly meaningless to me in passing a sentence,” the judge said. “It’s a tax case to me.”

That didn’t stop the Justice Department from bragging a bit, but it’s encouraging to see cannabis entrepreneurs being treated like everyone else — in theory, anyway — and for better or worse. On that point, we have often said on this blog that just because someone is violating one federal law by trading in cannabis, that doesn’t make it a good idea to violate all the others. And we always advise entrepreneurs to run their cannabis business like real businesses. That includes paying taxes.

 

california cannabis tax

On July 20, 2018, the CDTFA released its discussion paper on proposed rulemaking regarding the administration of the cannabis cultivation and excise taxes. This blog post highlights the issues addressed in the proposed regulation.

By way of background, on August of 2017 the CDTFA promulgated two emergency regulations. The first, Regulation 3700, Cannabis Excise and Cultivation Taxes, was promulgated to ensure that essential guidance was available when California’s regulated cannabis market became operational on January 1, 2018. The second, Regulation 3701, Collection and Remittance of the Cannabis Excise Tax, was promulgated to clarify the imposition, collection, and reporting of the Cannabis Excise Tax. We previously discussed these regulations here, and we a discussed the Cultivation and Excise Tax here and here.

The CDTFA will not take action on Regulation 3701. However, the CDTFA has proposed many revisions to Regulation 3700. We summarize them below, and provide some commentary throughout.

  • Expands the definition of cannabis flower to include trimmed or untrimmed flower but excludes leaves and stems removed before sale. The consequence of this proposed change is to assure that even trimmed flower will be taxed at the highest tax rate of $9.25 per dry weight ounce.
  • Clarifies that “fresh cannabis plant” must be identified as fresh cannabis plant and recorded in the upcoming track-and-trace system. Until the track-and-trace system come online, a paper invoice or manifest must indicate that “fresh cannabis plant” is being transferred. This documentation is important. Fresh cannabis plant is taxed at the lowest rate of $1.29 per ounce; the proposed change clarifies what information is required to support paying tax at the lowest cultivation tax rate.
  • Prohibits separately stating the cannabis excise tax on the receipt provided to a retail cannabis customer. Instead, the regulations require the invoice to state “The cannabis excise taxes are included in the total amount of this invoice”. Retailers purchasing from third-party distributors must compute the excise tax based on their wholesale cost plus 60% mark-up as determined by the CDTFA. Separately stating the excise tax allows a consumer to determine the wholesale cost of a cannabis retailer. The proposed prohibition does not provide retailers the flexibility to disclose the computation of the tax to its customers.
  • Clarifies that transactions between two distributors must document that no cannabis excise tax was collected or remitted on the transaction. That is, the distributor that sells cannabis to the cannabis retailer is the one responsible for collecting and remitting the cannabis excise tax to the CDTFA.
  • Clarifies that invoices documenting the cultivation tax must disclose the weight and category of the cannabis that entered the commercial market. This change is to assure that the receipt a manufacture provides to a cultivator includes the weight and category (i.e., cannabis flower, cannabis leaves, or fresh cannabis plant) of cannabis transferred. The weight and category must match the information in the track-and-trace system.
  • Requires a manufacture to provide a distributor (or next party in the transaction) an invoice or manifest that documents the weight and category of cannabis used to produce the cannabis product. This change is to assure that a distributor has the necessary information to properly collect and remit the cultivation tax to CDTFA.
  • Clarifies that a cannabis accessory is not subject to the 15% excise tax. When a cannabis product is sold with a cannabis accessory, the cannabis retailer must segregate the wholesale cost of cannabis from the wholesale cost of the cannabis accessory on the customer receipt. If a cannabis retailer is unable to segregate the wholesale cost, the cannabis excise tax will include the wholesale cost of the cannabis accessory in the computation. The proposed regulation places the burden on the retailer to segregate its wholesale costs to avoid including the cost of a cannabis accessory from the excise tax paid by a cannabis consumer.
  • Clarifies that a 50% penalty is imposed for unpaid taxes. The 50% penalty is added to the cultivation or excise tax not paid by the due date.  For example, the tax payment for the third quarter of 2018 is due October 31, 2018.  A payment on November 1, 2018 would subject the distributor to the 50% penalty. Although the penalty can be waived for reasonable cause, a best practice is to always file and pay your cultivation and excise taxes on time.
  • Introduces proposed Regulation 3702 which requires the following information to be entered into the California track- and-trace system including: name of originating seller of cannabis; name of retailer purchasing cannabis; unique identifying number of cannabis supplied to the retailer; and the retailers wholesale cost. The CDTFA intends to use the track-and-trace system to collect real data to assist in their determination of the appropriate mark-up used in determining the average market price the computation of the excise tax.

The regulations discussed above are only proposed and may change as CDTFA considers comments and another stakeholder input.  Nonetheless, many of the recommendations contained in the proposed regulations are already on the CDTFA website. For example, the CDTFA website provides that “the flower category includes all dried flowers of the cannabis plant, whether trimmed or untrimmed”. So some of these provisions seem very likely to stick.

California cannabis businesses should continue to monitor these regulations as the CDTFA considers stakeholder comments and likely revises some portion of the proposed regulation. As the regulations develop, business owners should also revisit their tax strategies and operational protocols for tax efficiency.

For more on California’s cannabis tax regime, check out the following:

cannabis tax lawyerIn Alpenglow Botanicals LLC v the United States of America the United States Court of Appeals for the Tenth Circuit just ruled that the IRS has the authority to determine that a cannabis business is trafficking in a controlled substance for purposes of applying IRC §280E. This decision is going to shift how cannabis businesses pay their taxes and how cannabis tax lawyers view cannabis tax obligations. And not in a good way.

Alpenglow Botanicals LLC is a medical marijuana business. The IRS audited Alpenglow’s tax returns and determined Alpenglow was trafficking in a controlled substance and so it denied the company’s business deductions under IRC §280E. Alpenglow paid the tax assessment and filed for a refund, which was subsequently denied by the IRS. Alpenglow then went to federal court to recover its refund claim. In court, Alpenglow made the following three arguments:

  • The IRS does not have authority to disallow deductions under IRC §280E unless the taxpayer has a criminal conviction for trafficking;
  • IRC§280E violates the 16th Amendment of the U.S. Constitution; and
  • IRC §280E violates the 8th Amendment of the U.S. Constitution.

The Court rejected all of these arguments.

The Court determined that a criminal conviction is not a prerequisite for the IRS to apply IRC 280E and that the IRS has the authority to determine on audit that a taxpayer is trafficking in a controlled substance. The Court relied on its earlier decision  in Green Solutions Retail Inc. where it stated that “the IRS’s obligation to determine whether and when to deny deductions under IRC §280E, falls squarely within its authority under the tax code.” The Court in Alpenglow went further than Green Solutions in ruling that there’s no evidence Congress intended to limit the IRS’s investigatory power here.

Alpenglow cited a line of U.S. Supreme Court cases for the proposition that courts have invalidated regulations involving the taxation of illegal conduct — these cases strike down the imposition of a tax as a violating a taxpayer’s 5th Amendment right against self-incrimination. The Tenth Circuit Court distinguished those cases, noting that Alpenglow is challenging the IRS’s very authority to tax and investigate illegal activity at all  and held that this prior line of cases don’t apply to the denial of a tax deduction as opposed to the imposition of a tax.

The Court also determined that IRC §280E does not violate the 16th Amendment, which grants Congress the power to tax “income,” or the 8th Amendment, which prohibits the federal government from imposing “excessive fines.” The Court ruled that IRC §280E is not an unlawful penalty and disallowing a deduction is not a “punishment.”

Most importantly, this court’s decision on IRC §280E is going to have real life implications for many cannabis businesses. Every cannabis business that has filed a tax return challenging the application of IRC §280E should immediately review its tax returns and reevaluate their options.

cannabis 280E marijuana taxOn June 13, the U.S. Tax Court issued an opinion regarding the application of IRC §280E. In Alterman v Commissioner of Internal Revenue (“Alterman“) the Court held, yet again, that IRC §280E operates to disallow a cannabis businesses’ tax deductions. A few days later, the Court also issued Loughman vs. Commissioner of Internal Revenue (“Loughman“). In that case, the Court held that IRC §280E disallowed the deduction of wages paid to S Corporation shareholders. The disappointing but predictable outcomes in these cases highlight the need for Congress to repeal or modify IRC §280E.

By now, the destructive force of IRC §280E is well known. IRC §280E disallows deductions and credits to a business trafficking in a controlled substance. One exception is cost of goods sold (“COGS”). Other than a 2015 IRS General Counsel memorandum, the IRS has not offered much guidance regarding the application of IRC §280E. With this gap in IRS guidance, it is the courts that have outlined the (fairly narrow) parameters of IRC §280E.

Reading the IRS guidance and court rulings together, it is clear that selling or growing cannabis is always considered trafficking and expenses related to such activity are disallowed. A cannabis business can deduct all expenses related to a separate trade or business. A court is more likely to accept a separate business activity if that business can operate independently of a cannabis business.

Alterman

Alterman does not offer broad guidance regarding IRC §280E. In part, this is because the Court issued a Memoranda opinion.  A Memoranda opinion does not set a precedent for taxpayers; however, they are useful to illustrate how the Court may analyze the law.

Laurel Alterman and William Gibson operated a Colorado medical marijuana grow and dispensary. These taxpayers also sold cannabis paraphernalia, hats and shirts. The Court held that the sale of paraphernalia, hats and shirts was not a separate trade or business primarily due to the lack of records. Accordingly, costs associated with these activities were not deductible under IRC §280E.

In addition, the Court determined that certain costs were not allowable as COGS because of insufficient records, which should be a lesson to any cannabis business owner: It’s not enough to have potentially deductible costs, if you don’t keep records! Interestingly, the opinion uncharacteristically discusses, in detail, the records available, only to hold that those records were insufficient. (Court cases that disallow deductions because of poor recordkeeping typically do not discuss in detail, the records examined.)

Because of the fact-specific nature of this case, Alterman offers little guidance to cannabis businesses other than recordkeeping must be sufficient to support deductions.

Loughman

In Loughman, the Court did not address the issue of record keeping or substantiation. Instead, the Court addressed the issue of double taxation of income because of IRC §280E. And the Court concluded that double taxation is allowed.

Jesse and Desa Loughman were licensed in Colorado to grow and sell cannabis through a Colorado corporation, Colorado Alternative Health Care (“CAHC”). The Loughmans were the sole shareholders of CAHC and elected to be treated as an S Corporation for federal tax purposes.

An S corporation is not subject to tax; instead shareholders are taxed on S Corporation income at the individual level. Special rules treat S Corporation shareholder/officers as employees and require the S Corporation to pay them a reasonable wage. Under ordinary circumstances, an S Corporation deducts shareholder/officer wages; the shareholder/officer then pays income tax on the wages. The S Corporation’s deduction of wages prevents double taxation.

In this case, the IRS applied IRC §280E and disallowed CAHC’s deduction for wages paid to the Loughmans. Consequently, the amount of S Corporation income passed through to the Loughmans increased. The result is that the Loughmans wages are taxed twice — first as an employee and then as S Corporation shareholders.

The Court rejected the argument that IRC§280E discriminates against S Corporation shareholders operating a cannabis business. The Court reasoned that wage payments to a third-party performing the same services as the Loughmans would not be deductible under IRC §280E. Accordingly, the amount of pass through income to the Loughmans would not change: IRC §280E applies equally to increase S Corporation income, regardless of who receives wages. Furthermore, the Court noted that the taxpayer did not have to, but chose to, elect S Corporation status for their cannabis business.

As in Alterman, the Court issued a memorandum opinion. Accordingly, the Court’s determination only applies to the Loughmans and does not set precedent. Nonetheless, the Court highlighted a serious disadvantage to operating a cannabis business through an S Corporation– namely, double taxation.

The STATES Act

So where does that leave us? These cases highlight the dire need for a legislative fix of IRC §280E. On June 7, 2018, Senators Gardner and Warren introduced the Strengthening the Tenth Amendment Through Entrusting States Act (The “STATES Act”). The STATES Act exempts persons from the Controlled Substances Act, so long as they are acting in compliance with a state’s cannabis law. Specifically, under the STATES Act, the production or sale of cannabis in a cannabis legal state “shall not constitute trafficking”. Because IRC §280E applies to a trade or business that consists of trafficking, the STATES Act would effectively eliminate the impact of IRC §280E.

As more cannabis businesses are audited, expect more cases like Loughman and Alterman to move through the system. In addition, expect similar results on similar facts, unless Congress finally takes action. The STATES Act would do a lot of good for the industry, and eliminating the oppressive impact of IRC §280E is high on the list.

industrial hemp tax 280E
Not always taxed like marijuana, in theory.

Short answer: It depends.

As we discussed last week, the US Court of Appeals for the 9th Circuit in Hemp Industries Assn. et.al., vs. U.S. Drug Enforcement Admin., upheld the Drug Enforcement Administration’s (DEA) broad rule creating a separate classification for “Marijuana Extracts.”  Marijuana Extracts are broadly defined as “any extract containing one or more cannabinoids that has been derived from any plant of the genus Cannabis”. The ruling received an extraordinary amount of press, but lost in all of this breathless reportage was a very important point for a certain class of hemp businesses: The Court explicitly stated that the 2014 Farm Bill (“Farm Bill”) preempts the federal Controlled Substances Act (CSA). Accordingly, expenses incurred through an activity conducted strictly within the parameters of the Farm Bill arguably are not subject to IRC §280E.

Businesses that are operating outside the narrow parameters of Section 7606 of the Farm Bill, however, whether trading in hemp or any derivative product, will have to deal with IRC §280E. As a refresher, the Farm Bill allows a state to grow “Industrial Hemp” if it has implemented an official agricultural pilot program. These pilot programs, generally administered through state Departments of Agriculture, issue licenses or permits to businesses and individuals, allowing the cultivation of “Industrial Hemp.” That cultivar is defined as any part of the cannabis sativa plant with less than 0.3% THC on a dry weight basis. If a plant contains 0.3% or more THC on a dry weight basis, or is not cultivated by a pilot program licensee, the cultivator is operating outside of federal law and hence subject to IRC §280E.

So why is this such a big deal? As we explained previously, IRC §280E prohibits a deduction for any amount paid or incurred in carrying on any trade or business that consists of trafficking in a Schedule I or II controlled substance under the CSA. Accordingly, any industrial hemp business conducting the following activities is possibly subject to the horror of IRC §280E including:

  • Food and Body Care;
  • Textiles;
  • Building Material; and
  • Cannabinoids.

If IRC § 280E applies to a hemp business, that business will lose deductions otherwise available to almost every other US business. Clearly, IRC §280E puts these businesses at a competitive disadvantage. The disadvantage can be so severe as to be fatal in certain cases.

It’s important to note that although IRC 280E disallows expenses and credits paid for trade or businesses engaged in trafficking of marijuana listed as a Schedule I drug, this onerous code section does not apply to cost of goods sold. As such, a grower, farmer, cultivator, processor, or a manufacturer of hemp products may deduct any costs that are properly included in cost of goods sold. This rule is noncontroversial: In 2015, the IRS Chief Counsel issued a memorandum that clarified that a cannabis business may deduct these costs under IRC §471 and related regulations. Specifically, under IRC §471, costs included in cost of goods sold are those costs incident and necessary to production including:

  • Direct material costs;
  • Direct labor costs;
  • Utilities;
  • Maintenance;
  • Rent (real estate and equipment); and
  • Quality control.

Depending on your treatment for financial statement purposes, the following indirect costs may be included in cost of goods sold including:

  • Taxes necessary for production;
  • Depreciation;
  • Employee Benefits;
  • Factory administrative costs; and
  • Insurance.

On the other hand, a non-Farm Bill compliant hemp producer will lose under IRC §280E deductions related to sales, marketing and non-production related management costs.

In addition to creating headaches for non-Farm Bill compliant growers, the application of IRC §280E will have a detrimental impact on wholesalers and retailers of CBD products who also are not operating in full compliance with the Farm Bill. For these businesses, IRC §280E would operate to disallow a deduction for most overhead costs. This could have an especially severe impact on mixed retail businesses that sell CBD products in conjunction with other products.

Example: A pharmacy that sells products containing non-Farm Bill CBD as well as more traditional health products (e.g., shaving cream) may now be subject to IRC §280E. Unless the sale of non-CBD products can be considered a separate trade or business, it is possible that IRC §280E would operate to disallow the deduction of all operating expenses.

Finally, it is unclear if the IRS will apply IRC §280E retroactively to non-Farm Bill hemp businesses. The IRS could apply IRC §280E retroactively on audit or to years otherwise open. For example, the IRS could go back to tax year 2014 and adjust the income tax returns of certain taxpayers engaged in hemp manufacturing and sales of hemp products.

Under the new tax law effective January 1, 2018, Congress gave U.S. business several targeted tax benefits. For many businesses in the developing industrial hemp sector, the impact of IRC §280E reverses many of the benefits of the new tax law. Perhaps Congress can address some of these issues by passing the expansive Hemp Farming Act of 2018 which, as currently written, would explicitly remove Industrial Hemp and derivatives of that cannabis cultivar from the Controlled Substances Act. Better yet: repeal IRC §280E.

The tax outlook for California canna manufacturers isn’t all bad.

We previously identified a number of sales tax exemptions available to California cannabis cultivators. Fortunately, the state legislature is looking out for other businesses up and down the supply chain, such that cultivators are not the only class of licensee eligible for sales tax exemptions. This post will focus on a partial tax exemption available to manufacturers and other cannabis businesses engaged in certain research and development. It’s an important exemption to understand.

First, the tax exemption is not so much an exemption as a reduction of the state sales tax rate.  For example, an Oakland manufacture’s purchase of $100,000 of qualified equipment ordinarily pays state and district sales tax at a rate of 9.25%. The 9.25% rate includes a state rate of 7.25% and a district rate of 2.0%. In this example, the sales tax due is $9,250. With the partial exemption, the state sales tax rate is reduced from 7.25% to 3.3125%. Accordingly, the sales tax due is $5,312 [$100,000*(3.3125%+2.00%)] resulting in a total tax savings of almost $4,000.

A manufacturer must satisfy three key requirements to qualify for the credit:

  • The manufacturer must be a “qualified person”;
  • The manufacturer must purchase “qualified equipment”; and
  • The equipment must be used in a “qualified manner”.

Note that the partial exemption applies to qualified equipment that is leased as well as purchased. The requirements are very specific and somewhat technical. What follows are the key points to consider when purchasing equipment.

Qualified Person

A qualified person is a business that engages more than 50% of the time in a business activity described in the North American Industry Classification System (NSICS) under manufacturing codes 3111-3399 or codes related to research and development, revised codes 541713 or 541715. The NSICS code is a standard used by the federal government to classify businesses.  It is no surprise that NSICS codes have not been created for the cannabis industry. However, it appears that all cannabis manufactures should qualify for Miscellaneous Manufacturing, Code 339999. Accordingly, all cannabis manufactures and processors should be considered qualified persons for purposes of the credit.

Determining what research and development businesses qualify is more difficult. The research and development class is narrowly defined.  However, the CDTFA website suggests (without providing much detail) that certain product development and process improvement activities may qualify for the partial exemption. It is fair to say that any cannabis company operating a testing or genetics lab should look at this credit closely.

Qualified Equipment

A wide variety of tangible property (i.e., equipment) qualifies for the partial exemption. First, the manufacturing process is broadly defined and includes tangible personal property involved in:

“manufacturing, processing, refining, fabricating, or recycling of tangible personal property, beginning at the point any raw materials are received by the qualified person and introduced into the process and ending at the point at which the manufacturing, processing, refining, fabricating, or recycling has altered tangible personal property to its completed form, including packaging, if required.”

Qualified Equipment includes:

  • Packaging equipment “necessary to prepare goods so that they are suitable for delivery to and placement in finished goods inventory, including repackaging to meet the needs of a specific customer.” This definition is expansive and should include equipment that trims, packs, and seals cannabis products for sale in compliance with MAUCRSA:
  • Pollution control equipment;
  • Quality control equipment;
  • Component parts such as belts, shafts and moving parts;
  • Equipment used to operate, control, regulate or maintain the machinery including:
    • Computers;
    • Software;
    • Repair and replacement parts (with a useful life of more than one year);
  • Special purpose buildings used in manufacturing or that constitute a research facility;

The following equipment generally does not qualify for the partial exemption:

  • Consumables with a useful life of less than one year;
  • Furniture;
  • Equipment used to store finished products (e.g., shelving); and
  • Equipment and property used in administration, management, or marketing.

Qualified Use

To meet this requirement, the tangible property must be used more than 50% of the time in:

  • Any stage of the manufacturing process;
  • Research and Development;
  • Maintenance, repair, or quality control activity related to qualified equipment.

Compliance

Generally, a seller of manufacturing and research and development equipment is required to collect sales tax from the buyer at the time of sale. However, a seller is not required to collect the full amount of sales tax if they receive from the buyer a partial exemption certificate, Form CDTFA 230-M.

The exemption certificate is proof that the seller properly collected a reduced amount of sales tax and protects the seller. The CDTFA can not collect the full amount of sales tax from the seller on audit provided that the seller accepts the exemption certificate in good faith. The good faith standard is reasonable easy to satisfy. However, the seller should look out for buyers tendering certificates for purchases of products that obviously do not qualify, such as consumables or office equipment.

If California sales tax is not collected by the seller, a California purchaser of manufacturing equipment is required to pay use tax. For example, the Arizona manufacturer of a dryer may not be required to collect California sales tax if the equipment is shipped from Arizona to a California cannabis business. In this situation, the California cannabis business is required to self-assess use tax on its purchases. Provided that the equipment meets the qualifications discussed above, the purchaser may claim an exemption on their use tax return filed with CDTFA.

California cannabis businesses operate in a very challenging tax environment. All marijuana businesses should be aware of the type of tax exemption available; aggressively pursue all that they qualify for; and, properly document all exemptions they claim. For large capital expenditures, a cannabis business should consider requesting from the CDTFA written confirmation that the planned expenditure qualifies for exemption. A cannabis business that discloses its name and accurately describes the facts of the transaction, may rely on the CDTFA’s determination.

california marijuana tax
Returns are due next month. Time to hustle.

In California, the first Cannabis Tax Return is due on April 30, 2018 and many of our clients are now working through the issues related to the Cannabis Cultivation and Excise Tax. In addition, many marijuana businesses must file their first 2018 estimated federal tax payment by April 17, 2018. To estimate taxable income, every Cannabis business must understand how to treat the Cannabis Cultivation Tax and the Cannabis Excise Tax on their federal income tax return. Are California Cannabis Taxes an expense of a cannabis business? If so, are cannabis taxes deductible for federal income tax purposes?

We have discussed the mechanics of IRC §280E here and here. IRC §280E disallows deductions for cannabis cultivators, manufactures, distributors and retailers. However, expenses included in cost of goods sold (“COGS”) reduce taxable income and operates outside the reach of IRC §280E. Generally speaking, IRC §280E is less damaging to cultivators than retailers, because cultivators can attribute more business expenses to COGS.

Cultivation Tax
California imposes a cultivation tax on harvested cannabis that enters the commercial market. The tax is:

• $9.25 per dry-weight ounce of cannabis flower;
• $2.75 per dry-weight ounce of cannabis leaves; and
• $1.29 per dry-weight ounce of fresh plant.

The tax is imposed on the Cultivator alone; under state rules, cannabis cannot be sold unless the tax is paid.

IRS regulations (Treas. Reg. §1.471-11) provide Cultivators and Manufactures with a helpful roadmap regarding what costs are appropriate to include in COGS. Taxes can be included in COGS if they are otherwise allowed as a deduction under IRC §164. Under IRC §164, state taxes are deductible if they are “paid or accrued … carrying on a trade or business”. In addition, the state taxes may be included in COGS if they are “attributable to assets incident to and necessary for production or manufacturing operations or processes”. For example, property taxes are included in COGS. Finally, the regulations look to whether a tax is included in COGS in the business’s financial statements.

Cultivation taxes are paid or accrued in carrying on a trade or business. The cannabis plant is an asset of the business (i.e., raw material) that is the core ingredient in all cannabis products grown or processed. Clearly cannabis is the raw material incident and necessary to production; cannabis may not be sold under California law unless the Cultivation Tax is paid. Finally, the tax is imposed based on a characteristic of a business asset (i.e., weight of raw material), like a property tax.  Accordingly, there is a reasonable argument that IRS regulations require that the California Cultivation Tax be included in COGS of a Cultivator.

Excise Tax
California imposes a 15% Cannabis Excise Tax on the purchases of cannabis or cannabis product sold. Generally, the tax is imposed on the average market price. The average market price is the Distributor’s wholesale cost plus a mark-up determined by the CDTFA. Currently the mark-up is 60%. For example, a retailer’s cost of an ounce of cannabis is $75/ounce plus $5 of transportation cost. The mark-up is $48($80 *60%). The average market price is $128 ($80 +$48); the Cannabis Excise tax is $19.20 ($128*15%). The Retailer’s COGS includes the $80 cost. The Retailer will charge the consumer tax of $19.20. Note that for cannabis retailers, COGS is generally limited to the direct purchase cost of cannabis.

So, the big question here is: Should the $19.20 of Cannabis Excise tax be included in the Retailers COGS? By statute, the cannabis excise tax “shall be imposed upon purchases of cannabis”. The Retailer collects the tax from the consumer and pays the tax over to a California Distributor. As the tax is the ultimate liability of the cannabis purchaser, the statutes suggest that the cannabis tax collected is not a cost to the Retailer. Like state sales taxes, the Cannabis Excise Tax is a liability to the Distributor. As such the Cannabis Excise Tax is reflected on the Retailer’s balance sheet and not as an expense on the income statement. The Cannabis Excise Tax probably escapes the reach of IRC §280E.

Although California cannabis taxes do not conflict with IRC §280E, all cannabis businesses should consult with their tax advisors before taking a final approach. For Cultivators and Manufactures, there is a reasonable argument that the Cultivation Tax is included in COGS. For Retailers, there is a reasonable argument that the Cannabis Excise Tax is passed directly to the consumer and, therefore, outside the reach of IRC §280E. At the very least, that may be a good place to start the discussion.