We are going to find out over the next couple of years whether businesses that studiously follow state and federal tax rules can survive and thrive as real businesses. We have blogged before about I.R.C. 280E, and how challenging it makes operating a marijuana business. We can talk your ear off about how difficult the taxes are to comply with in theory, but in this post I am going to dive into the numbers to actually show how burdensome the current state and federal tax systems can be.

Imagine that you are a retail cannabis operator in Washington State, and you buy a packaged gram of marijuana at wholesale for $5.00, including the 25% excise tax at that level (which is a price that the producers/processors will not be thrilled to accept.) You turn around and sell it for $10.00, plus the 25% excise tax, making a total of $12.50. Of that $12.50, you keep $5.00. Well, you do not actually keep it, as that $5.00 is needed to pay your rent, your electric bill, your employees, your accountant, your lawyer, your security company, etc. The real kicker, though, is that your federal tax is not based on the $5.00 you actually received, minus your costs. It isn’t even based on a total of $5.00. The IRS will claim that your income after cost of goods sold was $7.50, as they will include the excise tax as part of your income, and they will not let you deduct even that! The IRS will treat the money that you received only to hand off to state tax authorities as taxable income.

So, going back to our example, if your average tax rate is 30% and the taxable income is $7.50, we are looking at an additional tax expense of $2.25 taken from your $5.00. This means that you will be left with only $2.75 out of every $12.50 (not including sales tax) that the customer gives you. In other words, from every $12.50 sale that you make, you will have only $2.75 left over  to pay all of your expenses. Obviously very little to nothing at all is left over as profit.

So, what do you do? You jack up the prices. $10.00 per gram is yesterday’s news; let’s make the new price $15.00 or $22.00 per gram. Every time retailers crank that lever, however, the black market thrives. As cities and counties pass pro-black market bans on legal marijuana businesses — some of them downright hypocritical — illegal competitors will remain entrenched. If cannabis businesses do not get tax relief from either the state or federal government while this market develops, we may find that we do not have a legal market for very long.