As our Los Angeles cannabis business tax lawyers can explain, this is the latest development in a long-running legal battle over the much-derided IRS rule outlined in 280E, which curbs the deduction cannabis companies can take on their taxes.

Dispensary chain Harborside in Oakland is appealing in the U.S. Court of Appeals for the Ninth Circuit following a 2019 ruling by a U.S. Tax Court which ordered the company to pay $11 million in back taxes after wrongly claiming a host of business deductions. Such deductions are available to most businesses in the U.S., but cannabis companies don’t have that luxury, thanks to 280E.

What is Section 280E

The problem for the state-legal marijuana industry is the federal designation of marijuana as a Schedule I narcotic, in the same category as heroin – highly addictive and with no medicinal benefits. It’s an outdated classification, but one to which the federal government has held tight for decades.

Section 280E of the U.S. tax code holds that operations that profit from trafficking illegal drugs can’t turn around and deduct expenses incurred in the production, distribution and sale of those drugs. That means that even operations following their state law to the letter can’t deduct business operating expenses. The law was adopted in the 1980s – long before cannabis was state-legal – to prohibit illegal drug traffickers from claiming tax deductions.

There is an exception for the costs of goods sold, such as costs for seeds, water, nutrients, soil and expenses related to growing and harvesting the plant. Expenses racked up for distributing the product aren’t tax deductible. These include things like labor expenditures, overhead costs, shipping and rent.

What this all translates to are much higher tax bills for the cannabis industry because they are compelled to pay taxes on gross profit instead of their actual net income. For many operations, this can quickly make business unprofitable.

Let’s say a company brings in $2 million in revenue. If they deduct $600,000 in cost of goods sold, their gross profit is $1.4 million. A typical business can deduct expenses associated with sales, administration, etc. (let’s say $1.1 million). That business would have a net income of $300,000, and would be taxed on that amount. A cannabis business, however, would have to pay taxes on the gross profit of $1.4 million, ultimately paying more than $230,000 in additional taxes compared to other companies.

Legal Argument Against Section 280E

Harborside is appealing a tax court ruling that 280E was applicable. In a response filed last fall, the Internal Revenue Commissioner argued for dismissal on the grounds that the constitutional questions being raised by the dispensary chain weren’t previously raised with the lower court.

In a 35-page response, Harborside called the IRS’s position on exclusions “clever, but unconstitutional,” and that it forces companies operating at a loss, without income, to still pay substantial income taxes. Compelling the cannabis industry to acquiesce to a “new method of accounting” both oversteps the Constitution and misconstrues tax law.

The case is being closely monitored by those in the cannabis industry, including our Los Angeles marijuana business lawyers, because it could impact how businesses can deduct expenses on future tax bills.

Central to this dispute is how “income” is defined. The IRS argues that the 16th Amendment is applicable only to income derived from property (i.e., collecting rent) and doesn’t involve business income. Harborside argues this is an inappropriate interpretation of the Amendment, which allows Congress to tax income directly. Further, because the cannabis company was operating at a net loss for the years in question, there was no “income” to tax and the government is trying to impose a tax unlawfully.

So far, at least two amicus briefs have been filed by cannabis industry groups in favor of the dispensary’s position. Oral arguments are slated to begin next month.

The Los Angeles CANNABIS LAW Group represents growers, dispensaries, ancillary companies, patients, doctors and those facing marijuana charges. Call us at 949-375-4734.

Additional Resources:

Harborside Fires Back at IRS, Dec. 9, 2020, By Willis Jacobson, Weed Week

But even after just a few weeks, the state government is already reaping big cash benefits reefer. Gov. Jerry Brown estimates $643 million in marijuana excise taxes in the first year, according to a Los Angeles Times report. Earlier projections estimated tax revenue could eventually hit $1 billion. Brown cautioned we don’t fully know every market issue that is at play, so local governments should be careful before enacting any sweeping measures.

Even as such, the lower estimates more than cover the $52 million California budgeted for 2017-2018 to establish and run the marijuana licensing system. The $643 million also does not include local sales taxes or state license fees. It costs businesses $1,000 for a license to sell cannabis. The fees are set to cover all costs associated with permits, including background checks, and resources necessary for processing and issuing.Marijuana taxes are earmarked to fund job programs designed to curb environmental effects of illegal growers, youth prevention and treatment resources, help for communities most affected by the war on drugs, programs to prevent driving under the influence, and grants for job placement, substance-use disorder treatment, and mental health initiatives, among other causes. Each year, $15 million is also supposed to go to studies on the impact of marijuana by California Highway Patrol and universities.

Some say the sizable taxes are harmful to users and cannabis businesses. They warn that the current tax structure puts such an intense burden on these groups that black market growers and sellers will continue to thrive. The California Growers Association is advocating to drop the retail sales excise tax from 15% to 5% and amending the cultivation tax. It is also pushing for a ballot initiative for cannabis tax reform in 2018.

At the very least, the California Legislative Analyst’s Office must review and make a recommendation by 2020 as to whether the tax rate should change under the rules of Proposition 64.

While some argue that a reduction in excise tax will lead to less funding for all the beneficial programs in place, it’s possible a lower tax will encourage more businesses to operate above board. The state would therefore collect from those who previously were operating illegally. It also could lead to more customers, who might find the current price point of marijuana prohibitive to purchasing consistently. The additional sales tax from these users could potentially help make up the difference in lower taxes.

Others want to keep user costs high enough that minors are not able to easily acquire marijuana.

Regardless of the tax rate, our Los Angeles marijuana business attorneys know the best way to run a cannabis business is legally. It may be tempting to cut corners, but as regulations and enforcement strategies become more solidified, illegal operations will have fewer places to hide. Our knowledgeable attorneys will help you get a business plan in place that will keep you in compliance with state and local laws and protect you in the long run.

The Los Angeles CANNABIS LAW Group represents growers, dispensaries, collectives, patients, defendants, workers and those facing criminal marijuana charges. Call us at 949-375-4734.

Additional Resources:

California Could See a $643-Million Marijuana Tax Haul in First Full Year of Legalization, Gov. Jerry Brown Says, Jan. 10, 2018, By Patrick McGreevy, Los Angeles Times

More Blog Entries:

Tax Rate Fears Worry Some in Cannabis Industry, Nov. 22, 2017, Los Angeles Marijuana Business Attorneys Blog

Different Types of Cannabis Taxes

• The Medicinal and Adult Use Cannabis Regulation and Safety Act (“MAUCRSA”) imposes a cultivation tax upon cannabis growers, which is codified in the California Revenue and Taxation Code §34012. This tax is collected on the first sale or transfer of cannabis by the cultivator to the manufacturer. It is therefore the first tax assessed after marijuana is harvested and enters the commercial market.
• Like any other retail sale, cannabis sales in California are subject to an excise tax on the average market price of the product. This is currently set at fifteen percent by the MAUCRSA at the California Revenue and Taxation Code §34011. It is important to note that this percentage is subject to change. The average market price is also a volatile metric which can be determined either by the State Board of Equalization or the California Department of Tax and Fee Administration.
• The MAUCRSA specifically protects the rights of cities and counties to assess other taxes in addition to the state excise tax. California Revenue and Taxation Code §34021.5. While these entities may choose not to do so, business owners are wise to prepare for additional taxes, as it seems unlikely that any government entity would forego an obvious source of revenue.

Medical Marijuana Businesses According to the State of California Franchise Tax Board, medical cannabis businesses should operate as nonprofit cooperatives or collectives in order to comply with the current state of the law. These businesses do not qualify for income tax exemption under the Internal Revenue Code, nor under the California Revenue and Taxation Code. Though medical marijuana businesses can officially organize as a nonprofit mutual benefit corporation or nonprofit mutual benefit cooperative, this still does not grant them tax-exempt status. Regardless of the business entity type, such businesses must file appropriate tax returns. However: despite the fact that medical marijuana businesses are not officially tax-exempt, Proposition 64 did exempt sales of medical cannabis, medical cannabis concentrate, and edible or topical medical cannabis products from sales and use taxes. According to the California Board of Equalization, qualified patients must present their medical marijuana card and government identification at the time of purchase. The medical marijuana retailer does not collect sales tax on the transaction. Retailers should also claim the deduction on their sales and use tax returns and maintain the proper records to document all exempt transactions. California’s imminent sales of recreational marijuana can bring all sorts of business opportunities for the entrepreneurs who are prepared to access them. An experienced cannabis business lawyer can help cannabis entrepreneurs access capital, develop tax strategies, and build a profitable business from the ground up. The Los Angeles Cannabis Law Group represents growers, dispensaries, collectives, patients and those facing marijuana charges. Call us at 949-375-4734. Additional Resources: California’s New Marijuana Taxes – An Overview, August 23, 2017 by Jim Hunt, Bloomberg Bureau of National Affairs More Blog Entries: Cash Demanded for California Marijuana Dispensary Taxes, February 24, 2016, by Cannabis Law Group