By Darren Smith, Weekend Contributor
Washington marijuana businesses are becoming financially tenuous in large part due to the imposition of heavy taxation. The matter has been further compounded beyond simply an unsustainable state excise tax of twenty five percent levied at all stages of the supply chain (marijuana producers, processors, and retailers) but a federal tax code that prevents the excise tax and conventional business expenses from being deducted from federal income taxes. This is due to a prohibition specifically applicable to marijuana. The accounting effect of this means marijuana businesses must also pay federal tax on what the business pays in state taxes.
Marijuana retailers have stated in interviews this double taxation alone swallows much of their profits. It shows another formidable challenge to the survivability of the licensed cannabis industry in Washington..
The applicable section of the tax code reads:
26 U.S. Code § 280E – Expenditures in connection with the illegal sale of drugs
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
Marijuana is a Schedule I drug for the purpose of federal law.
The seeds of today’s state legal cannabis industry trouble germinated in 1982 when Congress passed legislation resulting in § 280E. The impetus for this change to the tax code stemmed from a reaction to a case where a Minneapolis drug dealer named Jeffrey Edmonson deducted expenses on his tax return related to sales of cocaine, amphetamine, and marijuana. The disputed expenses, among other items and claims, included rent expense, scales, packaging costs, travel, and telephone costs.
In 1981 A U.S. Tax Court ruled in Edmonson v. Commissioner that these constituted “an ordinary and necessary expense of petitioner’s trade or business and is to be allowed as a deduction.”
Congress, after the Tax Court’s ruling, sought to further restrict the illicit drug industry by applying additional financial pressure by enacting § 280E. At the time, of course, marijuana was illegal on both the federal and state levels for general business purposes. Now with the introduction of legalized recreational marijuana industries in two states and several others pending the section is likely outdated but nevertheless in force.
A partial mitigation to this prohibition by 280E on deductions against marijuana sales revenue would be to classify certain expenses as “Cost of Goods Sold”. These are costs for a business related to material and labor to produce products or the wholesale price of goods to a retailer. These are considered an adjustment rather than a deduction and therefore do not fall under the purview of 280E.
For a marijuana producer/grower COGS encompasses many costs because most of these are directly related to production. Some include the following: electricity for grow lamps; seeds; hydroponic supplies; labor relating to cultivation; etc. Retailers on the other hand can only use the Cost of Goods Sold adjustment for wholesale costs of marijuana and not for expenses for sales employees, utilities, rent and the like relating to their business operation.
The net result of the lack of deductibility of the state marijuana excise tax means effectively that the twenty five percent tax levied on the sale price becomes part of the complete lack of deductibility on business costs generally–effectively adding a tax upon a tax.
The confiscatory nature of the two tax systems is crushing businesses who otherwise have high sales numbers.
Cannabis City, the first marijuana retailer in Seattle, has the third highest sales volume in the state at just over two and a half million dollars in gross sales since the beginning of July. It is “struggling to stay alive” according to store owner James Lathrop.
James stated that in order to just cover his expenses and tax obligations, he would have to sell marijuana at three times the wholesale price. “To actually make it work you have to put it on the shelf at $36 per gram,” he said during a recent interview “We’re just taking a hit to pay those taxes and keeping the doors open.” Menu prices for their products are about $22 per gram. For reference, the black market price is about $10 per gram.
According to State Liquor Control Board records, Cannabis City claimed $2,524,685 in total sales and therefore owes $631,171 in Marijuana Excise Tax. The IRS will consider the dollar amount of excise tax paid as income. If the business pays thirty to forty percent tax rate the federal tax on this is $189,351.30 and $252,468.40 respectively. The latter amounts to ten percent of the total gross sales, an amount often considered a good profit margin for numerous retail entities. But that is only the tax on the excise tax. It is not the full tax liability which includes the federal income tax on the sales revenue without nearly all the deductions for operating costs that would be provided a regular business. Again, cost of goods sold appears to be one of the few significant reductions for tax liability.
Dean Guske, an accountant who represents one hundred fifty clients in the cannabis industry, sees the state marijuana excise tax as a significant challenge to the industry. In an interview with Crosscut, he stated:
“I would say that the biggest problem right now under 502 is the current structure of the excise tax,” he said, referring to Initiative 502, the ballot measure that voters approved in 2012 legalizing recreational marijuana in Washington. “It’s making it extremely difficult for retailers in particular to really be profitable.”
The tax problems endemic to the cannabis industry are at least, allegedly, being addressed by members of the Washington State Legislature.
State Sen. Ann Rivers of La Center along with Brian Hatfield of Raymond stated they are working together on legislation that would change the state’s marijuana excise tax to that of a Business and Occupation Tax which would allow these businesses to write off the amount as an expense against their federal taxable income.
B&O taxes, along with Sales Taxes, are collected under different accounting rules than excise taxes. They are not considered income because according to the Internal Revenue Code a business is effectively holding the money on behalf of the state whereupon it is then transferred to state revenue departments. But in the case of the marijuana excise tax the IRS sees this as part of the sales price and therefore it is considered revenue.
The hope is that for at least the state level, some progress can be made simply by changing the regulation of the excise tax’ nomenclature but there is no guarantee such legislation will pass, especially when the legislature is busy with addressing an unfunded school classroom size initiative that could cost the state a billion dollars to implement and a ruling by the State Supreme Court holding the legislature in contempt for failing to fund education.
Congress on the other hand has not shown any substantial progress in assisting the fledgling cannabis industry through the passage of basic legislation to enable the industry to operate legally and profitably. The removal of Section 280E from the Tax code, one simple paragraph, will make a polar change for the industry on a national scale as far as the tax code is concerned. But the will of politicians to make this happen is not something to risk relying on for investment in the industry to fully commence.
By Darren Smith
Sources:
Crosscut.com
Edmonson v. Commissioner via Leagle.com
Cannabis City
Washington State Senate (Photo Credit)
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Most people are unaware that the IRS is constitutionally prohibited from disallowing costs of goods sold. The definition of income which can be taxed under the 16th Amendment is gross receipts minus costs of goods sold. Deductions from income, however, enjoy no such constitutional “protection.” Hence the legality of section 280E.
As someone who regularly arm wrestles with IRS, I’ve seen the effect of section 280E on a client or two. But I predict change will come in the not too distant future. There are serious business people out there in this industry. For an example, with which I have no affiliation, check out the MCFM Group.
Agreed Ross; AND the People.
Olly: I clarified it exactly in the previous posting, the Jim Crow interpretation was wrong because states violated the rights of African-Americans and minority groups.
James Madison wanted every branch and level of government to uphold their oath of office to the U.S. Constitution. Today the federal government is an equal opportunity violator of our rights as the local and state governments.
Judges/justices are supposed to check the federal executive branch but have abdicated that duty, only the state attorneys general are left to provide judicial review.
So we now want to encourage people to get high on MJ? But discourage cigarette smoking?
Yep, makes sense to me.
Speaking of the Tenth Amendment:
“James Madison, writing in Federalist #46, said that such a “refusal to cooperate with officers of the Union” would create effective roadblocks to stop implementation of federal acts.”
http://blog.tenthamendmentcenter.com/2014/12/nullification-in-practice-new-south-carolina-bill-would-gut-obamacare-in-the-state/
There is a political issue for each state’s voters to decide. The constitutional issue is can a state decide for themselves as long as they don’t violate another citizen’s constitutional rights. Does the federal government have any jurisdiction at all on this issue under the U.S. Constitution?
David,
Taxing heavily and taxing properly is the issue. No one who was in favor of legalizing marijuana and taxing it wants to tax it “heavily”. It should be taxed as any other business product. The real problem is getting the Feds on board with the states who are legalizing it.
This case presents a very interesting constitutional debate about the proper interpretation of the 10th Amendment and the Supremacy Clause.
During the Jim Crow era the 10th Amendment was wrongly interpreted by state governments to allow violations of other constitutional rights of African-Americans and other minorities. Since the states violated those rights it was perfectly proper for the federal government to “check” the state and local governments. Due to this exploitation of the 10th Amendment by the Jim Crow states, most constitutional attorneys shy away from 10th Amendment challenges altogether until now.
The case above may provide a challenge to correct the interpretation of the 10th Amendment. In this case it is not being used to violate other rights by the state and local governments, so does a state have jurisdiction on this issue?
Put another way, all government officials/contractors (federal, state, local) take the very same loyalty oath as a condition of holding authority – to uphold the U.S. Constitution. If a state or local official betrays that oath the federal government is required to “check” the state and local government. If federal officials betray that oath (post 9/11), it is the duty of state and local officials to check the federal government.
If you read the Supremacy Clause as written [Article VI] that would seem to meet both the letter & spirit of the U.S. Constitution.
Add to this that the feds are making it impossible for pot growers to bank their money or get loans and you can see that they are trying to legally put them out of business.
This story reminded me of a terrific article titled: “Effects of the Affordable Care Act on Economic Productivity”. Here is a sample:
“Tax distortions are changes in behavior on the part of businesses or households for the purpose of reducing their taxes or increasing their subsidies. We call them distortions because they don’t occur for real business or real personal reasons. They occur because of the tax code.”
http://imprimis.hillsdale.edu/file/archives/pdf/2014_11_Imprimis.pdf
So what you’re saying is that these businesses might perform better with lower taxes and less regulation. Who’d a thunk it?
Good piece. The govt. routinely shows an uncanny ability to screw up a wet dream. Cannabis should be taxed EXACTLY the same as liquor.
When you tax something that is legal to prohibitive levels, the sale of the commodity will go underground…..in the illegal black market. This creates opportunities for more crime and then needs to be policed at even higher levels.
The case of Eric Garner is a prime example. Whether you like marijuana use or cigarette use, they are legal. Well, marijuana in some areas. They taxed cigarettes to such a high level that it was profitable for the seller to sell them illegally on the street corner by the each. Loosies instead of a package over the retail counter. It was affordable for the buyer as well. People will make the logical choice to buy at a reduced price…..especially when it is an addictive substance that they need and they are already at limited income levels. Selling individual untaxed cigarettes is/was illegal and we all know the end result of this chain of reactions.
Now that the government is trying to tax the “legal” marijuana retailers out of business, We will see an even higher participation in illegal market for pot. Rising crime and a rise in police activity to suppress the crime.
Why is it that our moronic political hacks can never see the end result of their actions?
Paul said it shorter. 🙂
“Leading scientists have determined marijuana grow fields reduce the negative affect of greenhouse gas emissions on global climate.”
Find ‘those’ scientists and before long your industry will be heavily subsidized by the federal government. Problem solved.
To justify the use of pot just helps the pushers
All the legal distributors have become is drug dealers for the government. To Justify the sale of pot just helps the pushers.
Bad tax policy creates illegal behavior. Why do we put up with this? So much for freedom loving Americans. I sure hope we can put that fallacy to rest.
The economist in me thought about the stupidity of the criminal element, who could be charging nearly double and still undercut the legal market. Even factoring the price premium for losses due to law enforcement, they still make out like…bandits.
This is a good case study for the problems of the regulatory government and why there needs to be drastic change to how business are regulated in this country.
Good analysis – few of your readers understood the harsh economics.
Like the NY cigarette taxes – these punitive taxes support the underground (read criminal) enterprises.
How often we heard that marijuana should be legalized so we can tax it heavily. Now when the rubber meets the road, we find out how unrealistic that assertion was. Tax deductions are meant to encourage certain behavior. So now we want the federal government not only to allow marijuana trade, but to encourage it through tax deductions. Interesting.