Will rescheduling cannabis help state legal dispensaries with their taxes? Probably not anytime soon

On October 6, 2022, President Biden issued a marijuana reform statement which outlined three steps to overcoming what he described as a “failed approach” to enforcing marijuana laws that has resulted in black and brown people being arrested, prosecuted and convicted at rates disproportionate to their white counterparts. The third step is interesting for the accounting and tax industry. The President asked the Secretary of Health and Human Services and the Attorney General to “initiate the administrative process to expeditiously review how marijuana is enshrined in federal law.” Marijuana is currently listed as a Schedule I substance under the Controlled Substances Act (passed in 1970), which organizes narcotic substances into five “schedules”. Schedule I includes not only marijuana, but also ecstasy, heroin, LSD and peyote. Schedule II includes methamphetamine, cocaine, fentanyl, oxycodone and Adderall. But what does drug planning and marijuana planning specifically have to do with taxes?

In 1982, Congress enacted Section 280E of the Internal Revenue Code. IRC § 280E states that drug dealers (including marijuana dispensaries in states where marijuana has been legalized at the state level) cannot deduct business expenses related to business income from trafficking Schedule I or Schedule II controlled substances. To date, 41 States (and the District of Columbia and Puerto Rico) have legal medical marijuana and 23 of them have either decriminalized cannabis use or legalized recreational marijuana use.

Since its enactment, attempts to circumvent IRC § 280E using accounting methods have been legion, as have the court cases surrounding them. Two of the most significant decisions were the Californians Helping to Alleviate Medical Problems (or CHAMP) case in 2007 and the more recent Harborside decision (2019).

The CHAMP decision stated that cost of goods sold (or COGS) could not be disallowed as a business deduction. Nonetheless, he always agreed that § 280E applied to state-legal medical marijuana businesses. According to Nick Richards, partner and co-chairman of the Cannabis Group at Greenspoon Marder, LLP, the decision for the most part simply “reiterated legislative history.” Specifically, he reiterated that “deductions are a matter of legislative grace,” a well-used point of tax law established in Welch versus Helvering in 1933. Commercial taxpayers must prove their right to any deduction. Jennifer Benda, tax attorney, former CPA, cannabis tax specialist and partner at Holland & Hart LLP, says that “While CHAMP seemed important at the time, the problem with applying it in the future has been that the facts were unique and not usually reproduced.” Bender goes on to note that “CHAMP has had limited benefits for the industry” and that it “[hasn’t] I’ve seen any situation where CHAMP has helped a state-legal marijuana company reduce their taxes. According to Richards, this is exactly the intention of the federal government. “Section 280E is the government’s war on drugs. Richards notes that § 280E was created during the Reagan administration specifically to prevent legalization by removing the economic benefits of legal state pharmaceutical companies. The continued emphasis on deductions being a matter of legislative grace means that in all cases where § 280E applies, even legal state enterprises will be denied their business deductions. Nevertheless, enterprising cannabis accountants and lawyers have recognized that the allocation of a deduction for COGS in the CHAMP decision meant that the more indirect expenses that could potentially be attributed to COGS, the better. Profits (and associated income taxes) would be reduced. In the years following the CHAMPS decision, this strategy has become increasingly common for legal marijuana businesses. Enter the Harborside Health Center.

According to Benda, “Harborside was the first case to really address how inventory rules apply when § 280E applies.” On November 29, 2018, the US Tax Court ruled in favor of the IRS in Harborside Health Center c. CIR. The United States Court of Appeals for the Ninth Circuit upheld the decision in 2019 based on the idea of ​​”legislative grace”. The Harborside decision essentially ended the practice of assigning a portion of the indirect expenses of a state-legal cannabis business to COGS. It also ended many legal marijuana businesses.

Nick Richards’ company represented Harborside in its appeal to the Ninth Circuit. Harborside had so much tax to pay as a result of the ruling that they cannot pay it back before the 10-year collection law expires. They are currently in a collection agreement with the IRS known as a “Partial Payment Agreement” (PPIA). According to Richards, Harborside “will eventually resolve some of its liability after 10 years.” This means that part of the debt will be paid and the IRS will write off part of it as outlawed. During the collection period, however, the IRS will continue to review Harborside’s ability to pay the outstanding debt and “if the IRS sees that it can pay more, it will demand [Harborside] pay more. »

The reality is that the Harborside decision created “giant” tax liabilities for state-legal cannabis businesses — in the range of $40 million to $50 million according to Richards. Benda observed that as the pandemic waned, many state-legal marijuana businesses experienced flattening. [of revenue] and some saw a contraction. She also notes that they face competition from the hemp industry, which has started producing derivative products that compete with cannabis. Meanwhile, according to Benda, “the industry’s effective tax rates continue to be ridiculously high.”

Richards thinks “the real dynamic is the debt caused by § 280E.” These debts can be bad for a big business, but they can be absolutely debilitating for a small business, especially small flow-through entities (STEs) such as LLCs that are taxed like partnerships. When these businesses are subject to an IRS § 280E audit, any tax liability incurred is now the personal liability of the partners. Any spouse who files jointly with a partner in a cannabis business is jointly and severally liable for this debt. This means that if the spouse who incurred this debt cannot pay, the spouse who did not incur it may still be liable for all of it (and any applicable penalties and interest). The IRS can file a notice of federal tax lien against a partner’s home until the debt is settled. Richards notes that organizing as a C corporation (having Inc. not LLC, after the company name) will solve the personal liability problem, but he also says that “unless you are aware of the problem, you think you are protected”. [by the LLC]. Even folks in the industry, if you’re not a familiar business owner, you don’t necessarily know about § 280E. IRS debts incurred as a result of adverse § 280E audits have, according to Richards, “been the downfall of many cannabis owners over the years.” Also, because the IRS is like offers in compromise (ICOs), where a taxpayer only settles their case for a portion of the debt owed (or “dimes on the dollar” if the ads are to be believed on the radio), represents an “end revolve around § 280E”, they will not allow cannabis businesses to enter into an ICO if they are still in operation. This leaves owners of state-legal marijuana businesses who find themselves with a significant tax debt in front of a difficult decision: to pay or to cease their activities in order to be able to apply for an ICO.

Benda believes that the question of what can be included in the inventory or COGS is “is the fiscal problem facing the industry. The decision did “reduce the scope of costs that can be included in inventory and COGS, especially for resellers.” She also feels that “there are issues with the Harborside decision that should be challenged.” Richards’ company raised such an issue in its appeal. The problem is that § 280E creates “phantom income” which may not be income under the 16e Amendment. That creates a lot of phantom revenue — up to $500,000 at a “standard mom and pop dispensary” according to Richards. In a traditional business, gross income is reduced by expenses to arrive at net profit and net profit is taxed as income. In a cannabis business, however, so many expenses are disallowed under § 280E that the company’s profit is much larger on its tax return than it actually is. Is this fictitious income really income under 16?e Amendment? No one knows because to date the issue has not been argued; § 280E cases have always boiled down to the “legislative pardon” argument.

Meanwhile, the Harborside ruling has also increased the likelihood that the IRS will audit marijuana businesses specifically to prohibit spending under Section 280E, as the law is now clearly on their side. Fighting the adverse outcome of a § 280E audit is costly, unlikely to result in a favorable outcome, and is not deductible to the business as legal fees. Which brings us back to President Biden’s request for a review of how marijuana is enshrined in federal law.

If marijuana were to be carried over to Schedule III (or IV or V), state-legal marijuana businesses would be allowed to deduct COGS and direct and indirect business expenses. This would result in lower federal income tax for new cannabis businesses, but existing businesses could still be audited during years in which cannabis was subject to Section 280E and all existing audits would remain in effect. . Still, Benda thinks that if marijuana were to be postponed, or even de-scheduled, it could lead to the IRS settling more cases rather than taking them to court. “However, I don’t think the IRS will stop pursuing § 280E cases because there is still a sense that the industry has not fully complied with § 280E, and in the eyes of the IRS, that means there is revenue to be collected.” Moving from Schedule I to Schedule II would not affect § 280E but would put marijuana “trafficking” in the hands of big pharma. scary,” according to Richards, who notes that such an outcome could make it difficult for the cottage marijuana industry to survive.

So while it seems like the president’s statement is a step in the right direction in terms of marijuana reform, it’s certainly a small step in terms of legalizing (and taxing) the marijuana trade. marijuana. The rescheduling process could take years, and in the meantime, § 280E audits and their consequences will continue to pile up for state-legal cannabis businesses large and small.

About Charles D. Goolsby

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