Taxation of cannabis businesses in the US: the do’s and don’ts

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While a number of US states have legalized marijuana and cannabis based products for medical and/or recreational use, the US federal tax rules take a harsh perspective on the deductibility of certain expenses associated with the cannabis businesses.

A number of cases ruled on in late 2018 have provided additional guidance.  We will discuss a brief background to the law as well as provide some “do’s” and “don’ts” to make sure that after tax profits of an operator or an investor in a US cannabis business do not go “up in smoke”.

Background

In 1970, the Controlled Substances Act (“CSA”) was signed into law by President Nixon[1].  Marijuana, or cannabis, was listed as a Schedule I Substance which had the “highest potential for abuse and no accredited medical use.[2]

In 1982, the Reagan Administration enacted Section 280E of the Internal Revenue Code in response to a Tax Court case where a drug dealer was allowed to deduct the expenses associated with his illegal activities to mitigate his tax liability[3].

Section 280E disallowed deductions or credits for amounts paid in the trade or business of trafficking in controlled substances within the meaning of Schedule I and II of the CSA (e.g. cannabis).  Though deductions are generally disallowed, the cost of goods sold may still be deducted.

Regulations have not been issued to specifically delineate deduction guidelines.  Therefore, those engaged in a US cannabis business must rely on the guidance provided in a number of court cases.

The sale of cannabis in some form has now been legalized in 33 states and the District of Columbia, although it remains illegal under federal law.

The US legal (from a state perspective) cannabis market had reached almost USD $10 billion in retail sales in 2017, the last year which statistics are available.  It is expected that the legal (again, state-wise) market will reach $24.5 billion by 2021[4].

Tax “Do” and “Don’t” List for a US Cannabis Business

Do: To the extent that other services such as caregiving, legal services, etc. are provided, careful accounting must be done to separate costs associated with the sale of cannabis is segregated from other costs.  In a case where a taxpayer was able to deduct 90% of its expenses, these processes were followed[5].

Don’t: Maintain sloppy or no records.  Also, do not treat the sale of cannabis and other “businesses” as a single trade or business[6].

Do: Consider separate management and employee payroll for the cannabis sale business and other businesses.  It can buttress the deductibility and other business under the “separate line of business” approach.

Don’t: Use the same management and employees for both businesses as it can blur the separation of the separate business and result in a disallowance of deductibility for both.

Do: Charge separately for otherwise bundled services and goods.

Don’t: Provide additional goods and services at no additional costs.  In the recent Harborside case, one of the largest medical dispensaries in California, the taxpayer provided patient services, community outreach and therapeutic sessions such a yoga and tai chi for no additional costs.  As well, it sold apparel and other branded souvenirs promoting the Harborside brand[7].

In its ruling, the court rules that Harborside’s branding activities were part of a “unified business enterprise” with its cannabis selling activities.  As well, other services provided were incidental to the sale of cannabis related products.  Therefore, it denied almost 99% of Harborside’s deductions[8].

Do: Use a C corporation to conduct US business.

Don’t: Use a flow through like an S corporation, LLC or partnership.  A flow-through could result in a disallowance at the entity level and an inclusion at the owner level resulting in a “double jeopardy” result especially where the flow through pays the owner.

Do: Use separate corporations for cannabis and non-cannabis operations.

Don’t: Assume that a separate management company for running the cannabis business will provide a workaround for deducting expenses.  A very recent case held that where the management company’s employees were engaged in the purchase and sale of marijuana, even where it did not assume title to the product, the costs of the management company were not deductible[9].

Have questions? For more information reach out to Zeifmans’ US tax partner, Stanley Abraham , or a member of our cannabis team.

[1] Pub. L. No. 91-513

[2] 21 USC §812 (b)(1)

[3] Edmonson v. Commissioner; T.C. Memo 1981-623

[4] Study by Arcview Market Research, in partnership with BDS Analytics

[5] Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173 (2007)

[6] See Olive v. Commissioner, 139 T.C. 19, aff’d 792 F. 3rd 1146 (9th Cir. 2015 and Alterman v. Commissioner, T.C. Memo 2018-53

[7] Patients mvt. Assistance Collective v. Commissioner, 151 T.C. No. 11 (Nov. 29, 2018)

[8] Id

[9] Alternative Health Care Advocates v. Commissioner: 151 T.C. No. 13 (Dec. 20, 2018)