The recent Tax Court decision in Northern California Small Business Assistants Inc. v. Commissioner [“Nor Cal”] made what is perhaps the most damning statement  yet regarding the application of IRC Sec. 280E to cannabis dispensaries. The Court stated:
“Our precedent is unambiguous. Congress, rather than this Court, is the proper body to redress the petitioner’s grievances. We are constrained by the law, and Congress has not carved out an exception in IRC Sec.280E for businesses that operate lawfully under State law.
Until then, the petitioner is not entitled to deduct expenses incurred in the operation of its drug-related business.”
In reaching our holding, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit.”
The Court in Nor Cal followed the Tax Court precedential analysis by Judge Mark V. Holmes in his opinion in the first Harborside case.
The first Harborside case rejected the manner in which the two dispensaries determined Cost of Goods Sold (“COGS”). Judge Holmes agreed with the Chief Counsel Memorandum that IRC Sec. 471 should be used by a cannabis dispensary to determine COGS. The opinion in Harborside rejected the use of IRC Sec. 263A and approved the use of IRC Sec. 471 in the determination of COGS.
The situation becomes particularly grim for California dispensaries beginning after 2017. California’s Bureau of Cannabis Control adopted regulations beginning in 2018 that require Retailers to purchase cannabis that has been tested, packaged, and labeled by a Distributor. The adoption of these regulations renders virtually all adjustments to COGS by a dispensary improper.
A California cannabis dispensary can mitigate against a significant portion of the adverse impact of the Harborside and Nor Cal opinions. These opinions create an opportunity for a cannabis dispensary to exclude from gross revenue a substantial portion of the money collected from cannabis consumers. Through the adoption of proper record-keeping systems and procedures, a dispensary can treat all of the money it collects for taxes that are not included in COGS as taxes imposed on consumers, or as reimbursements for taxes paid or payable by the dispensary, that must be remitted to various governmental agencies.
A dispensary will collect state-level Cannabis Excise Tax [“CET”], California Sales Tax, and it may collect any of a variety of municipal and county sales taxes, excise taxes, and gross receipts taxes. These funds are money that a dispensary is obligated to remit to various governmental agencies.
As a consequence of the Harborside and Nor Cal opinions, it is critical for a dispensary to not allow these funds [“Reimbursable Taxes”] to be included in gross revenue. If Reimbursable Taxes are properly identified and consistently segregated using an escrow account [“Reimbursable Tax Escrow”], all taxing agencies should recognize these taxes are properly excluded from gross revenue.
The taxes included in the money a dispensary will collect from retail customers can be classified into five categories as follows:
(1) income taxes which will be paid by the dispensary out of income;
(2) CCT which will be paid to a distributor by the dispensary as part of COGS;
(3) local taxes on cannabis that may be comparable to the preceding classification (2) or comparable to either of the two classifications (4) and (5) that follow;
(4) CET which is an excise tax that a dispensary is required to collect from a cannabis consumer that has some aspects of being money held in trust by virtue of the requirement that collections of CET in excess of the amounts actually paid by a dispensary to distributors are owed to California under the language of the statute; and
(5) Sales Tax collections which are more specifically money that constitute a trust fund in the hands of the retail seller that is collected as an agent for California and for which there is personal liability for a failure to remit.
We believe that the taxes identified in (1) and (2) above cannot be excluded from gross revenue. However, the taxes identified in (3), (4), and (5) may be excluded from gross revenue by a dispensary if:
Each of the taxes is separately stated and identified on sales receipts that the dispensary provides to its retail customers; and
The dispensary creates and maintains separate Reimbursable Tax Escrow trust account as well as complete and accurate records of each type of tax collected, deposited into the account, and remitted from the account, and performs a reconciliation for the trust account and the various Reimbursable Taxes each time the dispensary prepares a tax return and remits tax to a governmental agency.
While this issue is not entirely free from doubt, a dispensary that carefully maintains and utilizes a separate trust account, and minimizes transfers into and out of such an account, has a high probability the segregation of these funds as well as the exclusion of these funds from gross revenue will be respected.
 The taxpayer also argued in this case that IRC Sec. 280E solely applies to IRC. Sec. 162 deductions. The taxpayer argued that the text of IRC Sec. 280E “tracks” the language of IRC Sec. 162 which allows a deduction for all ordinary and necessary business expenses. The taxpayer argued the use of the same language indicated the prohibition of IRC Sec. 280E should solely apply to IRC Sec. 162 deductions. Judge Goeke points out the taxpayer’s argument ignored the first line of IRC Sec. 280E which states, “No deduction or credit shall be allowed . . . .” (Emphasis added.) The Court states the language of this section is clear and unequivocal.
Judge Goeke also points to a broader statutory scheme as support for the conclusion IRC Sec. 280E means what it says – no deductions under any section shall be allowed for businesses that traffic in a controlled substance. As the Court points out, IRC Sec. 261 which is found in part IX of subchapter B of Chapter 1 of the Code, provides that “no deduction shall, in any case, be allowed in respect of the items specified in this part.” IRC Sec. 280E is found in part IX
 The tax year 2015 is significant for two reasons. The Tax Court’s decision in Olive v. Commissioner, 139 TC 19, 36-42 (2012) aff’d 792 f.3d 1146 [CA-9, 2015] was the first reviewed decision that discussed the phrase “consists of” in IRC Sec. 280E. Olive was not affirmed by the 9th Circuit until 2015. Chief Counsel Memorandum 201504011 was issued in 2015. This Memorandum provided the first guidance from the IRS relating to IRC Sec. 280E. The IRS has never promulgated regulations relating to IRC Sec. 280E. A taxpayer that fails to utilize IRC Sec. 471 post-2015 is almost certainly subject to the “substantial understatement” penalty contained in IRC Secs. 6662, and potentially the civil fraud penalty in IRC Sec. 6663.
 See § 5412. Prohibition on Packaging and Labeling by a Retailer.
A licensed retailer shall not accept, possess, or sell cannabis goods that are not packaged as they will be sold at final sale, in compliance with this division.
A licensed retailer shall not package or label cannabis goods.
Notwithstanding subsection (b) of this section, a licensed retailer may place a barcode or similar sticker on the packaging of cannabis goods to be used in inventory tracking. A barcode or similar sticker placed on the packaging of a cannabis goods shall not obscure any labels required by the Act or this division.
Authority: Section 26013, Business and Professions Code. Reference: Section 26120, Business and Professions Code. and
5303. Packaging, Labeling, and Rolling.
A licensed distributor may package, re-package, label, and re-label cannabis, including pre- rolls, for retail sale. All packages of cannabis, including pre-rolls, shall comply with the following:
Until January 1, 2020, all packages shall meet the following requirements:
The package shall protect the cannabis, including pre-rolls, from contamination and shall not expose the cannabis or pre-rolls to any harmful substance.
The package shall be tamper-evident.
If the package of cannabis or pre-rolls contains more than one serving, then the packaging shall be resealable.
The package shall not imitate any package used for goods that are typically marketed to children.
Beginning January 1, 2020, all packages shall meet the requirements of subsection (a)(1) of this section and shall also meet the following requirements:
The package shall be child-resistant until the package is first opened. For purposes of this division, the following packages are considered child-resistant:
Any package that has been certified as child-resistant under the requirements of the Poison Prevention Packaging Act of 1970 Regulations (16 C.F.R. §1700.15(b)(1)) (Rev. July 1995), which is hereby incorporated by reference.
Plastic packaging that is at least 4 mils thick and heat-sealed without an easy-open tab, dimple, corner, or flap.
The package shall be labeled with the statement “This package is not child-resistant after opening.”
Notwithstanding subsections (a)(1)-(a)(2) of this section, immature plants and seeds shall not be required to be packaged in child-resistant, tamper-evident, and resealable packaging.
A licensed distributor shall not process cannabis but may roll pre-rolls that consist exclusively of any combination of flower, shake, leaf, or kief. Pre-rolls shall be rolled prior to regulatory compliance testing.
Licensed distributors may label and re-label a package containing manufactured cannabis goods with the amount of cannabinoids and terpenoids based on regulatory compliance testing results.
Authority: Section 26013, Business and Professions Code. Reference: Sections 26013 and 26120, Business and Professions Code.
 The common practice for California dispensaries prior to the Harborside decision was to purchase flower in bulk, and then process and package, label, and possibly test the flower in-house. With proper substantiation, the opinion in Harborside permits a dispensary to utilize IRC Sec. 471 to increase COGS for both the direct and indirect costs properly allocable to the handling, processing, packaging, and security for the conversion of bulk purchases of cannabis inventory into a retail product.
The Harborsideopinion approves the use of IRC Sec. 471. California’s regulation of its cannabis industry, however, now prohibits a dispensary from processing products for retail sale. A California dispensary must acquire cannabis products from a distributor in a consumer-ready form. Commercial cannabis products must be acquired by a California dispensary fully packaged and labeled. As a consequence of regulatory requirements, effective January 1, 2019, a California dispensary is effectively subject to income tax on Gross Income (Gross Revenue less Cost of Goods Sold [“COGS”] ) for federal income tax purposes.
 A similar set of principles applies to the portion of employment taxes which are withheld from employee paychecks and treated as “trust funds”. A discussion of employment taxes is beyond the scope of this article.
 An escrow account is an account where funds are held in trust for a particular purpose, for example a segregation of funds that were collected for a taxing agency. In formalized escrow arrangements third-party acting as a fiduciary will hold funds in a segregated trust account. Funds are subject to disbursement in accordance with the contractual arrangements for the escrow.
Editors Note: This is republished with approval from A Biz In A Box author Jordan Zoot.
Choosing Cannabis Tax Advisors – is one of the most important decisions that the owners of a legal commercial cannabis business must make. We are consistently disappointed by the lack of consideration owners invest in making their selections and abhor the misformation and in some instances criminal conduct by a small number of “tax advisors”. This piece is NOT about our practice, it’s about the selection process. We readily acknowledge that we are not the only skilled and qualified tax advisors out there, they do exist and our goal is to assist everyone in finding one. We have been very careful to divide the piece into distinct parts, the first part is comprised solely of factual information where the source of information will be hyperlinked, or a citation provided. The second part is going to reflect our opinions on the topic, and we certainly accept that “opinions are like a**holes”, everybody has one. The California Board of Accountancy [“CBA”] maintains a Cannabis Industry Information page on its website which highlights its unique status.
Critical Criteria – FACTUAL INFORMATION
The U.S. Treasury – Internal Revenue Service [“IRS”]
The Internal Revenue Service maintains an extensive structure for the oversight, regulation, supervision, and, and if the required discipline of individuals and firms that are involved with Federal taxes. The oversight is divided into several broad groupings and you need to understand the differences between them. They are:
Office of Professional Responsibility [“OPR”] – OPR’s vision, mission, strategic goals, and objectives support effective tax administration by ensuring all tax practitioners, tax preparers, and other third parties in the tax system adhere to professional standards and follow the law. OPR’s goals include the following: (1) Increase awareness and understanding of Circular 230 and OPR through outreach activities, (2) Apply the principles of due process to the investigation, analysis, enforcement, and litigation of Circular 230 cases and (3) Build, train and motivate a cohesive OPR team.
Return Preparer Office [“RPO”] – is a community of professional tax practitioners working with the IRS to improve tax administration with the strategic goals to register and promote a qualified tax rofessional community,improve the compliance and accuracy of tax returns prepared by tax preparers and engage stakeholders to create an environment that fosters compliance and program improvement
Treasury Inspector General for Tax Administration [“TIGTA”] – audits, investigations, and inspections and evaluations protect and promote the fair administration of the Federal tax system and work to ensure that the Internal Revenue Service (IRS) is properly doing its job. TIGTA reports directly to the Secretary of the Treasury and has oversight and review responsibility that extends to the IRS Office of Chief Counsel, the IRS Oversight Board, and the Taxpayer Advocate Service maintains a highly skilled, proactive, and diverse Inspector General organization dedicated to working in a collaborative environment with key stakeholders to foster and promote fair tax administration. TIGTA reports directly to the Secretary of the Treasury and has oversight and review responsibility that extends to the IRS Office of Chief Counsel, the IRS Oversight Board, and the Taxpayer Advocate Service. A maintains a highly skilled, proactive, and diverse Inspector General organization dedicated to working in a collaborative environment with key stakeholders to foster and promote fair tax administration.
OPR is responsible for the top tier of tax “professionals” – attorneys, certified public accountants and enrolled agents who are subject to the provisions of Circular 230 [“Circ. 230”] – Regulations Governing Practice before the Internal Revenue Service.
Certified Public Accountant [“CPA”] Verification – The tools available to perform that task include cpaverify.org a CPA lookup tool populated by official state regulatory data sent from Boards of Accountancy to a central database. The website represents the first ever single-source national database of licensed ‘ and CPA firms. Determine a CPA or CPA firm’s credentials without having to search each of the 55 Boards of Accountancy website individually. The California Board of Accountancy [“CBA”] licensee search is located here.
Enrolled Agent [“EA”] Verification – An enrolled agent is a person who has earned the privilege of representing taxpayers before the Internal Revenue Service by either passing a three-part comprehensive IRS test covering individual and business tax returns or through experience as a former IRS employee. Enrolled agent status is the highest credential the IRS awards. Individuals who obtain this elite status must adhere to ethical standards and complete 72 hours of continuing education courses every three years. Enrolled agents, like attorneys and certified public accountants (CPAs), have unlimited practice rights. This means they are unrestricted as to which taxpayers they can represent, what types of tax matters they can handle, and which IRS offices they can represent clients before. An Enrolled Agent’s credentials can be verified here.
Return Preparer Verification [make sure you understand how they differ from Circular 230 Practitioners]
Registered Tax Return Preparer [“RTRP”] – Program suspended due to IRS loss in litigation read here.
California Tax Education Council [California Registration Only] – Verify a Tax Return Preparer here [Circ. 230 Practitioner are Exempt]
Annual Filing Season Program [“AFSP”] aims to recognize the efforts of non-credentialed return preparers who aspire to a higher level of professionalism. Those who choose to participate can meet the requirements by obtaining 18 hours of continuing education, including a six-hour federal tax law refresher course with a test. The return preparer must also renew their preparer tax identification number (PTIN) for the upcoming year and consent to adhere to the obligations in Circular 230, Subpart B and section 10.51.
Preparer Tax Identification Number [“PTIN”] – anyone who prepares or assists in preparing federal tax returns for compensation must have a valid 2019 PTIN before preparing returns. All enrolled agents must also have a valid PTIN. The PTIN Directory is located here.
Authorized eFile Provider –the “Authorized IRS e-file Provider” database is a nationwide listing of all businesses which have been accepted to participate in the electronic filing (IRS e-file) program.
Circ. 230 Practitioners are the ONLY group of tax advisors that are permitted to sign extensions of time to file, and represent a taxpayer before the IRS and state tax agencies for the Examination, Appeals and Collection functions Does it make sense to select a tax advisor that isn’t permitted to defend the positions claimed in your tax return, particularly if they prepare the return?
Certified Public Accountants [“CPAs”] are the only tax advisors that may* be permitted to certify financial statements, review or compile financial statements. Enrolled Agents [“EA’s”] are not permitted to provide certification, review or compilations of financial statements. The IRS is prohibited from hiring EA’s as Revenue Agents [the entry-level position for “auditing” tax return unless that possess a CPA Certificate or have completed thirty hours of accounting courses at the college level. The IRS is limited to hiring EA’s that don’t meet the criteria as mail or file clerks.
Enrolled Agents [“EAs”] often state that “EAs are the only federally licensed tax professionals who also have unlimited rights to represent taxpayers before the IRS”. The statement is factually untrue as CPA”s and attorneys have the same rights and obligations when representing taxpayers before the IRS. There are some additional distinctions which need to be made at the state level.
California is one of seven states that requires registration of tax return preparers [Circ. 230 Tax Practitioners are EXEMPT from the requirement. The registration is accomplished through the California Tax Education Council [“CTEC”] and requires continuing tax education and a $5,000 surety bond.
CPA’s may either complete a process known as “reciprocity” and obtain a license in a state other than their state of primary licensure, or they may utilize the procedures developed under the National Association of State Boards of Accountancy [“NASBA”] CPA Mobility Project to obtain a “limited practice privilege“. Once a CPA have completed either of the two steps above they have rights to represent a taxpayer in any location which is the same as an EA.
* – the California Board of Accountancy issues two types of licenses, A and G.
Type A – “Authorized” means the CBA has determined that the CPA completed a minimum of 500 hours of the experience required for licensure in attest work. The 500-hour minimum standard ensures entry-level exposure to attest engagements.
Type G – “Qualified” means that regardless of whether a CPA has met the minimum steps to be authorized to sign reports on attest engagements, they comply with applicable professional standards, which requires the CPA to undertake only those professional services that can be reasonably completed with professional competence, including achieving a level of competence that will assure that the quality of service meets the high level of professionalism required. It is the responsibility of the CPA to evaluate whether their specific education, experience, and judgment are adequate to perform the services being requested. As a result, it important to ask the CPA about their number of years and level of experience, continuing education, and recent peer review, if any.
California CPA’s and CPA Firms that provide attest services are required to undergo a quality control process known as “peer review“.
CPA’s that certify financial statements or provide SSARS-21 attest services for a client are strictly prohibited by “independence rules which can be found under both state accountancy statutes and professional standards from providing bookkeeping or technology services, such as accounting software or POS systems for the same client.
Choosing Cannabis Tax Advisors
Our Recommendations – Opinion
We believe that the optimal combination of tax advisors for a cannabis business would be to have BOTH a CPA with a graduate degree [a Masters in Taxation or “MST”] and a tax attorney with a graduate law degree [an “LLM – Taxation”]. Our rationale for the collaboration of both is detailed in “Legal Cannabis Support – Clarion Call“. You can learn more about the importance of having access to both sets of skills in “CPA Becomes A Cannibal” and “Kovel Accountants Cannabis Industry“
Where your tax advisor went to school is important, and we believe continues to be relevant without regard to the number of years since they graduated. I personally have an undergraduate degree in accountancy from the University of Illinois – Urbana, and an MST from the University of Texas – Austin. Both programs have been ranked no lower than #3 in the United States for the past FORTY years.
Listings of top undergraduate and graduate accountancy and tax programs can found here for undergraduate and here for graduate and LLM – Tax are here.
Experience with a Big 4 Accounting Firm is important. The level of experience is probably of greater importance – the usual progression is Staff Accountant [“Analyst”], Senior Accountant [“Associate”], Manager [“Director”], Senior Manager [“Director”], and Partner [“Managing Director”]. Big 4 experience at the Partner level is the “gold standard” with fewer than one in thirty Big 4 firm hires becoming partners.
Additional Recommendations – Opinion
Professional Memberships are important, with increased value ascribed to participation in the organization’s Technical Committees increasing their value
State Society Membership – provides development of local relationships and is a stepping stone to AICPA Committee appointed membership. CalCPAcan be found here, and the other state societies here.
AICPA Private Companies Practice Section [“PCPS”] for firms – The AICPA’s
Private Companies Practice Section (PCPS) supports CPA firms in the everyday intricacies of running a practice. PCPS partners with firms of all sizes, creating targeted and customizable practice management resources, networking opportunities and is a strong, collective voice within the CPA profession. PCPS provides content designed to sharpen technical proficiency to best practices in firm practice management.
Locate the Firm’s website and explore it, and investigate the firm’s presence on social media. You are welcome to explore our firm’s digital presence here.
We hope this piece provides insight into the process of selecting a professional tax advisor and welcome your comments, you can email us at firstname.lastname@example.org.
Despite the overwhelming majority of Californians being happy with the legal cannabis market, there is still a significant percentage of residents who buy marijuana illegally, due in large part to high taxes on the substance.
A new report from Eaze Insights shows that 84 percent of Californians are “satisfied” with the legal marijuana market, but approximately 20 percent have purchased illegal or illicit marijuana in the past three months. Concerning to regulators and the state’s finances is that 84 percent of that segment of the population is “highly likely to repeat that behavior in the future due to the illicit market having cheaper products and no tax.”
Part of the concern is that although consumers would like to purchase marijuana legally if, given the option, the taxes are a major concern for many consumers. According to the California Department of Tax and Fee Administration, marijuana has a 15 percent excise tax, though recent reports have suggested the state is looking at cutting taxes as a way of driving legal means of consumption.
Approximately 85 percent of Californians have purchased cannabis from “unlicensed sources,” but most of them cited factors such as lower prices and a lack of taxes for the reasons those purchases were made.
Other consumers say they have purchased from illegal marijuana vendors because it’s “hard and time-consuming” to find legal businesses. Approximately 1 in 7 respondents said it was “not easy to identify licensed cannabis businesses.”
Although the picture has been painted with some negative brushes, there are changes that can be made that will positively affect California’s burgeoning weed economy.
If taxes were decreased by 5 percent, that could drive much of the illegal market into the legal market, Eaze notes. The town of Berkley took that initiative early on when it lowered its city tax on cannabis from 10% to 5%.
“A 5% decrease in the overall tax rate in CA could bring twice as many CA consumers to only purchase cannabis from licensed businesses (from 16% to 32%),” Eaze wrote in an email obtained by Green Market Report. “Conversely, a 5% increase in the overall tax rate in CA would drive twice as many CA consumers to only purchase from unlicensed businesses (12% to 23%).”
Use cases in the state include wellness (treating or coping with illnesses such as cancer) and consumers are increasingly becoming more sophisticated in the types of cannabis they consume.
“They care the most about consistent product quality, fair pricing, packaging, safe access and a great customer experience, the same way they care about those things for more traditional consumer products,” the email obtained by GMR said.
New data released by Flowhub finds the price of an eighth of cannabis in U.S. cities can vary by as much as 15 percent after taxes have been applied. Now that cannabis is being regulated by cities and states with complicated tax codes, consumers can pay 20 to 40 percent tax on their purchases.
The cities included in the data were Boston, Denver, Las Vegas, Los Angeles, Portland, San Diego, San Francisco and Seattle—the top eight major urban cannabis markets. In order to determine which city had the highest priced eighth of an ounce of flower, Flowhub started by assuming the price of each eight was $35 and then added on the taxes associated with that location. Prices do not reflect the actual cost of an eighth in those cities.
Most expensive was Seattle, with a cost of $51.49. Seattle was first place in price on the list because it also has the highest tax rate at 37 percent.
Second place Los Angeles came in at $48.48. The 35 percent taxes include excise, sales, and business-REC taxes. Taxes in California are calculated against the subtotal and applied taxes. For example, in San Francisco, the state sales tax is 8.5 percent of the subtotal plus the excise tax.
Interestingly, prices in the three California cities differ by quite a bit. Eighths in San Diego and San Francisco cost $45.54 and $43.67, respectively. That’s almost $5.00 less than the price in Los Angeles. San Diego taxes at 27.75 percent and San Francisco, 23.5 percent—a big difference from LA’s 35 percent.
Denver places the largest number of taxes on cannabis of any of the cities on the list. The 26.15 percent taxes include a state cannabis retail tax, state and municipal sales taxes, a Denver retail marijuana tax, an RTD tax, and a cultural tax. Still, with all these taxes, Denver was 5th in price, at $43.14.
Eighths in Boston and Portland are taxed at 20 percent and both have a cost of $42.00. Boston places excise, state sales and local municipal business taxes on cannabis, while Portland has two taxes: OLCC state and Portland city.
Las Vegas came in the lowest priced at $41.39. Taxes there run 18.25 percent and consist of a state recreational cannabis tax and sales tax.
Smaller dispensaries and entrepreneurs are fearful that high taxes will force them out of the market, so Flowhub has some advice for them. It includes understanding local laws, keeping detailed records, setting an order of operations for tax calculations and being upfront with consumers. They also suggest fighting for fairness by lobbying lawmakers for responsible regulations in the cannabis market.
California’s cannabis market is on the verge of a crisis, according to a new report released by the California Growers Association (CGA), which represents more than 1,100 small and independent cannabis businesses.
According to the report, less than one percent of California’s cannabis cultivators are licensed by the state; leading many to ask: Why? What is it that is keeping cannabis cultivators out of California’s legal cannabis market? In part three of this four-part series, Green Market Report will examine the cultural and financial barriers that are keeping cultivators out of the market, as outlined by the recent CGA report.
If you’ve missed the previous parts, you can click here to view Part One and Part Two and get caught up.
The cannabis industry’s lack of adequate banking services has been well reported on. But what has slipped through the cracks are the other financial barriers that keep small to midsize cannabis cultivators out of the legal market; such as the lack of small business loans.
The single greatest barrier keeping cultivators out of the legal market, according to a survey of CGA members, is taxation. Due to the federal status of cannabis, most cannabis businesses cannot take standard deductions for business expenses like other industries have.
In many cases, this has the effect of creating an unreasonable tax burden on small to midsize cultivators; with some paying an effective federal tax rate as high as 60%. Additionally, state and local taxes have also proved to be burdensome for small-scale operators.
Many local governments have passed “gross receipt taxes” which are assessed at each step in the supply chain. More often than naught, theses taxes compound each other; turning a modest 5% into a cumulative 25% by the time it reaches the supply chain.
The CGA estimates that the effective tax rate for cannabis cultivators in California can range between 40%-60%, compared to states like Oregon where the effective tax rate is 18%. While larger operators can bear the brunt of this tax rate, many small businesses cannot.
Additionally, inefficiencies in tax collection can incur more unnecessary costs. Once a harvest leaves the cannabis producer, the cultivation tax is required to follow the harvest throughout the supply chain. In situations where a cultivator is directly supplying a retailer, this is not a problem.
However, this is often not the reality. Typically a harvest will pass through multiple points in the supply chain before reaching retailers. If the cannabis industry was not a cash-only business, this would not be a problem, but it’s not. Because of federal, cannabis businesses must physically move the cultivation tax through each point in the supply chain; creating a logistical and security nightmare.
Furthermore, cannabis cultivators must pay taxes on their harvest as soon as it moves through the supply chain; without any consideration of whether it will actually reach the market. The end result is cannabis cultivators having to pay their taxes before the even receive that money that’s actually being taxed.
Another financial burden is the lack of access to small business loans. While large-scale operations with deep-pocketed investors can get by without access to business, small-scale cultivators cannot.
Another barrier contributing to the small number of licensed cannabis cultivators is the culture in California. Approximately 20% of CGA members have been growing for more than two decades and well before medical cannabis was legal in California. These former outlaws have a deep seeded mistrust of the state and federal government and are reluctant to embrace state regulations. Conversely, many in state and local governments operate under incorrect assumptions and stereotypes about cannabis and consequently legislate accordingly.
The CGA also estimates that approximately 30% of the state’s cannabis cultivators operated “off the grid,” where electricity and broadband access is limited. The end result is that many cannabis cultivators that want to come into compliance simply can’t because they lack these basic resources.
While not necessarily an institutional barrier, some cannabis cultivators are simply not good at business. With a gossamer of state and local regulations, many small to midsize cannabis cultivators become overwhelmed by all of it and simply need more time to absorb the new rules.
The final and some would say most regrettable barrier to bringing cultivators into the market is that they simply don’t want to.
Some cultivators may be operating on public lands while others just have a general disrespect for the law. The side effect of this disregard for the law is that those that interested in becoming compliant are treated the same as those that don’t, and the CGA encourages the state to do all it can in provide a path to legality for cultivators acting in good faith.
Stay Tuned for Part 4
The greater question remains of how to address all of the other institutional, financial, and cultural barriers preventing cultivators from entering the market. Where do we go from here? What should be done? In the fourth and final part of our series, Green Market Report will examine the solutions put forward by the CGA to fix this emerging crisis.
If you can’t beat ’em, join ’em. And if you can’t tax ’em, smoke ’em.
Just weeks after marijuana became legal for retail sale in the state of California, there has already been a tax cut, with the city of Berkeley cutting its tax to 5% from 10% of gross receipts. Credit rating firm Fitch said it’s due in part to high levels of both state and local taxes on cannabis, but also because illegal sales of cannabis are impacting legal sales, forcing legal dispensaries to compete on price.
The move comes after advocates in the Bay Area said taxes on marijuana were too high.
Steve DeAngelo, the co-founder, and CEO of Harborside in Oakland said in January that the tax rate for cannabis was nearly 35%, including state and local taxes, up from 15% prior. Included in that rate is the regular 6% sales tax, 3.25% sales tax for Alameda County, a 15% state tax on marijuana and a 10 percent Oakland tax on recreational marijuana.
“That is a huge hit. And it’s going to mean that a significant number of people, less affluent consumers, are going to turn to the lower prices of the underground market,” DeAngelo said in an interview with CBS SFBayArea.
DeAngelo added that people might turn to the black market because of the high taxes, but that his dispensary had a variety of different products, in addition to being tested.
“All of our medicine is tested in a laboratory,” DeAngelo said. “It’s evaluated both for safety, for things like pesticides and pathogenic molds, and it’s also evaluated for potency.”
Aside from the aforementioned tax rates in Oakland, tax rates throughout the state vary greatly and can add as much as 10% or 20% of the cost, just because of local taxes. There is also a $9.25 per ounce state tax on cultivation, as well as a 15% state excise tax and state and local sales taxes as high as 10.25%.
The added tax revenue was a factor in the state passing a law to allow recreational cannabis sales. A November 2017 Fortune article cited data that the state could generate as much as $1 billion in added tax revenue, but some people in the cannabis industry said the high tax rates could allow for illicit or black market sales to gain an unfair advantage.
Fitch estimates that tax collections have “far exceeded initial estimates” in both Colorado and Washington, which began collecting taxes on legal sales in 2014. The rating firm added that while it is still too early to know if California will generate the same levels of revenue that Colorado and Washington have, high taxes are going to be an issue.
“[C]omparatively high taxes on legal cannabis will likely continue to divert sales to illegal markets, reducing potential tax collections despite actions such as Berkeley’s,” the firm said in an email obtained by Green Market Report.
The way the legal and regulatory framework was set up in California, it allows local jurisdictions to ban sales of non-medical cannabis entirely. Despite that, illegal sales have continued, flooding the market and negatively impacting the sales potential for legal goods.
The city of Berkeley and mayor Jesse Arreguín hope that the tax cut will improve its competitive position; the tax cut may also be a sign of things to come in a state where 67 cities and counties have taxes on legal cannabis sales.
When a U.S. Congressman recently told me that getting rid of Section 280E of the Internal Revenue Code “would amount to a tax cut for pot growers,” I was caught off guard by his twisted interpretation of this tax policy.
It was a huge reminder of how much more work organizations like the New Federalism Fund, of which I am a proud member, have left to do in our efforts to secure fair tax policy for the legal cannabis industry. Widespread misconceptions persist even at the highest levels of our government, with many continuing to regard our industry as an easy way to strike it rich in the new American “green rush.” But the truth is, there are still major hurdles that make it particularly hard for businesses to actually profit in the new marijuana sector.
Section 280E, which prevents state-legal marijuana companies from deducting otherwise ordinary business expenses from their total income, is one of the biggest obstacles cannabis entrepreneurs run up against. To many, this may seem like a mere inconvenience or minor setback. But I can assure you, it is not.
While most companies in the U.S. pay a standard corporate tax rate of 35 percent, cannabis businesses, thanks to 280E, often face effective tax burdens of 70 percent or more.
But there is hope on the horizon. Just this week, Sen. Cory Gardner’s press secretary said the senator “plans to file an amendment” to the sweeping Senate tax overhaul bill that would reform 280E so it no longer applies to marijuana businesses operating in accordance with state and local laws, according to a Forbes report.
Gardner, a Colorado Republican, also cosponsored a standalone bill to reform this tax measure earlier this month.
“Our current tax code puts thousands of legal marijuana businesses throughout Colorado at a disadvantage by treating them differently than other businesses across the state,” Gardner said in a press release. “Coloradans made their voices heard in 2012 when they legalized marijuana and it’s time for the federal government to allow Colorado businesses to compete.”
What is 280E and why does it matter?
The heart of Section 280E centers around how federal tax law deals with businesses that are associated with “trafficking” substances that are listed in Schedule I or Schedule II of the Controlled Substance Act. Since cannabis remains listed as a Schedule I substance at the federal level, the Internal Revenue Service applies Section 280E to most state-legal marijuana companies, preventing them from deducting normal business expenses from their total income.
The measure was originally passed in response to a 1982 U.S. Tax Court case in which a cocaine dealer successfully defended tax deductions relating to his illegal drug business. Congress enacted 280E to prevent other drug dealers from following suit and trying to deduct business expenses relating to their illegal activities.
Although it stems from the case of someone who was operating clearly outside the bounds of all state and federal laws, the IRS has subsequently determined Section 280E also applies to licensed, regulated marijuana businesses acting in full compliance with state cannabis laws and federal guidelines.
Most businesses in the United States are only required to pay taxes on their taxable income, which is calculated by subtracting business expenses from total income. But cannabis businesses can only deduct the cost of goods sold on their taxes – that is, the direct costs of the materials used in creating goods along with the direct labor costs used to produce those goods.
We cannot deduct operating expenses like payroll, rent, electricity, and advertising, or the high costs of obtaining a state marijuana license. Together, these non-deductible costs account for a substantial portion of the total costs associated with running a business.
As a result, state-legal marijuana companies are taxed at roughly double the rate of businesses in other sectors. Our tax burden is downright prohibitive, and it has nothing to do with the original intent of 280E to penalize illegal drug dealers.
280E undermines fundamental American values
On a very basic level, federal taxes represent a contract of sorts between private entities and the U.S. government. We pay taxes so that our government can collect the money it needs to fund vital services and programs that help citizens fulfill the classic American ideals of “life, liberty and the pursuit of happiness.”
For corporate entities, tax contributions help ensure a system of law and order exists in which they can confidently conduct legitimate business operations. But the federal tax contributions of state-legal cannabis companies often serve the opposite purpose, hobbling an industry seeking to legitimize itself, rather than giving it basic survival tools afforded to every other legal industry.
The federal government collects disproportionately large amounts of tax money from an industry it still won’t recognize in full, then turns around and uses that money to enforce policies that further stifle the industry’s growth. This double-whammy is a gross manipulation of the basic principles on which the American tax system was built.
Despite numerous federal memos and other directives explicitly giving state-legal cannabis businesses the ability to operate, the IRS still treats us like we’re convicted criminals undeserving of fair and equitable tax laws.
It should be noted that Section 280E also penalizes states that have made the thoughtful decision to have cannabis sold by regulated businesses instead of criminals. By over-taxing these state-licensed businesses, the provision literally takes tens of millions of dollars out of state and local economies and gives it to the federal government.
Where do we go from here?
Cannabis companies have created tens of thousands of new jobs in this country, and it’s time for federal tax policies to start acknowledging the very real contributions this industry is making toward the overall health of the American labor economy. The legal marijuana industry generated nearly $7 billion in sales in 2016, and market reports project that number to reach $50 billion by 2026.
While getting rid of 280E won’t erase every legal obstacle cannabis businesses face, it would at least set their tax burdens on equal footing with other legal industries. And that notion of equal footing is key. Cannabis businesses aren’t asking for tax breaks or special treatment, they’re just asking for the same financial opportunities given to every other legitimate business in this country. What could be more American than creating an equitable tax environment for all?
Soon after your opening launch celebrations, you face the grim realities of your first tax return as a Cannabis business owner. (Cue Death Star music.)
Section 280E of the tax code states that “No deduction or credit shall be allowed” for businesses that are prohibited by Federal law. Section 280E explicitly mentions businesses that deal in “trafficking” substances that fall under Schedule I and Schedule II of the Controlled Substances Act.
This is potentially devastating for cannabis businesses, and raises the effective tax rate of a retail or production business to 70%, up from what should be in the neighborhood of 30%. That’s based on a business with $1,000,000 gross receipts, cost of goods sold (COGS) of $650,000, with as much as $200,000 in allowable deductions for a non-cannabis business and $0 allowable deduction for the cannabis business. In that scenario, the non-cannabis business will pay tax on $150,000 of income after deductions, while the cannabis business will pay tax on $350,000 of income after deductions, despite the fact that their COGS were the same, dollar-for-dollar.
Four Easy Ways to Save 40% on Your Tax Bill Every Quarter
Establish a second business for every operation that is not directly related to your cannabis inventory. Name it and claim it. Have one business that is just the cannabis business. If you are a retail cannabis business, the only activity in that business will be the buying and selling of your product. If you are a production business (grower or producer), keep at least one other item in your line that is not cannabis related so that you can handle the tax consequences of §280E. Keep inventory lists separate, according to the differentiated revenue streams. In a retail operation, branded items, other health or wellness products, accessories, and accoutrements — these can be inventoried and their associated costs can be deductible. For example, if you have a dispensary, but you also sell glassware or cleaning products, keep those in a separate business. Voila! You now have deductions that you can claim! Most of your rent, utilities, and marketing of anything not expressly cannabis – entirely legal deductions.
Document each and every item separately. Many cannabis businesses make the mistake of thinking, “What’s the use of keeping books if I can’t claim deductions?” Big mistake! If you receive goods from a supplier, make sure you have them ship the cannabis products separate from any other goods you may acquire from them. Doing so will create a fool-proof way to trace expenses that are solely related to cannabis, and help your other deductions survive the scrutiny of an audit.
Micro-manage the tasks that your staff performs while on the clock. If you are a producer, your employee spends a great deal of time with tasks such as checking timers on lights, running water lines, locking and unlocking cabinets, running spreadsheets, cleaning work tables. If, out of one hour, that employee spends 45 minutes with hands off of the cannabis products and you can document it, you have just found a way to claim 45 minutes of that employee’s time on your taxes. Document these tasks, minute-by-minute. Score! You’ve just made the majority of your employees’ wages deductible. Now take it one step further and cut checks from two separate businesses each pay period for your employees. They will still be making the same hourly wage, but it will come from two separate business entities.
Pay yourself a bigger salary in your non-cannabis business than in your cannabis business. You ARE paying yourself, through your business, right? Being in business is a big time commitment; avoid burnout and personal detriment by paying yourself a sustainable salary. As CEO, Manager, Founder, or whatever your title might be, cut yourself a bigger check from the non-cannabis business than you do from the cannabis business. Go ahead. Be aggressive with this. If you have structured the two businesses so that the cannabis-inventory-based business is only 10-20% of the total enterprise activity, you can get away with paying yourself 80-90% of your salary from the non-cannabis business, and the remaining 10-20% of your salary from the cannabis business.
The Green Market Report focuses on the financial news of the rapidly growing cannabis industry. Our target approach filters out the daily noise and does a deep dive into the financial, business and economic side of the cannabis industry. Our team is cultivating the industry’s critical news into one source and providing open source insights and data analysis