On October 6,2022, President Biden issued a statement on marijuana reform that outlined three steps to overcoming what he described as a “failed approach” to enforcing marijuana laws that resulted in Black and brown people being arrested, prosecuted, and convicted at rates disproportionate to their white counterparts. Of interest to the accounting and tax industry is the third step. The President asked the Secretary of Health and Human Services and the Attorney General to “initiate the administrative process to review expeditiously how marijuana is scheduled under 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 ecstasy, heroin, LSD, and peyote. Schedule II, includes methamphetamine, cocaine, fentanyl, oxycodone, and Adderall. But what does drug scheduling and marijuana’s schedule specifically have to do with taxes?
In 1982 Congress enacted § 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) may not deduct business expenses related to business income from trafficking in Schedule I or Schedule II controlled substances. As of today 41 states (and the District of Columbia and Puerto Rico) have legal medical marijuana and 23 of those have either decriminalized cannabis use or have 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 important 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. Nevertheless, it still concurred that § 280E applied to state-legal medical marijuana businesses. According to Nick Richards, Partner and Cannabis Group Co-Chair at Greenspoon Marder, LLP, the decision for the most part simply “reiterated legislative history.” Specifically it reiterated that “deductions are a matter of legislative grace” a well-used point of tax law established in Welch v. Helvering way back in 1933. Business taxpayers must prove their entitlement to any deduction. Jennifer Benda, tax attorney, former CPA, cannabis taxation specialist and partner at Holland & Hart LLP, states that “While CHAMP seemed significant at the time, the problem in applying it going forward has been that the facts were unique and are not typically replicated.” Bender goes on to note that “CHAMP has had limited benefits for the industry” and that she “[hasn’t] seen any situation where CHAMP helped a state-legal marijuana business lower their taxes.” According to Richards, that’s exactly what the federal government intended. “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 from state-legal drug businesses. The continued emphasis on deductions being a matter of legislative grace means that in any case where § 280E applies, even state-legal businesses are going to have their business deductions denied. Nevertheless, enterprising cannabis accountants and attorneys recognized that the CHAMP decision’s allowance of a deduction for COGS meant that the more indirect expenses that could potentially be allocated to COGS the better. Profits (and the associated income taxes) would be lowered. In the years after the CHAMPS decision, this strategy became increasingly common for state-legal marijuana businesses. Enter Harborside Health Center.
According to Benda, “Harborside was the first case to really address how the inventory rules apply when § 280E applies.” On November 29, 2018 the U.S. Tax Court ruled in favor of the IRS in Harborside Health Center v. CIR. The U.S. Court of Appeals for the Ninth Circuit upheld the decision in 2019 based on the idea of “legislative grace.” The Harborside decision basically put an end to the practice of allocating a portion of the indirect expenses of a state-legal cannabis business to COGS. It also put an end to many state-legal marijuana businesses.
Nick Richards’ firm represented Harborside in their appeal to the Ninth Circuit. Harborside had so much tax liability as a result of the decision that they cannot repay it before the 10-year collection statute expires. They are currently in a collections arrangement with the IRS known as a “partial pay installment agreement” (PPIA). According to Richards, Harborside “will eventually get some of their liability resolved after 10 years.” That means that some of the debt will be paid and the IRS will write some of it off as out of statute. During the collection period, however, the IRS will continue to review Harborside’s ability to pay the outstanding liability and “if the IRS sees they can pay more they will require [Harborside] to pay more.”
The reality is that the Harborside decision created “giant” tax liabilities for state-legal cannabis businesses—on the order of $40M to $50M according to Richards. Benda has observed that as the pandemic has waned, many state-legal marijuana businesses have seen a flattening [of revenue] and some have seen a contraction. She also notes that they are facing competition from the hemp industry, which has begun producing derivative products that compete with cannabis. Meanwhile, according to Benda “The industry’s effective tax rates continue to be ridiculously high.”
Richards thinks that “the real dynamic is the debt that § 280E causes.” Those debts may be bad for a large company but they can be absolutely debilitating for a small business, especially small pass-through entities (PTEs) such as LLCs that are taxed as partnerships. When these businesses are subject to an IRS § 280E audit, any tax liability that is incurred is now the personal debt of the partners. Any spouse who files jointly with a partner in a cannabis business has joint and several liability for that debt. That means if the spouse who incurred that debt can’t pay, the spouse who didn’t incur it can still be responsible 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 business name) will solve the personal liability issue, but he also says that “unless you are aware of the issue you think you are protected [by the LLC]. Even people in the industry, if you are not a business owner who is familiar with it you don’t necessarily know about § 280E.” IRS debts incurred as the result of unfavorable § 280E audits have, according to Richards “been the ruin of many cannabis owners over the years.” Additionally, because the IRS feels like offers in compromise (OICs), where a taxpayer settles their case for only a portion of the debt owed (or “pennies on the dollar” if the radio ads are to be believed), represent an “end run around § 280E” they will not allow cannabis businesses to enter into an OIC if they are still engaged in business. That leaves owners of state-legal marijuana businesses who find themselves with a large amount of tax debt with a tough decision—pay or go out of business to be able to request an OIC.
Benda feels that the issue of what can be included in inventory or COGS is “is the tax issue the industry faces.” The decision really “narrowed the scope of costs that can be included in inventory and COGS, particularly for resellers.” She also believes that “there are problems with the Harborside decision that should be challenged.” Richards’ firm brought up one such problem in their appeal. The problem is that § 280E creates “phantom income” that may not actually be income under the 16th Amendment. It creates a lot of phantom income—up to $500,000 in 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 the net profit is taxed as income. In a cannabis business, however so many expenses are disallowed under § 280E that the business’ profit is much larger on their tax return than it is in fact. Is that phantom income really income under the 16th Amendment? No one knows because to date the issue has not been litigated; § 280E cases have always come down to the “legislative grace” argument.
Meanwhile, the Harborside decision also increased the likelihood of the IRS auditing marijuana businesses specifically to disallow expenses under § 280E because the law is now clearly on their side. Fighting the unfavorable result of an § 280E audit is expensive, unlikely to result in a favorable outcome, and—non-deductible to the business as a legal expense. Which brings us back to President Biden’s request for a review of how marijuana is scheduled under federal law.
Should marijuana be rescheduled down to Schedule III (or IV or V) state-legal marijuana business would be allowed to deduct COGS and direct and indirect business expenses. This would result in lower federal income taxes for new cannabis business, but existing businesses could still be audited for years in which cannabis was subject to § 280E and all existing audits would remain in effect. Nevertheless Benda believes that should marijuana be rescheduled, or even descheduled, it might lead the IRS to settle more cases rather than taking them all the way to court. “However, I don’t think the IRS will stop pursuing § 280E cases because there is still the impression that the industry has not fully complied with § 280E, and in the eyes of the IRS that means that there are revenues to be collected.” Rescheduling from Schedule I to Schedule II would not affect § 280E but would put marijuana “trafficking” in the hands of big pharma. A “scary” proposition according to Richards who notes that such an outcome could make it difficult for the cottage marijuana industry to survive.
Consequently, while it appears that the President’s statement is a step in the right direction in terms of marijuana reform, it is certainly a baby step when it comes to legalizing (and taxing) the business of marijuana. The rescheduling process could take years and, in the meantime, the § 280E audits and their consequences will continue to pile up for state-legal cannabis businesses both small and large.