Extras on Excise: Marijuana Producers, States Struggle with Prohibition of Business Deductions

In an effort to provide marijuana businesses with some tax relief, last year Washington state decoupled from I.R.C. § 280E—a federal tax statute that has been the thorn in the side of marijuana businesses across the country. Now that states are trending towards decriminalization and legalization of medical and recreational marijuana, the impact of §280E is becoming more and more relevant. I.R.C. § 280E, titled “Expenditures in connection with the illegal sale of drugs,” states:

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.

Basically, this law is saying that people who are in the business of selling illegal drugs may not take any deductions or apply any credits for federal income tax purposes. The law applies to street drug dealers and crime bosses who may hire the services of distribution and armed security, or “muscle.” Unfortunately for state-sanctioned marijuana businesses, the law also applies to them with respect to their normal business expenses.

Marijuana is within the scope of §280E because it is a schedule I drug under the Controlled Substances Act (CSA). The other schedule I drugs under the CSA are heroin, LSD, ecstasy, methaqualone (Quaaludes) and peyote. Steve Fox, of counsel for the marijuana law firm Vicente Sederberg and co-founder of the National Cannabis Industry Association (NCIA), said that marijuana does not belong among those drugs in the schedule I class. “If marijuana was removed from schedule I or II, §280E wouldn’t apply,” Fox said during an Aug. 20 telephone interview with Bloomberg BNA.

This federal code provision denies marijuana businesses the ability to take any tax deductions or credits—even for regular business expenses like employee salaries and storefront rents. According to Fox, §280E is just a harsh reality that medical and recreational marijuana retailers have to deal with for now.

By disallowing deductions and credits, §280E is raising the actual amount of tax dollars paid by marijuana businesses to drastically high proportions. “It changes the effective tax rate from 35 percent to 50 – 70 percent,” Fox said about §280E’s impact on marijuana businesses.

Section 280E is a federal statute that has the same meaning facially in each state, but its effects vary from state to state. Section 280E’s impact affects Washington and Colorado, the two states that have legalized recreational marijuana, very differently. In Colorado, much of a marijuana retailer’s business is actually on the production side of the business. This is because Colorado has a “70/30 rule,” where 70 percent of the marijuana that a retailer sells is required to be grown by that same business. This forced vertical integration allows marijuana businesses to shift much of their costs to production, where §280E does not apply. “You want to put as much under production as you can legitimately,” Fox said.

However, in Washington, there is no 70/30 rule. Washington does not allow any vertical integration with respect to recreational marijuana production and retail. A holder of a marijuana retailer’s license in Washington is not allowed to hold a producer or processor license. Colorado is distinguishable from Washington where marijuana retailers cannot push their costs to the production side to soften the blow that § 280E causes.

Section 280E also affects states differently depending on how the state conforms to the Internal Revenue Code. The starting point of taxable income for many states is taxable income for federal tax purposes. Some states conform to the I.R.C. at a specific point in time, and others conform on a rolling basis. States also follow certain provisions of the I.R.C., but not others. Washington does not have a corporate or individual income tax, so I.R.C. conformity is irrelevant in Washington with respect to §280E. However, Colorado does have both corporate and individual income tax. On May 2, 2013, Colorado enacted HB 13-1042, a bill that decoupled Colorado’s tax code from §280E. Effective Jan. 1, 2014, Colorado began to allow marijuana businesses to take deductions for state tax purposes that the federal government does not allow for federal tax purposes.

Fox and the NCIA have worked with members of congress on the §280E issue, and they hope change comes soon. “We continue to push and push,” Fox said.

As long as §280E is in its current form, and as long as marijuana remains a schedule I or II drug in the CSA, the I.R.C is going to be much harder to deal with in states like Washington that do not allow vertical integration, and therefore do not allow marijuana retailers to shift their costs to production.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Should state-sanctioned marijuana businesses be allowed to take deductions under §280E?

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