Garner Ginsburg & Johnsen: Cannabis Taxation

Authored By: Elliot Ginsburg and Kirsten Nordstrom

1. Introduction

Businesses in the cannabis industry are no stranger to complex and largely unintuitive laws and regulations governing their operations. What they may not be aware of, however, are the unique and burdensome tax requirements resulting from operating in an industry that is still illegal under federal law. Cannabis businesses should be aware of the interplay between state and federal taxes, and the policies behind different forms of taxation so that they can reduce their tax burden, avoid underpayment and associated underpayment penalties, and maintain sufficient records to protect themselves if audited.

1. State Taxation

States and local governments tax cannabis in three ways. First, states with a general sales tax will collect revenues on cannabis sales as they would with any sales. Similarly, local governments may impose a local sales tax on all goods, including cannabis. Finally, states or local governments may choose to impose an excise tax, more commonly known as a “sin tax,” just on cannabis products. Cannabis sales may be subject to multiple, or even all three forms of taxation at different points in the production and sales process.

As some states do not have general sales tax or wish to raise tax revenues beyond their general sales tax, excise taxes are common in the cannabis industry. Excise taxes are taxes on specific goods or services, such as taxes seen on alcohol, tobacco, and gasoline. Generally, they are imposed to discourage use of the product or raise revenue to offset potential social costs. With respect to cannabis, excise taxes can be calculated in several different ways, either by using the product’s weight, sales price, or potency as the basis for taxation, among other, less common options.

1. Weight-based excise taxes

Lawmakers commonly impose excise taxes based on the weight or quantity of taxable products sold. For example, the federal government currently imposes a $2.70 per gallon tax on spirits[1] and $1.01 tax per carton of cigarettes[2]. The Marijuana Policy Project, a cannabis industry advocacy group, recommends a tax of $50 per ounce of cannabis flowers, $15 per ounce of cannabis leaves, and $25 per mature plant sold, accounting for both the weight of the product sold and, to a lesser extent, its likely potency.[3]

There are several benefits for states that choose a weight-based excise tax system. Most notably, weight-based systems provide states with a relatively stable revenue source that is not impacted by market price fluctuations.[4] Taxes collected based on the weight of the taxable product are also generally collected during production, and not at the final point of sale, easing enforcement burdens. For example, a weight-based tax would likely be levied on a cannabis product before it is processed with other ingredients and turned into edibles, allowing for a more accurate assessment of the actual weight of the cannabis than would be available at the point of sale. Earlier collection also establishes an early record of the product, decreasing the likelihood it will end up in the black market. Additionally, as it is likely that fewer state entities will be involved in collecting the tax in a weight-based system, auditing tax returns will be simpler.

Weight-based taxation also disincentivizes tax avoidance schemes, such as cannabis “giveaways” conditioned on the consumer purchasing a non-cannabis item for an inflated price, as all cannabis will be taxed regardless of if it is actually sold. Finally, weight-based tax systems are far simpler for the vertically integrated cannabis markets present in some states, as weight is far simpler to determine than the value of cannabis as it passes through different divisions of a single business.

There are several drawbacks, however, to weight-based excise taxes on cannabis. First, weight-based taxation generally fails to account for potency. Several states with weight-based excise taxes on cannabis have mitigated this issue by taxing more potent parts of the plant at higher rates than less potent parts. For example, California currently taxes cannabis flowers at $9.25 per ounce, leaves at $2.75 per ounce, and recently harvested plants that have not yet been processed at $1.29 per ounce, therefore accounting for the average potency levels in different parts of the plant and the likely water content of the unprocessed plant.[5] Weight-based taxes on cannabis plants are also vulnerable to inflation, and tax rates require frequent adjustments. States, however, can allow for the tax to be adjusted annually based on a broad measure of inflation. Finally, weight-based taxes must take into account moisture content, and require more testing than a price-based format, making it harder for regulatory authorities audit the accuracy of reports.

1. Price-based excise taxes

Arguably the simplest way to tax cannabis is to levy a tax on its retail or wholesale sale price. Priced-based excise taxes can be easily administered, as the taxing authority can rely on reported sales prices as opposed to relying on and verifying the accuracy of reported weight or potency. Additionally, these taxes will more significantly impact higher-priced, premium cannabis sales, therefore likely resulting in less of a tax burden on lower income individuals. As premium cannabis is also likely to be more potent, price-based taxes also discourage high-potency use, which some lawmakers may perceive as a benefit.

Price-based taxation has several major drawbacks, however. First, tax revenues can be hard to predict, and will be vulnerable to falling prices. This will make it harder for governments to rely on the cannabis tax proceeds to fund programs or provide a consistent revenue stream. In Colorado, for example, the average annual adult use cannabis flower prices fell 62% between 2014 and 2017, from an average of $14.05 to $5.34 per gram.[6] Additionally, in some situations price is not an accurate indicator of potency, meaning that a price-based system will not reliably tax high-potency products at a higher rate than low-potency products, therefore not necessarily discouraging high-potency use. Over the same period from 2014 to 2017 in Colorado where average cannabis prices fell 62%, average potency increased with average THC percentages rising from 16.4% to 19.6% in all tested flowers.[7]

Price-based taxation is also vulnerable to tax-avoidance schemes, such as bundling lower priced cannabis with an overpriced service or product that does not have an excise tax, such as a t-shirt or pipe. In Colorado, for example, cannabis delivery services have been a popular method for avoiding Colorado’s price-based excise tax. As opposed to selling the cannabis, delivery services will ask for a specific “donation” for the delivery service, depending on the amount of cannabis delivered.[8] Colorado recently passed a law authorizing cannabis delivery to hopefully curb this practice.[9] Washington expressly prohibits bundling discounted or free cannabis with other goods or services, although it is unclear how effectively this provision can be regularly enforced.[10]

Finally, price-based excise taxes can be difficult to impose on vertically integrated cannabis markets, where transfers between producers, wholesalers, and retail establishments occur within the same company. Colorado and Nevada, the only two states with a price-based tax at the wholesale level, both base their tax calculations on an average market price in order to combat this program, essentially adopting a weight-based tax system at the wholesale level.[11]

1. Potency-based excise taxes

In 2011, as part of a bill to legalize recreational cannabis, Massachusetts considered an excise tax based on THC content, as opposed to weight or price of a cannabis product.[12] Had the bill passed, cannabis would have been taxed at ten dollars per percentage point of THC per ounce. This taxation system is similar to that seen in the alcoholic beverage industry, where spirits are taxed at a much higher rate per volume than beer.[13]

A potency-based excise tax system incentivizes sellers to accurately report the potency levels of their products, as over-reporting would result in tax penalties and under-reporting would result in decreased consumer demand. Additionally, some experts believe that a potency-based tax system would most efficiently maximize cannabis tax revenues should it be legalized nationwide.[14]

Potency-based taxation methods, however, come with significant testing, accuracy, and reporting challenges. Although most states require sellers to disclose a product’s THC content already, many cannabis testing methods are highly subject to error and difficult to replicate.[15]

• Federal Taxation

Although legal medicinally or recreationally in many states, cannabis with a THC content of higher than .3% is still considered a Schedule 1 controlled substance, and is therefore illegal federally.[16] Cannabis’s illegal status, however, does not exempt legal dispensaries from paying federal income taxes.[17] Instead, cannabis businesses actually have to pay more in taxes than other businesses. In 1982, Congress amended the tax code to prohibit anyone who traffics in controlled substances from deducting ordinary business expenses, meaning that state-legal cannabis facilities cannot deduct business expenses beyond the cost of goods sold (“COGS”).[18] So, while an ordinary legal business can deduct things like rent, utilities, and wages, a dispensary cannot. The only reprieve available to cannabis businesses comes from the Supreme Court’s interpretation of the 16th Amendment in Doyle v. Mitchell Bros.[19] In Doyle, the Supreme Court held that the 16th Amendment precluded taxing the return of capital.[20] As the cost of goods sold is essentially a return of capital, cannabis businesses may still reduce their returns by COGS. This means that cannabis businesses will be taxed on their gross income, not net income. Therefore, some in the industry have concluded that federal tax laws, not federal criminal laws, are the largest threat to state-sanctioned cannabis businesses.[21]

As a result, cannabis businesses are left with two strategies to minimize their tax liability: separate the cannabis business from any non-cannabis business, and maximize COGS reductions by characterizing costs as COGS to the greatest extent possible.

1. Separate Businesses

Many cannabis businesses are engaged in activities separate from selling cannabis, and may be able to deduct expenses associated with those non-cannabis business lines. For example, a business may operate as a marijuana dispensary and a coffee shop, or offer medical marijuana and caregiving services. In these instances, the business should be able to deduct a proportion of their business expenses relating to their non-cannabis business, as long as their business lines are substantially different and can justifiably be called independent trades or business lines.

For example, in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, the court allowed a medical marijuana dispensary that also offered caregiving services to deduct the ordinary and necessary expenses attributable to its caregiving services, even though it was precluded from deducting those expenses attributable to the dispensary side of its business.[22] The court reasoned that Californians Helping to Alleviate Medical Problems, or “CHAMP,” could deduct its caregiving expenses because its caregiving services were sufficiently separate from its cannabis business.[23] CHAMP’s customers paid a membership fee that entitled them to receive duly prescribed medical marijuana, as well as to access all of CHAMP’s extensive caregiving and counseling services, which included daily hot lunches, group counseling, biweekly massages, hygiene supplies, and social events, among others.[24] Many of CHAMP’s members suffered from debilitating diseases, including AIDS, cancer, and multiple sclerosis.[25]

As the caregiving services CHAMP offered were so extensive, it asserted, and the court agreed, that the businesses were separate, and that the caregiving service could stand on its own.[26] The court reasoned that there was no evidence that Congress, in amending the tax code to prohibit taxpayers from deducting expenses associated with drug trafficking, intended to also prohibit taxpayers from deducting expenses attributable to facets of their business not associated with controlled substances.[27] Therefore, CHAMP was allowed to deduct the proportion of its business expenses associated with its caregiving services, including 18/25ths of its employee expenses (based on the number of employees not involved in providing medical marijuana), certain other business expenses including vehicle costs and laundry and cleaning costs, and 9/10ths of CHAMP’s remaining expenses, as only 10% of the square footage of their facility was used to provide medical marijuana.[28]

Although a promising result for CHAMP, other dual-purpose dispensaries have not been successful at using similar arguments to reduce their tax bill. In Olive v. Commissioner, for example, the Ninth Circuit upheld a tax court determination that a dispensary called the Vapor Room which also offered a complementary “community center” for its patrons, could not deduct its proportion of expenses associated with operating the community center.[29] The court concluded that the community center could not constitute a separate trade or business because it did not charge for its services, and therefore did not generate any revenue.[30] Therefore, the court reasoned, the Vapor Room’s only “trade or business” was dispensing medical marijuana, preventing it from deducting any of its business expenses.[31]

In Olive, the court helpfully compared CHAMP and the Vapor Room to two different coffee shops.[32] CHAMP, it said, was similar to a book store that sold books, but also contained a café area that sold coffee and pastries. The Vapor Room, on the other hand, was most akin to a bookshop that offered complementary coffee and pastries to its customers. The CHAMP-like bookstore therefore had two separate lines of business, selling books and operating a café, whereas the Vapor Room-like bookstore only sold books. Should a cannabis business wish to deduct expenses associated with activities separate from selling marijuana, Olive notes that those activities must truly constitute a business in themselves in order to bring the business out from the “drug trafficking” umbrella.

Beyond qualifying as a separate activity, any non-cannabis related businesses must be sufficiently extensive for a cannabis business to deduct its related business expenses. In Altermeds LLC v. Commissioner, the court denied a dispensary any deductions associated with what it claimed was a separate line of business selling pipes, papers, and other related products.[33] The court reasoned that Altermeds’s sales from selling those related products were too low to constitute a separate business, as they only made up approximately 4% of Altermeds’s revenues.[34] Additionally, the court stated that the non-marijuana products too closely complemented Altermeds’s efforts to sell medical marijuana to be considered separate.[35]

Notably, the court emphasized that, even if selling pipes, papers, and other related products could be considered a separate business entity, Altermeds’s business records were not sufficiently detailed or comprehensive to allow the court to determine the proper amount to deduct.[36] Instead, Altermeds’s ledgers sorted its expenses into broad categories, were often incomplete, and did not include receipts or notations differentiating between expenses associated with the businesses.[37] This highlights another key point for any cannabis business trying to deduct expenses associated with non-cannabis business activities: the business must keep clear and comprehensive records that sufficiently differentiate between expenses associated with the different businesses. Any cannabis business pursuing this strategy to reduce its tax burden should be prepared to identify specific payments included in any claimed deduction and be able to show proof of those payments, something that will require extremely detailed and organized bookkeeping.

1. Maximizing COGS

Many cannabis businesses will only be able to minimize their tax liability by maximizing COGS, as they will not engage in separate lines of business independent from selling cannabis. Although COGS can include more than the direct costs of the product, it cannot expand past costs to acquire the inventory.[38] COGS is computed using a relatively simple formula: Beginning Inventory + Production Costs (for growers) or Purchases (for resellers) – Ending Inventory.[39] Although most businesses are also required to capitalize a portion of their necessary general and administrative expenses (G&A), such as costs associated with payroll and legal functions, in their COGS reduction,[40] cannabis businesses generally cannot. This is because I.R.C. § 263A, which requires including G&As in the COGS reduction, also contains language that prohibits the section from converting any nondeductible expenses into deductible expenses.[41] Therefore, as cannabis businesses cannot deduct any G&As, application of § 263A is generally not available as a way to maximize COGS.

With that in mind, a reseller’s COGS would generally include the price paid for inventory, freight costs, and any other cost involved in acquiring the product. It would not include things like handling and storage, which would ordinarily be deductible for businesses that do not “traffic” in controlled substances. The COGS analysis for producers is more extensive, and is governed by several additional treasury regulations to determine inventory cost.[42] For producers, COGS generally includes the cost of raw materials and supplies consumed in connection with production, expenditures for direct labor, and indirect production costs incident and necessary for production, including a portion of management costs.

1. Relief Provided by States

As many states compute income tax based on the federal standard, cannabis businesses in some states may be prevented from deducting business expenses from their state tax returns as well. Currently, Alaska, Arizona, Connecticut, Delaware, Washington D.C., Florida, Illinois, Iowa, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Missouri, Montana, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Dakota, Ohio, Rhode Island, Vermont, and West Virginia use federal taxable income as the starting point for calculating state income taxes and do not provide any exceptions for cannabis businesses. Other states, however, have passed laws allowing state-legal cannabis companies the same deductions afforded to other legitimate businesses.

On Oct. 12, 2019, California Governor Gavin Newsom signed a bill allowing cannabis businesses to claim all deductions and credits available to all other legitimate businesses.[43] Prior to this law passing, only California corporations could deduct business expenses, and any business organized as a sole proprietorship, partnership, or LLC was subject to the federal rules.[44] Now the deductions are available to all businesses.

Colorado, Oregon, and Hawaii allow cannabis businesses to deduct business expenses as any other business would.[45]

Arkansas technically allows business deductions for cannabis businesses, as it does not use federal income tax as a starting point for levying state individual or corporate income taxes and has no provision prohibiting deductions associated with drug trafficking.[46] Several other states similarly do not use federal income tax as a starting point for personal income taxes, including Pennsylvania, New Hampshire, and New Jersey. In these states, a business organized as a sole proprietorship, partnership, LLC, or other entity with pass through taxation would be eligible to deduct business expenses, whereas a corporation would not. Nevada does not collect personal or corporate income taxes.

1. Takeaways

Thanks to unfriendly federal tax laws and the ever-evolving regulatory landscape surrounding the cannabis industry, taxes are often a major burden for cannabis businesses. Businesses should regularly monitor laws in their state to ensure that they are complying with any changes in the tax code, monitor case law, including caselaw coming from the United States Tax Court, and review best practices and study the regulations dealing with determining COGS. Additionally, cannabis businesses should keep extensive and detailed financial records so that they can prove entitlement to any claimed deductions should they be audited.

[1] Alcohol and Tobacco Tax and Trade Bureau of the U.S. Department of Treasury, Tax and Fee Rates, available at https://www.ttb.gov/what-we-do/taxes-and-filing/tax-rates (last visited Dec. 30, 2019).

[2] Id.

[3] Model Legislation to Regulate and Tax Marijuana Similarly to Alcohol, Marijuana Policy Project, available at https://www.mpp.org/issues/legislation/model-state-bill-to-replace-prohibition-with-regulation/ (last visited Dec. 30, 2019).

[4] Carl Davis, Misha E. Hill, and Richard Phillips, Taxing Cannabis, institute on taxation & economic Policy (January 2019) available at https://itep.org/wp-content/uploads/012319-TaxingCannabis_ITEP_DavisHillPhillips.pdf.

[5] California Department of Tax and Fee Administration, Tax Rates – Special Taxes and Fees, available at https://www.cdtfa.ca.gov/taxes-and-fees/tax-rates-stfd.htm (last visited Dec. 30, 2019).

[6] Adam Orens et al. Market Size and Demand for Marijuana in Colorado 2017 Market Update, Colorado Department of Revenue (August 2018) available at https://www.colorado.gov/pacific/sites/default/files/MED%20Demand%20and%20Market%20%20Study%20%20082018.pdf.

[7] Id.

[8] Pot Delivery Services Thriving in Colorado’s Black Market, CBS 4 Denver (May 6, 2015) available at https://denver.cbslocal.com/2015/05/06/pot-delivery-services-thriving-in-colorados-black-market/.

[9] Colo. H.B. 19-1234 (2019);

[10] R.C.W. 69.50.380(1)

[11] Colo. Code Regs. § 39-28.8-302(5)(a)(i)(B); Nev. Admin. Code § R092-17.

[12] H 187-1371 (Mass. 2011).

[13] Beer brewed by a domestic brewer who produces less than 2,000,000 barrels per year is currently taxed at a rate of $3.50 per barrel (31 gallons) for the first 60,000 barrels produced while spirits are taxed at the rate of $2.70 per proof gallon for the first 100,000 gallons produced per year. This amounts to an average tax of $0.02 per can of beer, but $2.14 for each bottle of 80 proof distilled spirits. ALCOHOL AND TOBACCO TAX AND TRADE BUREAU OF THE U.S. DEPARTMENT OF TREASURY, TAX AND FEE RATES, available at https://www.ttb.gov/what-we-do/taxes-and-filing/tax-rates (last visited Dec. 30, 2019).

[14] Jonathan P. Caulkins, et al., High Tax States: Options for Gleaning Revenue from Legal Cannabis, 91 Or. L. Rev. 1041, 1053 (2013).

[15] Laura Cassiday, The Highs and Lows of Cannabis Testing, Inform (October 2016) available at https://www.aocs.org/stay-informed/inform-magazine/featured-articles/the-highs-and-lows-of-cannabis-testing-october-2016.

[16] 21 C.F.R. §1308.11(31).

[17] U.S. Const. amend XVI; also see I.R.C. § 61(a)(3) (defining gross income as all “gains derived from dealings in property” with no exclusion for controlled substances).

[18] I.R.C. § 471.

[19] 247 U.S. 179 (1918).

[20] Id. at 185.

[21] Marijuana Business Conference Wrapup: 36 Tips, Lessons & Takeaways for the Cannabis Industry, Med. Marijuana Bus. Daily (Nov. 15, 2012) available at https://mjbizdaily.com/marijuana-business-conference-wrapup-36-tips-lessons-take-aways-for-the-cannabis-industry/.

[22] 128 T.C. 173, 173 -74 (2007).

[23] Id. at 183.

[24] Id. at 175-76.

[25] Id. at 174.

[26] Id. at 183.

[27] Id. at 182.

[28] Id. at 185.

[29] 792 F.3d 1146, 1147 (9th Cir. 2015).

[30] Id. at 1149.

[31] Id.

[32] Id. at 1150.

[33] 115 T.C.M. (CCH) 1452, at *10 (2018).

[34] Id. at *9.

[35] Id.

[36] Id.

[37] Id. at *5-6.

[38] I.R.C. § 471.

[39] Toni Nitti, The Top Tax Court Cases of 2018: It Wasn’t a Good Year for the Marijuana Industry, Forbes (Dec. 17, 2018) https://www.forbes.com/sites/anthonynitti/2018/12/17/the-top-tax-court-cases-of-2018-it-wasnt-a-good-year-for-the-marijuana-industry/#494b26b3c55c.

[40] I.R.C. § 263A.

[41] I.R.C. § 263A(a)(2).

[42] Treas. Regs. § 1.471-3(c), § 1.471-11.

[43] 2019 Cal. Legis. Serv. Ch. 729 (A.B. 37) (West).

[44] See Cal. Rev. & Tax Code § 17201(c) (2018).

[45] Colo. Rev. Stat. Sec. 39- 22-104(4); Colo. Rev. Stat. § 39-22- 304(3)(m), (n); O.R.S. § 316.680(1)(i); ORS § 317.763 Haw. Rev. Stat. § 235-2.4(v).

[46] See Ark. Code Sec. 26-51-201.

 

Elliot Ginsburg
Garner, Ginsburg & Johnsen, P.A.
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Email:  eginsburg@yourfranchiselawyer.com

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Our cannabis lawyers have backgrounds in many legal areas including business, franchise, distribution, trademarks, and alcohol beverage law.  We have expanded into helping those in the cannabis industry.

• • Elliot Ginsburg has:
    • Presented on tax issues in the cannabis industry for a continuing legal education program in 2020
    • Served on a cannabis regulatory panel at the Minnesota Hemp Association 2019 convention
    • Gave a presentation in 2019 for lawyers on cannabis regulations and the history of cannabis and the law in the U.S.
    • Presented to the Minnesota Association of  Criminal Defense Lawyers on cannabis and its status in the U.S.
    • Presented to a Minnesota Chamber of Commerce meeting that included educators, legislators, business owners, and other members
• • We represent a CBD retailer with several locations and help with everything from general business issues to hemp/cannabis regulatory matters
  • With years of experience in the alcohol beverage regulatory space, our lawyers are well-suited to navigate the similarly complex and diverse laws implemented to regulate the growth, distribution, sale, and use of marijuana;
  • Many states have set up a tiered system in the marijuana industry that mirrors the three-tiered system most states employ in the alcohol beverage system. Chronic Lawyers are situated to help you find your way through the thicket of laws and regulations.