Guest Post - Tax Practitioners and Marijuana Business Clients

Here is a guest post from Brett A. Podolsky, an attorney who is also a Criminal Legal Specialist certified by the Texas Board of Legal Specialization. He is the former Assistant Criminal District Attorney for the State of Texas. As a criminal defense attorney in Houston, Texas, Mr. Podolsky dedicates his entire practice to litigation. He handles a wide variety of cases, including drug charges, federal crimes, white-collar crimes, and sex crimes. Brett offers some suggestions for practitioners on what you need to know about taxation and marijuana.

Unanswered questions remain concerning whether tax practitioners, e.g. CPAs and attorneys, can aid a marijuana business entity with its tax issues, including tax planning and/or compliance, since the sale of marijuana is still considered a federal crime. Practitioners ask, “Is assisting a marijuana business an ethical violation?” as well. All businesses, including those that sell cannabis, require tax, legal, and accounting assistance. Businesses need answers regarding business structure, taxes, and future financial planning. This post addresses what business owners and advisers should know and contemplate before agreeing to take on a client engaged in the sale, production, or use of marijuana.

State Laws and Marijuana

Today, in many states and the District of Columbia, commercial entities may form under state laws to grow and/or sell cannabis. The laws are strict concerning who may grow (produce) or sell to consumers and who may purchase. Each state’s regulations, statute, and guidelines may also interact with additional laws, e.g. employment or zoning laws. All the while—and despite the fact that states’ laws allow for cannabis production, sales, and use—these actions remain crimes under the Controlled Substances Act of the federal government. Like other businesses seeking advice about the newly passed tax laws, marijuana businesses are likely to want assistance from a tax adviser as well. Certified public accountants and attorneys may be cautious about whether they wish to, or should, assist these businesses. If CPAs and attorneys decide to assist the marijuana business, they will want to ensure that their actions won’t lead to licensure or rules of conduct violations to which they’re subject.

Attorneys and Professional Conduct

The Bar Association of San Francisco (2015) issued Ethics Opinion 2015-1 to discuss whether an attorney in California may ethically represent clients engaged in a medical marijuana business. The opinion concludes that “a lawyer may ethically represent a client on the facts presented consistent with California Rule of Professional Conduct 3-210…provided that (the attorney’s) legal advice and assistance is limited to activities permissible under state law and the lawyer advises the client regarding the possible liability under federal law and other potential adverse consequences under state and federal laws.”

Marijuana Business Overview

Most states and the District of Columbia have passed laws that allow some forms of growing, selling, and using medical marijuana. 

• Eight states – Washington, Alaska, Oregon, California, Nevada, Colorado, Maine, Massachusetts, and the District of Columbia (about 21 percent of the country’s population) – allow recreational marijuana use. 
• Although most states allow medical marijuana usage, federal classification of marijuana (cannabis) remains a Schedule I controlled substance. This classification is somewhat at odds with the idea that marijuana may be safely used under medical supervision. 
• Colorado’s sales taxes, licenses, and fees from marijuana sales continue to show robust growth. Total revenues were about $67.6 M in 2014, $130.4 M in 2015, $193.6 M in 2016, and about $247.4 M in 2017 (Colorado Department of Revenue). 

The marijuana industry is a high growth industry. State taxation of marijuana businesses is widely discussed.

Marijuana Tax Revenues

Businesses selling marijuana have tax compliance issues to consider as well. When states sought to adopt cannabis legalization laws, taxation was an essential element of attracting political support. For that reason, tax rates were set high: 

• Washington (37 percent), Colorado (29 percent), Alaska (25 percent), and Oregon (25 percent) 
• The Tax Foundation reports robust growth of tax revenues in these states. 

California established a 15 percent excise tax and other states have pegged revenue rates at 10 – 25 percent. Lawmakers note that consumers have the option to travel to another state with lower marijuana tax rates. Competition in the free and open markets are likely to determine at what rates states tax marijuana businesses in the future.

Tax Reform and Marijuana

The Tax Cuts and Jobs Act (PL 115-97) was passed on December 22, 2017. It’s widely considered as the most notable overhaul of the United States Tax Code since the Reagan Administration.

IRC § 280E

Cannabis businesses must understand how these new laws affect them. The following are some of the significant tax issues cannabis businesses face now: 

• The Tax Cuts and Jobs Act didn’t repeal IRC § 280E. 
• This section prevents the cannabis producer, processor, or retailer from subtracting expenses from income (other than those deemed ‘Cost of Goods Sold’). 
• As a result, cannabis businesses must determine the expenses included in Cost of Goods Sold and identify deductible expenses. As of this writing, little guidance is available to assist taxpayers in making these determinations. 
• Note that, on audit of a California medical marijuana dispensary, the IRS used IRC § 280E to prohibit it from deducting any operating expenses (e.g. auto expenses and officers’ salaries). In other words, IRS sought to prevent the dispensary from earning a profit on the medical marijuana business. 

Tax experts theorize that IRC § 280E wasn’t repealed because it would’ve been considered a tax cut – which would’ve prompted the U.S. Congress to replace lost revenues. However, cannabis businesses will pay lower federal taxes starting this year. Tax rate decreases mitigate its effect.

Corporate Structure

In addition, cannabis businesses should consider corporate structure under the new tax law: 

• The Tax Cuts and Jobs Act make “C Corporations” more tax-favorable. 
• C corporations pay taxes at the corporate level. 
• Individual shareholders pay taxes on dividends paid by the corporation (at rates up to 20 percent). 
• In past years, double taxation discouraged C corporations. The Tax Cuts and Job Act effectively reduces this issue by lowering C corporate tax rates to 21 percent. (Tax rates on dividends are unchanged under the Act.) 
• C corporations also enjoy 1) shareholder audit protection as well as 2) more flexibility in employee benefits. 

The new tax law may disfavor certain Limited Liability Companies (LLCs) and Pass-Through entities: 

• To date, many new businesses automatically choose the limited liability company corporate structure. 
• LLCs assume a variety of forms but, commonly, income is passed through to the entity’s owner(s). Pass-through income is taxed at the owners’ or member’s individual tax rates: in some instances, the owners may see (20 percent) of the business’ income. 
• For instance, a single person in the 24 percent bracket earns net income from an “ancillary” cannabis enterprise that he runs as a sole member of an LLC. The LLC’s income is $100,000. His federal taxes from the enterprise are $19,200, or $100,000 net less $20,000 times 24 percent. 
• Take note of exceptions: Congress has framed the pass-through entity benefit in the IRS code as a deduction: IRC § 280E disallows the deduction from cannabis retailers, producers, distributors, and manufacturers. In this scenario, the cannabis business referenced above will pay taxes on its full net income.**
• In this way, the new tax law punishes cannabis businesses. 
• Although some ancillary businesses benefit from a 20 percent deduction, others (pass-through entities) see the 20 percent deduction minimized or disallowed because of many inter-related and/or complex rule exceptions.

Tax laws favor concerns committing significant capital

Generally speaking, the new tax law exceptions favor those businesses making significant capital investments, e.g. real estate, over concerns that are either labor-intensive or service-focused. For instance, many service businesses, e.g. consulting or health care concerns, don’t qualify for the new deduction (unless overall taxable income, net of several adjustments, is less than $157,500 or $315,000 for joint filers. 

However, an ancillary business, e.g. a real estate lessor, may benefit from an LLC structure.

Possible limited tax deductions for debt financing

Some investors would rather loan money to a cannabis enterprise than invest in it as an equity shareholder. Under IRC § 280E, it’s challenging for the cannabis enterprise to deduct interest expense costs. (Under old tax laws, the ancillary business could deduct 100 percent of its interest costs.) Under the Tax Cuts and Jobs Act, the total amount of interest expenses permitted for deduction can’t be a greater than interest income plus 30 percent of adjusted taxable income plus interest expenses from floor plan finance costs: Adjusted taxable income is usually taxable net (with adjustments for) expense and interest income, losses, and specific capital investments. [IRC Section 163(j)]

Fine-Tuning the Tax Cuts and Jobs Act

The new tax law passed in December 2017 became effective in 2018. It’s probable that the Internal Revenue Service will be hard-pressed to offer guidance to businesses and tax advisers. It’s also likely that the IRS will add regulations this year. If Congress seeks to fine-tune the tax bill or enact additional reforms, might IRC § 280E be repealed, or at least limited in application to state-legal marijuana operations? We'll see.

Contact a Cannabis Business Lawyer

Marijuana businesses are a robust source of tax revenues for state and local governments. Marijuana businesses must pay taxes. Most business owners want to file an accurate return and grow their business to take advantage of significant demand. However, taxes may be an especially complex task for marijuana businesses attempting to figure out their taxation obligations this year. It’s important to get legal assistance concerning your marijuana tax questions. The new cannabis industry is high-regulated at the state level and complicated for many reasons including the fact that it still involves activity illegal under federal law.


**Note from Annette Nellen (host of 21st Century Taxation blog): Brett is correct that the Section 199A Qualified Business Income provision, added by the TCJA, allows a deduction from taxable income. However, it is an odd "deduction" in that it is really a bonus deduction intended to provide some rate reduction to businesses not operating as a C corporation since C corporations got a rate reduction by the TCJA. So, this deduction is not one with a direct cash outlay. The language at Section 280E states, "No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in ..."  Query: May a marijuana business claim a deduction under Section 199A since it is not a deduction "paid or incurred"?  The provision is in Part VI on deductions (in Subchapter B of Chapter 1). But it was addeed for rate relief. If all business owners obtained rate reductions by the TCJA, even marijuana business owners would obtain that benefit. We'll see if the IRS provides any clarification on this matter.

What do you think?