The Taxation of Legal Cannabis Part 1

Mikhail Parnes Barth Daly

Mike Parnes, Attorney at Barth Daly LLP

With the recent legalization of recreational cannabis sales in Alaska, Colorado, Oregon, and Washington,[1] the writing is on the wall for the world’s eighth largest economy.[2] As of the writing of this blog, there are eleven competing ballot propositions seeking to legalize recreational cannabis use in California in 2016.[3] As Colorado and Washington have already experienced, the legalization of recreational cannabis brings an abundance of new business opportunities. And, as with any business, properly complying with legal obligations is critically important to minimizing risk. Chief among these obligations is tax compliance.

Despite the policy preferences that these states expressed (with the exception of California as of now), discussing state cannabis legalization and its taxation should not omit the obvious point that the United States federal government regulates cannabis. The federal government continues to treat cannabis as a Schedule I narcotic under the Controlled Substances Act (“CSA”).[4]  This means that Food and Drug Administration licensed physicians cannot prescribe cannabis; and, distributing or manufacturing cannabis is a serious felony.[5]

Cannabis’s classification under the CSA also empowers federal tax law to stand in the way of permitting states from realizing their full policy objectives. This isn’t news to businesses who have operated in the medical cannabis space for some years. As the industry’s lead trade publication reported, “the federal tax situation is the biggest threat to [state-sanctioned cannabis] businesses and could push the entire industry underground.”[6] An industry insider put it another way, “[n]o business, including ours can survive if it is taxed on its gross revenue. The IRS is trying to tax us out of existence.”[7]

What this industry insider referred to is Internal Revenue Code section 280E. Section 280E proscribes businesses trafficking in Schedule I or II substances under the CSA from deducting their ordinary and necessary business expenses from gross income. Thus, current federal tax law bars state-sanctioned cannabis sellers from deducting their expenses before calculating their taxable income.

While the status quo is far from ideal, commercial cannabis enterprises are not without recourse. Over the next few weeks, I will publish a series of blogs demonstrating some of the available tax planning opportunities to mitigate section 280E’s force.

After that series, I’ll write several blog posts dealing with the new medical cannabis regulatory and transaction tax (e.g., excise, sales, and use taxes) framework teed up by Governor Brown’s recent signing of three bills into law comprising the California Medical Marijuana Regulation and Safety Act.

Mike Parnes is an associate attorney representing private and public sector clients in various legal disputes. Mr. Parnes’s experience ranges from contract, real property, labor and employment, and fiduciary duty disputes to state and local tax and entity formation matters.

Before joining Barth Daly LLP, Mr. Parnes worked on the Professional Services team of a large tax technology company advising multistate businesses on various sales and use tax issues. During law school, Mr. Parnes clerked for a national firm’s state and local tax controversy practice, served as an extern for the State Board of Equalization’s Franchise Income Tax Appeals Division, and worked for two Sacramento civil litigation firms in his first and second summers.

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