Business

Could an Obscure Tax Loophole Have “Dire Consequences” for Cannabis Businesses?

By Dan Mitchell Jul 30, 2020
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Dan Mitchell is a veteran journalist based in Oakland, Calif. He has written for The New York Times, Fortune, Wired, National Public Radio, the San Francisco Chronicle, the Chicago Tribune, Leafly, and many other publications.
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Dan Mitchell is a veteran journalist based in Oakland, Calif. He has written for The New York Times, Fortune, Wired, National Public Radio, the San Francisco Chronicle, the Chicago Tribune, Leafly, and many other publications.
See my articles
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In March, the U.S. Treasury Inspector General for Tax Administration (TIGTA) issued a report with the scintillating title, “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.”

The report’s contents are as dry you’d expect. But it should serve as a warning: as long as pot remains a Schedule 1 narcotic under federal law, the Treasury Department and Internal Revenue Service pose a major threat to legal cannabis.

In calling for “increased tax compliance efforts,” TIGTA’s report encouraged the IRS (which is part of the Treasury Department) to step up audits of legal cannabis companies. It’s not known to what degree the IRS has done so, but pot lawyers and others in the cannabis industry have been warning for at least a year that more audits are likely. 

At issue is a provision in the U.S. tax code, section 280E, which forbids businesses that sell Schedule 1 narcotics from writing off expenses on their income-tax forms, as all other companies are allowed to do. The provision is at the heart of a case involving Harborside, the Oakland-Calif.-based dispensary chain. In 2019, the U.S. Tax Court ruled Harborside liable for $11M in underpaid taxes from 2007-2012, because it had improperly written off expenses. In June, Harborside appealed the case to the U.S. Court of Appeals for the Ninth Circuit.

A flood of audits?

Harborside’s defense is constitutional. The dispensary “wants to be treated just like Whole Foods or Kroger,” Harborside’s attorney, James Mann, told WeedWeek recently.

Under the Constitution, he argues in the appeal, the federal government can tax only “income.” But under 280E, companies can be compelled to pay tax even in the absence of income: that is, when they lose money.  “If more than Harborside’s income is being taxed, then it’s not an income tax and it’s unconstitutional,” the appeal says.

The cannabis industry has long complained about 280E, and understandably so, since it can push effective tax rates up to 70%, or more. But not adhering to it can lead to audits, heavy penalties, the possible loss of business licenses and even criminal prosecution for tax evasion.

Congress passed the 280E provision into the tax code during the Reagan administration’s “war on drugs.” It was aimed specifically at criminals, as a supposed punishment and as a deterrence. Unfortunately for state-law-abiding cannabis businesses today, the courts aren’t allowed to recognize the fact that many state governments have since legalized weed.

According to TIGTA’s report, many companies are opting to ignore the provision and write off expenses such as rent and utilities, either directly like any other business, or by accounting for them as part of the cost of their inventories, thus reducing their taxable incomes.

TIGTA conducted an analysis of cannabis businesses in California, Oregon, and Washington, and found that 59% had improperly written off expenses on their 2016 income-tax forms, saving them a combined $7.3M that, according to the government, they should have paid on about $48.5M in taxable revenue that wasn’t reported as such.

At the time, the report led cannabis attorneys to renew their warnings about a coming spate of audits. One lawyer told Mariuana Business Daily there would be a “tsunami” of tax-enforcement actions. “Buckle up,” advised another.

TIGTA released its report just as the COVID-19 pandemic reached the U.S. It’s not clear whether the IRS has delayed actions against cannabis companies as a result of the quarantines, but it seems likely: Corporate tax audits in general fell by 71% from April 1 to June 1, compared to the same period in 2019. Cannabis companies would be wise to expect action to step up when the quarantines are lifted.

Loophole or trap?

As TIGTA sicced the IRS on cannabis companies, however, it also suggested a possible loophole. Under the 2018 Tax Cuts and Jobs Act, the report noted, companies reporting less than $25M in revenues are allowed to count all expenses — including things like rent and utilities — as directly related to the cost of inventory (called “cost of goods sold,” or COGS, by accountants). Larger companies must continue to count only directly related expenses, such as payments to shippers, as part of inventory costs.

Whether this provision, called 471C, overrides section 280E, hasn’t been adjudicated. A company with less than $25M in revenue might at least be able to use it as a defense against any enforcement action.

One accountant recently sent WeedWeek an email pitch offering his services to fight 280E.  “We are very aggressive CPA’s,” he wrote. “We don’t want our clients paying any tax if possible. We know how to use 471c to navigate the unfair implications of 280e.” (As a media company that doesn’t sell cannabis, WeedWeek is not subject to 280E).

However, Sean Hardwick, a regulatory analyst with Mr. Cannabis Law, recently warned that 471C could spell “dire consequences for the marijuana operator” who depends on it. In the absence of “clear guidance from the IRS,” a cannabis business depending on 471C could end up in big trouble, he wrote.

Like so many other cannabis industry problems, this one will disappear if and when cannabis is legalized or decriminalized at the federal level. For the foreseeable future, however, it will remain one of the biggest roadblocks to a thriving industry.

In a set of briefs submitted to the Ninth Circuit on behalf of Harborside, several trade associations such as the National Cannabis Industry Association and the Marijuana Industry Group, decried the continued enforcement of 280E, in part by noting that it tends to encourage the very criminality it was meant to punish.

“The tax burden lawful marijuana operators suffer through the IRS’ imposition of §280E is so severe, that many commentators identify punitive taxation under § 280E as the single biggest threat to the Industry,” the briefs’ introduction says. “If legal marijuana is taxed out of existence, one inevitable consequence is an expansion of the illegal market.”

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Dan Mitchell
Business columnist