Whitney EconomicsCannabis Research recently conducted a comprehensive analysis of the impact of federal taxes on the cannabis industry. The findings revealed that in 2022, cannabis operators incurred a staggering $1.8 billion in additional taxes compared to traditional businesses. Looking ahead, this overburden is expected to grow to $2.1 billion in 2023.
The reason behind the higher tax burden on cannabis dealers
Despite a growing number of states legalizing medical or adult cannabis use, the classification of cannabis as a Schedule I controlled substance under the Controlled Substances Act (CSA) remains unchanged.
Under this designation, cannabis businesses that operate under state law are considered criminal enterprises engaged in the trafficking of controlled substances under federal law. This label treats law-abiding business owners and operators as drug dealers who sell substances as harmful as cocaine and heroin. As such, these companies are subject to Section 280E.
Section 280E is a provision that penalizes those involved in trafficking in Schedule I or II drugs By preventing the deduction of “normal and necessary” business expenses. This includes discounts below the line, even after reducing gross receipts through the cost of goods sold (COGS). This results in the federal income tax liability being calculated based on gross income rather than net income.
In this landscape, seemingly obvious business choices such as accounting methods, entity selection, and ownership structure have important implications in terms of risk management. Let’s say the cannabis company fails to structure itself strategically and accurately from a tax standpoint. In this case, the effect of disallowing the deduction in Section 280E can result in effective tax bills and rates that match or even exceed the economic profits of the business.
This often leaves the company operating at a financial loss. Adding to the challenges, Section 280E puts the top-tier owners of partnerships at significant risk to face the massive federal tax liability that stems from their participation in plant-touching cannabis partnerships.
The IRS acknowledges that Section 280E is somewhat complicated and tries to explain how it works. According to the IRS website, while Section 280E of the IRS Code expressly prohibits deductions and credits for illegal businesses, there is an exception. Cannabis business owners can deduct cost of goods sold, which represents the cost of their inventory. However, regular overhead expenses such as advertising, wages and salaries, and travel expenses are not deductible.
The impact of the hemp tax
U.S. cannabis operators face many challenges beyond cannabis taxes, including onerous anti-business regulations, lack of banking services, and restrictions on interstate commerce.
The weight of the tax burden is so great that it is just 24.4% of the cannabis operators surveyed reported being profitable, indicating a significant drop from the previous year’s figure of 42%. Notably, cannabis retailers often deal with effective tax rates in excess of 70%.
A bleak outlook for the cannabis business.
According to an upcoming business conditions survey report by Whitney Economics, cannabis operators currently face daunting challenges and do not see any immediate improvements on the horizon. They hardly cling to difficult circumstances and grapple with them.
Bo Whitney, chief economist at Whitney Economicsthat the cannabis industry is experiencing severe economic hardship, and the current regulatory and tax framework is not sustainable, even in the short term.
Whitney further noted that many state markets appear to be on the verge of imminent collapse, which could cause significant damage to personal wealth and pose a disproportionate threat to smaller cannabis operators. He noted that implementing tax reform could be a viable approach to stabilize the industry and generate billions in economic activity.
Reason for optimism
Implementing tax reform could provide a much-needed boost to the cannabis industry while spurring the generation of billions in economic activity. Despite the lack of success to date in challenging the IRS’ enforcement of Section 280E and the constitutional foundations of Section 280E, there are still reasons for optimism within the industry.
A very recent and high-profile case involved Harborside, the preeminent California operator of cannabis dispensaries. They sought to discharge their corporate income tax liabilities, which totaled about $11 million, between July 2007 and July 2012. By doing so, they aimed to prove the unconstitutionality of Section 280E, which charges taxes based on gross income rather than net income. This case has received a lot of attention and scrutiny.
Judge Daniel Press called the “ongoing multimillion-dollar tax controversy” the latest effort by a medical marijuana retailer to mitigate significant tax implications imposed by Congress on companies involved in the distribution of controlled substances. This case exemplifies the ongoing struggle he faces Cannabis companies regarding their tax liabilities.
Although marijuana sales have recently been legalized in some states, federal law still classifies it as a prohibited substance. This stark contrast between federal and state law creates the basis for our ongoing multimillion-dollar tax controversy.
Unfortunately, Harborside was unsuccessful in their case, and Section 280E is still in effect, preventing cannabis companies from claiming standard business deductions on their federal taxes. In a statement, the company expressed concern about the continued negative impact of Section 280E on the growth of the legal cannabis industry, associated job creation, and state and local tax revenues that would otherwise have been generated.
While it could take a long time for a cannabis tax bill to repeal Section 280E to pass, cannabis business owners should expect frequent audits and the burden of excessively high tax rates for such or similar legislation to succeed in the Senate.
According to a recent analysis by Whitney Economics, a reassessment of tax policy, specifically the reform of Section 280E, is expected to increase profitability for cannabis operators. In addition, this will increase the employment of cannabis and generate an estimated $35.2 billion in economic activity over ten years. These potential benefits come at a critical juncture for the cannabis industry, which recently experienced its first decline in employment and is expected to experience slow growth over the next seven quarters.
Conclusion
The cannabis sector faces a variety of challenges, including high regulatory costs, financial constraints, and inconsistencies in federal and state regulations. These elements contribute to the current economic turmoil and low profitability that many cannabis business owners are experiencing.
However, tax reform, especially a revision of Section 280E, can reduce some of these costs and enable the industry to reach its full potential. Such actions may increase revenues, create jobs, and stimulate significant economic activity. Stakeholders are eager to make constructive reforms to aid the sustainable development of the cannabis industry as it deals with these challenges.
What is 280E, read on …
