In 1989’s Bill & Ted’s Excellent Adventure, Keanu Reeves plays a stoner who gets caught up in historical shenanigans. By 2014, Mr. Reeves progressed past his teenage high jinks to become a James Bond-like action hero in his John Wick series. Mr. Reeves’ maturation and progression from a hapless pothead to a debonair action hero loosely tracks US society’s relationship with recreational cannabis. However, as state after state has changed cannabis’ classification from illegal drug to regulated adult pastime (40 at last count), the federal income tax treatment of cannabis has remained stubbornly antiquated. Several recent developments, however, foreshadow a rational path towards the taxation of this burgeoning industry. We’ll attempt to cut through the haze and explore several of these developments in this Legal Update.
THE SECTION 280E CONUNDRUM
On May 16, 2024, the Biden Administration proposed to reclassify cannabis from a schedule 1 controlled substance to a schedule 3 controlled substance by filing the proposed change in the Federal Register.1 Section 280E of the Internal Revenue Code of 1986, as amended (the “Code”) does not apply to schedule 3 controlled substances. The Department of Justice is soliciting public comment on this change. The markets are pricing in the fact there will be a significant amount of time before the change becomes effective.2 Once cannabis has been rescheduled, however, cannabis businesses will no longer be required to adopt the extraordinary measures required to segregate businesses or pursue capitalization strategies to obtain a tax benefit for the costs of operating their businesses.
By way of background, Code § 280E is a tax rule that supplements criminal tax laws against drug dealing. Specifically, Code § 280E disallows credits and deductions with respect to any trade or business expense incurred in “trafficking in controlled substances (within the meaning of schedule I and II of the [federal] Controlled Substances Act) . . . .”3 The federal Drug Enforcement Agency (the “DEA”) has designated cannabis as a schedule I controlled substance.4 The Internal Revenue Service (the “IRS”) has successfully asserted that Code § 280E applies to cannabis businesses even when operating in states that have legalized cannabis usage.5
The cost of goods sold is not a deduction, and, therefore, is not subject to Code § 280E.6 Thus, amounts properly added to inventory in a cannabis business are effectively deductible as such amounts reduce gross income. This dichotomy between expenses categorized as trade or business expenses (which are non-deductible) and the cost of goods sold (which is effectively deductible) creates a strong incentive on the part of cannabis businesses to expansively apply the inventory capitalization rule contained in Code § 263A. One significant challenge to this approach is that Code § 263A(a)(2) does not permit the capitalization of nondeductible costs. Code § 263A, however, does not apply to businesses with annual average gross receipts of less than $25 million.7 Thus, smaller cannabis businesses can benefit from cost capitalization without the restrictions imposed by Code § 263A.
In addition to taking an expansive view on inventory capitalization, cannabis businesses have adopted two strategies to mitigate the impact of Code § 280E. First, cannabis businesses have segregated business activities that directly involve cannabis production, distribution or sale from other parts of their businesses. These other parts include ancillary services and cannabis-related products. Many cannabis businesses rely heavily on the Tax Court decision in Californians Helping to Alleviate Medical Problems, Inc. v. Comm’r8 in implementing this strategy. In this case, the taxpayer established that its medical marijuana dispensary business was separate from providing health care services to AIDS victims.9 Accordingly, the taxpayer was permitted to deduct the costs of providing health care. In addition, Code § 471(c) provides businesses with annual average gross receipts of less than $25 million to apply an expansive view of cost capitalization provided that such capitalization comports with the company’s books and records. In a 2021 Chief Counsel Memorandum, the IRS opined that a taxpayer electing to capitalize costs under Code § 471(c) could capitalize certain purchasing costs, certain storage and handling costs, costs of preparing the goods for resale (including inspection costs, packaging costs, and the labor associated with these activities) and of reselling the goods (selling expenses, including associated labor costs), even though these costs would not be capitalizable for a corporation that did not meet the $25 million gross receipts test.
The possible successful application of these strategies has been highlighted by the recent announcement by Trulieve, a multi-state cannabis business. At the end of February 2024, Trulieve reported that it had received federal tax refunds of $113 million attributable to claims that Code § 280E did not apply to all business expenses incurred by the company. Trulieve’s Chief Financial Officer stated:
Given the uncertain position of the claims as they sit today, we do view that as ‘trade secret’ and in large part specific to our position and our organization. We are not going to be sharing that information publicly given the fact that it is in or could be in a litigation posture, and specifically that information would become available if and when we actually get to a court filing.10
Accordingly, while it is not possible to know exactly how Trulieve determined that it was entitled to a federal income tax refund, it felt comfortable enough to file the claim.
S. 4226 THE CANNABIS ADMINISTRATION AND OPPORTUNITY ACT
On May 1, 2024, Senator Corey Booker introduced proposed legislation to impose a new excise tax on cannabis. The excise tax would be imposed at a 10% rate for the two years following enactment. The excise tax would scale up to 25% beginning in the fifth year after enactment. The excise tax would not be imposed on the actual sales price of the cannabis. Instead, the excise tax would be imposed on 25% of the “prevailing sales price of cannabis flowers sold . . . during the 12-month period ending one calendar quarter before such calendar year.” The excise tax would be capped. Specifically, in the first two years after enactment, the maximum excise tax would be $2 million. The cap scales up to $5 million beginning in the fifth year after enactment. The cap would not apply to both legally imported cannabis and cannabis that is smuggled into the United States. The excise tax would not apply to an individual who cultivates cannabis for their personal use, provided that such individual is not otherwise engaged in a cannabis business. Cannabis produced for export outside of the United States would be exempt from the proposed excise tax.
The proposed legislation would prohibit the cultivation of cannabis outside of a “bonded premises of a cannabis production facility duly authorized to produce cannabis products according to law.” The limitation would not apply to individuals who cultivate cannabis for their personal consumption. In order to spur domestic cultivation of cannabis, the tax rate would be reduced by one-half with respect to cannabis produced by a “qualified domestic manufacturer of cannabis products.” The legislation leaves it to the Treasury Department to promulgate regulations specifying the requirements of a “cannabis production facility.’
TAKE-AWAYS
Tax planning for cannabis businesses is likely to remain bespoke for some time as the reclassification of cannabis is not likely to occur right away. Furthermore, if a more conservative regime takes control of U.S. politics, the DEA action could be reversed and/or IRS audits of cannabis businesses could be increased. Accordingly, while the dual proposals, reclassification and the imposition of an excise tax foreshadowing federal legalization, are both promising developments, cannabis businesses will likely be required to continue to grapple with deduction disallowance for the foreseeable future.
1 Department of Justice, Drug Enforcement Administration Docket No. DEA-1362; A.G. order No. 5931-2024 Re: Schedules of Controlled Substances: Rescheduling of Marijuana.
2 The North American Marijuana index (NAMMAR) barely moved on the news of the filing by the DEA. The NAMMAR Index jumped, however, the week before on the news that filing would be made. See https://www.investing.com/indices/north-american-marijuana
3 The Controlled Substances Act is codified as P.L. 91-513. Code § enacted in response to the Tax court decision in Edmondson v. Comm’r, 42 TCM 1533 (1981).
4 See Congressional Research Service (“CRS”) Report R44782, The Evolution of Marijuana as a Controlled Substance and the Federal-State Policy Gap (Updated April 7, 2022).
5 Oakland Cannabis Buyer’s Co-op, 532 US 483 (2001); Canna Care, Inc. v. Comm’r, TC Mem. 2015-206, aff’d 694 F. App. 570 (9th Cir. 2017); California Small Bus. Assistants Inc. Comm’r, 153 TC 65 (2019); See IRS, Marijuana Industry Frequently Asked Questions, I operate a business that consists of selling marijuana. Can I claim deductions to determine my taxable income?
6 Treas. Reg. § 1.62-3(a).
7 Code § 263A(i)(1).
8 128 TC 173 (2002).
9 Other taxpayers, selling cannabis paraphernalia, have not received similar results. See Alterman and Gison v. Comm’r, T.C. Mem. 2018-83.
10 Simakis, Trulieve Reports Receiving Refund For 280E Taxes Paid (Cannabis Business Times) (February 29, 2024. https://www.cannabisbusinesstimes.com/news/trulieve-280e-taxes-refund-2023-financial-report/
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