Of all the challenges cannabis companies face as they fight for survival and market share in 2022, the tax man remains one of the most daunting. States that have legalized adult use collectively generated more than $3.7 billion in tax revenue from recreational sales in 2021, according to the Marijuana Policy Project. The figure represented a 34-percent increase compared to 2020.
While the new source of revenue has been a boon for state budgets, it has been a bane for companies trying to turn a profit in an industry that produces and sells a Schedule I drug. As a result of the plant’s criminal federal status, each state defines its own tax rates, which vary widely and have created incentives for consumers to cross state lines to buy cheaper products.
Most jurisdictions apply an excise tax to cannabis sales, and these are levied at the retail and/or wholesale level. In nine states, the excise tax is levied in addition to the general sales and use tax, and an additional local option tax applies in eleven states. In California and some other states, addition of a local tax means some consumers are paying up to 40 percent more than the base price of the product.
Given the exorbitant taxes, an essential part of running a successful business is limiting the tax burden and finding tax relief in every nook and cranny of local, state, and federal codes.
Jennifer Benda, a partner at Holland & Hart LLP, counsels cannabis-industry clients on tax strategies and how to navigate state tax audits. While more states are legalizing medicinal and recreational use, she said Internal Revenue Code Section 280E — which prevents cannabis companies from deducting most business expenses — remains a major thorn in the side of all cannabis operations, and companies continually look for ways to work around it.
“One of the issues out there is we now have a deduction in the code that is meant to alter the tax rate on business income that’s reported by individuals,” she explained. “Prior to that, there was a similar section of the code that provided this deduction for people who are engaging in domestic production, which is what these companies are doing. So, many cannabis businesses didn’t claim this domestic production activity deduction because of 280E. However, we raised that issue in a case and the [Internal Revenue Service] conceded it. So I think there are some areas of the code that can be explored like that one.”
Currently, cannabis companies file tax returns with “a lot of uncertainty,” she said, because multiple tax-court cases remain undecided. “We’re still trying to clarify what inventory rules apply to the industry, as that’s a very evolving area and constantly changing,” she said. “So, it’s hard to fully advise people on the risks of different positions they might take.”
Unfortunately, Benda predicts audits will become more commonplace moving forward, which means companies must ensure they have effective systems for tracking all the financial aspects of their business up and down the supply chain. Benda has worked with cannabis clients since 2015 and said audits were fairly common in the past, but COVID disrupted the norm. “My clients were reporting to me that everyone they knew in the industry was being audited,” she said. “I’m not hearing that same thing now, but I think it’s only a matter of time with the IRS ramping up.”
Beyond having a bank account and applications such as Metrc and QuickBooks in place, she said it’s important for companies to “capture the right inventory costs, review things regularly, and make sure you haven’t misclassified things. It really is a lot of documentation that goes into not only maximizing what’s allowed, but also saving yourself when an audit comes around.”
The Secure and Fair Enforcement (SAFE) Banking Act — designed to help cannabis businesses secure more financial services — has an outside chance of passing this year, and it would represent significant federal reform. If passed, the law also could help pave the way for eventual repeal of 280E. But don’t get your hopes up for a reduced burden. Benda said we can expect 280E’s death to be accompanied by yet another tax for companies to contend with: a federal excise tax.
“At the national level, I’m interested in how a potential national excise tax might be put together, and I think there’s a lot to say about that as far as what’s been proposed and what makes sense,” she said. “Are we basing it on an alcohol model or something simpler? So, how they implement the excise tax and whether it’s transparent to consumers is very important.”
While every cannabis company would applaud the repeal of 280E, the idea that another tax could take its place will be a hard pill to swallow for companies that are struggling to turn a profit in states where the tax rates already soar through the roof.