Tag Archives: Federal Regulation

280E and Recreational Cannabis: It Keeps Coming Back to This

As California nears a ballot vote on legalizing recreational cannabis, the Ninth Circuit has ruled on the very important issue of whether cannabis businesses may deduct their business expenses. While the case, Olive v. Comm’r, dealt specifically with a medical cannabis business, it has far-reaching implications for future cannabis businesses (regardless of whether they’re medical or recreational). Deductions allowed for business expenses are the keystone tax benefits and incentives for taxpayers to run their own businesses. Without these deductions, running and owning a business becomes an even more cumbersome and costly endeavor. This, in turn, diminishes incentive for current black-market participants to enter the legal sphere. (See my previous post for a discussion on why these consequences should matter to all Californians, proponents and opponents of legalization alike).

On July 9, 2015, the Ninth Circuit affirmed a previous Tax Court decision denying a medical cannabis dispensary the typical tax deductions afforded for ordinary and necessary business expenses. Petitioner, herein referred to as Taxpayer, owned a medical marijuana dispensary and was denied deductions for his business expenses because his particular business fell under one very consequential exception of the Federal Tax Code: section 280E. Despite months of speculation as to whether Section 280E applies to cannabis businesses, it is now clear that it does apply to medical cannabis businesses, and, based on the rationale of the Court, will apply to recreational cannabis businesses as well.

For those unfamiliar with section 280E, it specifically prohibits deductions for business expenses incurred where the  “trade or business” consists of trafficking controlled substances prohibited by federal law. The Controlled Substances Act classifies cannabis as such a substance and federally prohibits its use or sale. Marijuana businesses are required, like all other businesses, legal or illegal, to adhere to both state and federal tax laws. 280E changes liability substantially: cannabis businesses have to capitalize the cost of the business expenses and have to wait until the product is off the shelves to report the “Cost of Goods Sold” (COGS). The items that constitute COGS are much more limited than the plethora of expense types typically allowed under the business expense deduction. COGS, for example, include the cost of purchasing inventory (or product such as cannabis flower), and storage. In contrast, the business expense deduction includes rent, employee wages, and insurance, among others.

In Olive v. Comm’r, Taxpayer argued that 280E should not apply and he should be allowed to deduct his business expenses. His argument relied on recent federal directives (e.g., the Cole Memorandum, 2015 Appropriations Act (128 Stat. 2217), etc.), which cumulatively give states the latitude to implement legalized cannabis systems without federal interference. The Court disagreed and pointedly explained that the applicability of section 280E to cannabis businesses is wholly separate from recent federal directives regarding the enforceability of federal preemption of statewide legalized cannabis systems. The Court’s opinion rested on the statutory interpretation and authority within section 280E, and the meaning of “trade or business” as used in the tax code.

First, the Court opined that recent federal directives regarding cannabis do not preempt or reverse the current statutory law governing tax deductions for business expenses. The determination of whether section 280E applies to cannabis businesses is a matter of statutory interpretation of section 280E and the Controlled Substances Act (CSA). To date, Congress has not amended or repealed the CSA. Thus, the sale and use of cannabis remains prohibited by the CSA, i.e., federally prohibited. And, as mentioned above, section 280E specifically precludes deductions for businesses whose “trade or business” consists of activities that are federally prohibited. The language of both federal provisions is simple and easy to interpret. The Court found that the first prong, as to whether the “trade or business” was federally prohibited, applied, and therefore prohibited the taxpayer from deducting his business expenses.

Next, the Olive Court defined “trade or business,” saying an activity constitutes a “trade or business” where the activity was entered into with the dominant hope and intent of realizing a profit. 792 F.3d 1146 at 1149 (citing 477 U.S. 105) (emphasis added). The Court was clear that Taxpayer’s sale of medical cannabis was the only activity that met the “trade or business” standard as it was the only one that generated income. The Taxpayer’s business offered patrons other services including, but not limited to, yoga, counseling, and food and drink. However, all of those activities were offered free of charge to patrons. Thus, the Court concluded that the free services were clearly not offered with the dominant hope and intent of realizing a profit. In the Court’s view, Taxpayer’s only “trade or business” was the sale of medical cannabis.

The Court recognized that the taxpayer’s business was legal on the state level. However, federal law still controls where the issue being litigated deals with federal tax law. Despite federal directives that have eased or eliminated enforcement of the CSA, the law is still the law in this court’s eyes. And unlike other tax codes, section 280E uses clear and plain language. There is no other way for the Court to interpret such a statute. Unfortunately, recreational cannabis also clearly falls under the CSA prohibition and therefore to section 280E. Thus, the analysis used here will remain the same. Section 280E will continue to pose a costly problem for cannabis businesses.

Although the Ninth Circuit’s ruling is legally sound, it is a disappointing outcome for cannabis businesses held in the states comprising the circuit. It also sets a strong precedent for other circuits to follow. For California, however, this ruling comes at an opportune time as it and a number of its sister states prepare for the so-called inevitable legalization of recreational cannabis. Armed with the knowledge that 280E will apply to cannabis businesses, California can take a more proactive approach and establish a state tax model that considers the effects section 280E will have on its local businesses.

States embarking on legalizing recreational cannabis should recognize the 280E problem and realize that it will continue to cost cannabis businesses more than those in other industries. Implementing a new recreational cannabis system with high State taxes will win votes and may draw in high revenues initially, but such a system will only make it more challenging for small businesses and new business owners to remain profitable and open for business. High taxes also do not help educate users on safety or help diminish the social harms associated with cannabis use. (See “Cigarettes and Booze” for the full discussion on this topic). Lower taxes or incentive programs that include state tax credits for compliance, on the other hand, are great options to relieve recreational cannabis businesses from the cumbersome consequences of 280E. Incentive programs and State tax credits can also be especially useful for encouraging “best practices,” or compliance with regulations that are specifically designed to lower specific social harms. (See my earlier post for examples from the tobacco and alcohol industries). From a business and economic perspective, they could also lead to a more stable industry by allowing businesses to flourish and thereby remain in the legal market. Above all, such options incentivize market participants to enter the legal sphere, and will help small businesses grow within California.

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