Medical cannabis is now legal in 39 states and the District of Columbia. Additionally, adult, recreational use of marijuana is currently legal in Washington, D.C., and 19 states. Unfortunately, the federal government still views cannabis as illegal contraband and treats the state-licensed companies that make legal cannabis products as criminal enterprises even though they’re operating in states that have legalized marijuana.
At the same time, the federal government takes in billions of dollars in tax revenue from these same state-legal cannabis companies. There are several bills sitting in Congress that would reduce the uncertainty these businesses face. For example, the proposed States Reform Act would drastically reduce the federal tax burden facing legal cannabis companies and help lay the groundwork for a stable, legal cannabis marketplace.
The need for legislation like the States Reform Act stems from federal regulation that is in direct contradiction with state-level marijuana legalization efforts. Dating back to the Richard Nixon administration, the executive branch has chosen to classify cannabis as a Schedule I substance under the Controlled Substances Act.
This classification automatically invokes a number of other laws such as the Bank Secrecy Act, which make it difficult for financial institutions to service the accounts of even fully compliant legal cannabis companies. Perhaps even more significantly, the Schedule I classification makes state-legal cannabis companies subject to a provision in the federal tax code that disallows the deduction of expenses or the claiming of credits that are available to most other businesses.
Whether filing as a partnership, corporation, or sole proprietor, most businesses may deduct expenses considered “ordinary and necessary” to carry on their trade from their gross income. These expenses may include lease payments, wages paid to employees, utility costs, advertising, and a wide range of other legitimate expenses. Internal Revenue Codes 164, 165, 167, and 170 respectively allow businesses to deduct state and local tax assessments, prior-year net operating losses, depreciation, and charitable donations. Credits to offset net tax liabilities may also be available for domestic manufacturing, job creation, and a range of other reasons determined by Congress.
However, none of these deductions nor credits are available to state-licensed cannabis companies due to Internal Revenue Code Section 280E, as amended by the Tax Equity and Fiscal Responsibility Act of 1982. Congress passed this act in response to a famous case where the Tax Court determined that a cocaine dealer could deduct his rent, telephone, and automobile expenses from the illicit income he claimed on his federal tax return. The act banned tax deductions and credits for all taxpayers that traffick in any Schedule I or II substance under the Controlled Substances Act (CSA), including cannabis.
As a recent report from the Congressional Research Service declares:
Like non-marijuana businesses, marijuana businesses are subject to tax on all of their income. Under federal law, all income is taxable, including income from unlawful activities. In contrast, not all expenses are deductible from a taxpayer’s gross income. The Supreme Court has explained that tax deductions and tax credits are matters of “legislative grace.” Taxpayers conducting lawful activities may deduct “ordinary and necessary” trade or business expenses when computing their taxable income, and taxpayers may claim tax credits to the extent permitted by statute.
Section 280E of the Internal Revenue Code denies tax deductions and tax credits attributable to the trade or business of trafficking in CSA Schedule I or II controlled substances where the trafficking is “prohibited by Federal law or the law of any State in which such trade or business is conducted.
As noted, under the Controlled Substances Act, marijuana is a Schedule I controlled substance. It is a federal crime to produce, dispense, or possess marijuana outside the context of federally approved scientific studies. Accordingly, Section 280E prohibits marijuana businesses from deducting expenses and claiming tax credits.
The result of these laws is that legal, licensed cannabis businesses in full compliance with state laws face a financial penalty on federal income taxes. This penalty could result in large assessments even in years the licensed cannabis businesses suffer financial losses because they are taxed on a modified gross-receipts basis. By contrast, similarly situated businesses in other industries could not be pushed into the red by federal income taxes because they are assessed only as a percentage of net income.
The financial impact of these provisions will vary by the business, but Americans for Tax Reform has estimated it results in income tax rates “close to 90 percent.”
Over 10 years, the Joint Committee on Taxation has estimated that these tax rates have generated $5 billion for federal coffers over and above what cannabis businesses would pay under normal tax rules, allowing Congress to benefit from the cannabis trade even as it declares that trade illegal.
Congress has authorized a series of budget riders that prevent the Justice Department from expending any resources to prosecute state-licensed cannabis businesses in good standing.
Marijuana legalization proposals like the States Reform Act would remove cannabis from the federal Controlled Substances Act and allow cannabis businesses to claim deductions on the same basis as similarly situated businesses in other industries. This legislation would enact a federal excise tax on marijuana sales at 3%.
The States Reform Act’s rates would represent a net tax cut for legal cannabis companies when considering the elimination of the income tax penalty under Section 280E of the Internal Revenue Code.
That change could also help to resolve the tax-induced price disparity between legal and illegal cannabis products that have allowed the illicit market to thrive even in the face of state-led legalization efforts.
Congress should move ahead on much-needed marijuana legalization efforts. If it wishes to help establish an orderly, legal marketplace, it must also eliminate the federal income tax penalty and promote tax relief for legal cannabis businesses.