High-Flying Cannabis Industry Faces Big Tax Problems

Cannabis has been a popular area for investment and building new businesses, although some of the bloom seems off the bud. For a good governmental reason. Not the Drug Enforcement Agency, but the Internal Revenue Service.

If you were thinking of investing in the cannabis industry, here’s some totally necessary downer news from the National Taxpayer Advocate at the IRS.

The problem is that “the Controlled Substances Act (CSA) makes it illegal under federal law to manufacture, distribute, or dispense marijuana, which is classified as a ‘Schedule I’ controlled substance,” even if states have decriminalized the substance. (And, by the way, even CBD can be legally problematic, according to the FDA.)

And now, the problem:

“While businesses can generally deduct from their gross income ‘all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on [the] trade or business’ pursuant to section 162(a), there are exceptions. Section 280E, enacted in 1982, forbids businesses from deducting expenses from their gross income if the business consists of illegally ‘trafficking’ in Schedule I or II controlled substances. Because marijuana is still classified as a Schedule I controlled substance under federal law, all cannabis businesses fall into the category of drug trafficking and remain prohibited from writing off otherwise legitimate business expenses. (Similarly, because marijuana is not a federally recognized course of medical treatment, individual taxpayers are prohibited from claiming associated expenses as itemized deductions on Schedule A of their Form 1040 tax return.)”

While the tax law does allow deduction of costs of goods, even for a controlled substance, the other costs—rent, utilities, wages, legal bills, advertising, and so on—can’t be. The company is taxed on gross profits and may lose money after the tax bill. Here’s a theoretical example from the IRS:

“A marijuana retailer has gross revenue of $1,000,000. It spent $750,000 on COGS and incurred another $200,000 in business expenses (which are nondeductible per Section 280E). Assuming a 30 percent effective tax rate, the marijuana retailer has a federal tax burden of $75,000 ($250,000 taxable income x 0.30). Had the business been allowed to deduct the other $200,000 in business expenses, its tax burden would have been reduced to $15,000 ($50,000 taxable income x 0.30).”

Now, in this example, there’s only $50,000 left after the cost of goods (COGS) and other business expenses ($750,000 plus $200,000 being $950,000). But the federal tax owed (not including payroll, state, or local taxes) is $75,000. The company is in the red by $25,000.

Say you wanted to invest in a public cannabis company that was trafficking in a controlled substance. What are the actual profits? You’d have to go to the financials and check whether the tax provisions were accurate. Try taking the gross profits after cost of goods and then comparing that to the operating expenses, and then pre-tax, to see what might be happening.

Large corporations can afford to buy parts of cannabis companies and potentially see long-term losses as a way of hedging against the possibility that, just maybe, Congress might one day remove the materials from the controlled substances lists. Given the current dynamics of politics, that seems unlikely, but, still, they can afford to wait.

But for a regular investor, this becomes an issue. What will the stock market bear? Can you expect prices to keep rising so you’ll see a return on your investment? Or will the companies continue to face withering tax regimes?

That’s just on the stock side. Then there are the people who want to start businesses, maybe start a dispensary or, possibly, put their green thumbs, along with fertilizer and grow lights, to work and raise a crop. This becomes a real problem.

The inability to deduct ordinary business expenses is a crushing one. Even if the numbers worked out to allow some slim margin of profit, a payoff for all the investment necessary to start could take a long time to see.

So, before putting money into a pot farm or dispensary, whether through a stock or your own work, go through the numbers with an accountant, determine how much money would likely go to taxes, and then see how much sense investing your nest egg is.