Understanding the Tax Implications of the Legal Marijuana Industry

The legal marijuana industry is growing – and fast! As of 2019, 11 U.S. states and Washington, DC, have legalized marijuana for recreational use. The number of states that allow medicinal use of the drug is also steadily growing. As the legal marijuana industry grows, there is also a growing need for business and tax advice. This raises a few questions for CPAs.

Becker instructor and tax expert Tim Gearty has detailed the ins-and-outs in his recent CPE webcast, Understanding the Tax Implications of the Legal Marijuana Industry. Throughout the course, Gearty details the key issues faced by CPAs in serving the legal marijuana industry at both the federal and state level. Here’s what you need to know.

Industry-Specific Federal Tax Issues

For federal tax purposes, it’s most important to know which expenses are deductible at the federal level. In general, Section 162 of the Internal Revenue Code (IRC) permits the deduction of ordinary and necessary business expenses. This would include general and administrative expenses, overhead expenses, advertising expenses, etc.

However, IRC Section 280E prohibits the deduction of expenses associated with trafficking in controlled substances. Ordinary and necessary business expenses are not deductible for marijuana businesses because marijuana is considered a controlled substance at the federal level.

Section 280E essentially nullifies Section 162 for purposes of the legal marijuana industry.

Cost of goods sold is not a deduction, but rather a reduction of gross income, codified in the regulations of the tax code under Regulation Section 1.61-3(a). Thus, income in the legal marijuana industry may be reduced by the cost of goods sold, even if those goods are a controlled substance under federal law.

The substantial difference in deductibility at the federal income tax level between cost of goods sold and ordinary and necessary business expenses creates additional risk for CPAs working in this area.

Business owners in the legal marijuana industry may be tempted to inappropriately shift operating expenses into cost of goods sold. As such, CPAs may need to apply special scrutiny when evaluating these areas for tax and audit purposes. 

CPAs should be especially vigilant in reviewing and gaining comfort with operating costs and cost classification. Due to the differences in federal tax treatment for certain costs, business owners in the legal marijuana industry may be motivated to take especially aggressive tax positions in the following areas:

  • Classifying their business as a producer rather than retailer in an attempt to capitalize indirect costs into inventory.
  • Shifting costs from operating costs (i.e., ordinary and necessary business expenses) into cost of goods sold.
  • Incorporating other financially inconsequential elements or business lines (i.e., also selling clothing, accessories, wellness classes, etc.) into their primary business model in order to justify shifting overall operating and overhead costs into those business lines, claiming they are deductions under Section 162.

In addressing these issues, CPAs should consider:

  • The primary structure, function, and operation of the business; are they really producing the product or just acting as an intermediary between the producer and end consumer?
  • How do the margins of the business compare to industry averages? For example, if a marijuana dispensary is reporting gross margins 40% below the industry average, then there is a higher risk that this business owner has inappropriately shifted operating costs into cost of goods sold.
  • When evaluating business lines, CPAs should focus on substance over form. What is the real primary purpose of the business? Where are the majority of revenues derived?

Industry-Specific State Tax Issues

In states where recreational or medicinal use of marijuana is permitted, there are state-specific income tax questions to consider, especially when reviewing state corporate returns and state individual returns.

Recall that at the federal level, Section 280E prevents the deduction of ordinary and necessary business expenses associated with trafficking in a controlled substance. What about in states where marijuana use is legal?

Four states have specifically permitted deductions disallowed under Section 280E, including California, Colorado, Hawaii and Oregon. Arkansas does not disallow 280E deductions. In these states, the starting point for calculating state income tax return is the federal tax return. Then, adjustments are made for state-specific items that may be added back or further deducted.

Beyond income tax considerations, sales and excise tax considerations also apply at the state level. In 13 states where medicinal marijuana is permitted, it is not subject to sales tax. 

In 17 states, the sale of medical marijuana is subject to sales tax.

The sale of marijuana for recreational use is generally subject to sales tax, with the exception of Oregon, which has no state sales tax.

Separate from sales tax, some states impose an excise tax on marijuana, ranging from 3-37%. Additionally, some states impose a specific excise tax on controlled substances, which may or may not include marijuana. CPAs should understand whether these controlled substances taxes apply to legal businesses.

Since marijuana laws greatly vary across the U.S. and continue to change, it’s important to keep a close watch on your state’s stance. Check the AICPA’s listing of state board positions for a better understanding of your state’s enforcement of providing services to businesses in the marijuana industry.

Key Issues for CPAs to Consider

  • Will providing these services in a state where they are permitted affect a CPA’s reputation with clients in another state where marijuana is not legal?
  • Does the CPA or the CPA firm have the industry-specific expertise to serve the clients in a professionally competent way?

To mitigate these risks, the AICPA suggests:

  • A clear engagement letter detailing the exact services to be provided.
  • A signed representation letter from management, updated regularly, that states management understands the requirements of state law related to the cannabis business and that they intend to fully comply with those requirements at all times.
  • Full documentation of all communications and services provided.

Learn more about legal marijuana’s effects on tax and earn 2.5 CPE credits by joining a Becker webcast.

Resources

  1. Benda, Jennifer E., and Millis, Jacob D. “Cannibis Industry State Tax Guide.” Fox Rothschild LLP. September 2018.
  2. Berke, Jeremy, and Gould, Skye. “This Map Shows Every Place Where Pot Is Legal.Business Insider. January 4, 2019.
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