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Cannabis Industry Tax Overview

By Colleen Kern, CPA

Posted Sat, September 7, 2019

If you’ve been around the cannabis industry for more than a minute, you know that it’s not the get rich scheme many thought it would be. While it is currently a $10 billion industry (yes billion with a “b”) and prospected to grow to $550 billion at maturity, the marijuana industry is complex. From the red tape cannabis businesses need to navigate to get started, to the constantly changing regulatory landscapes in each state, there is a ton of questions and not a lot of answers. This is not a business for faint of heart. Then again, as we would tell any small business owner, “if it was easy, everyone would be doing it.”

And then there’s cannabis industry taxes. How the heck does that work? States give a thumbs up and the IRS gives a thumbs down. Now what? Why is the taxation of the cannabis industry complex? To fully appreciate how we got here, let’s take a trip in the time machine.

Cannabis Industry History

How did we get here? The road to your CPA and all their regulatory boards talking openly about pot isn’t a short one or a sign that they’re all hippies now. Known usage of the cannabis plant goes back over 10,000 years. Where legislation and general confusion begins is in the terms.

Cannabis, Marijuana, or Hemp? What is it?

Cannabis is a genus of flowering plants in the Cannabaceae family which has three primary species: Cannabis sativa, Cannabis indica, and Cannabis ruderalis. Say that 10 times fast, or even just once. Good luck!

cannabis industryIt is from these three species that we get both marijuana and hemp. The cannabis industry distinction between marijuana and hemp is a broad classification adopted by culture. Marijuana contains greater than 0.3% THC (by dry weight) and can induce psychotropic or euphoric effects on the user, while Hemp contains less than 0.3% THC (by dry weight) and cannot. (Thanks to CBDOrigin for their helpful overview!) The definitions matter because they drive legislation.

Prior to 1900, there was no distinction between marijuana and hemp, it was all just cannabis. The distinction came due to anti-Mexican sentiment, when approximately one million Mexicans migrated to the United States to escape the Mexican Revolution. Several states passed anti-marijuana laws which helped lead to Federal legislation in the form of Marihuana Tax Act of 1937. In theory, this act was to regulate the importation, cultivation, possession and/or distribution of marijuana. In reality, industrial hemp, which was used for textiles, paper products, and more, was caught up in the legislation, making importation and production on a commercial level less economical in the US. It also had the impact of decreasing scientific and medical testing to almost nil.

By 1970, marijuana got caught up in the War on Drugs, and was classified as a Schedule 1 substance on par with narcotics in the Controlled Substances Act (CSA). Changes have occurred over the last 40 years with all but 4 states having some sort of public cannabis access program and with 11 states, DC, and Guam, having full Adult (recreational) and Medical Use programs in place. Commonly among cannabis business owners the distinction on permitting is rec versus med… recreational versus medical.

Source: National Conference of State Legislatures (State Medical Marijuana Laws) as of August 1, 2019[/caption]

The most recent federal tax legislation that mentioned cannabis affecting the cannabis industry was the Agriculture Improvement Act of 2018, more commonly known as the Farm Bill. The bill “legalize[s] industrial hemp and make hemp producers eligible for the federal crop insurance program.” This is part of the reason that you are now seeing hemp related beauty and health products explode into the mainstream US market. Prior to the legalization of growing hemp as a crop, all hemp had to be grown outside of the US. It also made “hemp” a classification of cannabis versus “marijuana” as legal definitions in the US (those greater than or less than 0.3% of THC by dry weight differences).

Neat. So, what does that mean from a cannabis business and tax prospective? We are glad you asked. You didn’t come here for history and botany class.

Cannabis Industry Taxation Challenges

Here’s where all that cannabis industry information above comes in handy. According to the federal government, if you grow and sell hemp, you are a farmer. If you grow and sell marijuana you are a drug trafficker.

Wait. What?!

Yup. There are some hackles being raised for sure. The economic process of buying and selling marijuana products is considered illegal at the federal level and therefore falls under the term trafficking. Trafficking conjures up visuals of false bottoms in moving trucks and guys with machine guns. Seems harsh, but we don’t make the rules.

Marijuana, cannabis with greater than 0.3% THC content, still falls under its 1970 classification within the Controlled Substances Act (CSA) as a Schedule 1 substance. Schedule 1 drugs are considered the most serious and have no valid medical use.

Sidebar from Jason Watson: NFL players argue that the team doctor can prescribe one of the most powerful and addictive drugs on the planet in the form of oxycontin; but some dude all beat up and bruised can’t sit in a hot tub and roll a joint. Seems beyond hypocritical; seems flat-out ignorant. Let’s not forget the most abused drugs in the world are caffeine, nicotine and alcohol. Would you rather have a neighbor tossing beer cans in your yard at 2AM, or smoking some pot watching MASH re-runs?

Back to the issue… While most states and many people disagree with the classification, it is Schedule 1 and 2 within the CSA that sparks the rule that businesses which engage in trafficking of a controlled substance fall under US Code Sec. 280E which states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

It is this classification and related tax codes that makes the cannabis industry such a complex taxation landscape. And that’s just the federal level. It doesn’t take into account how each state taxes cannabis.

Over a series of articles, we’ll be exploring this landscape and how those within the cannabis industry can take advantage of the few tax wins for those in the know, such as:

  • The relationship between Gross Receipts and Gross Income – why these words don’t mean the same thing.
  • A little thing called UNICAP (Uniform Capitalization Rules) aka Sec 263A for inventory & how indirect costs and expenses under Sec 471 effects COGS
  • Relevant Tax Cases to the Cannabis Industry
  • Cannabis Tax Strategies

Stay tuned as we explore this fascinating niche of cannabis taxation.

Colleen Kern, CPA is a tax professional for WCG Inc., a business consultation and tax preparation firm, and is part of the business development team.