The audit letter came in 2015, and Tim Cullen had a pretty good idea what the IRS was going after.
The former high-school biology teacher, who had started a Denver-based cannabis company two years earlier, had been reading up on an obscure part of the tax code called Section 280E after hearing about a precedent-setting court case in California.
Cullen found that, unlike most businesses, the cannabis industry generally couldn’t take tax credits or even deduct ordinary business costs such as marketing, payroll, employee benefits, and rent. The result is effective rates of upwards of 75 percent, depending on the type of business, according to industry professionals.
By the time the IRS finished auditing Cullen’s Colorado Harvest Co., the damage came to $2 million in back taxes—half the revenue of the businesses under scrutiny in the first year of the audit. Colorado Harvest sold a retail dispensary license held by one of its stores in Aurora, Colo., significantly reduced advertising, and even designed a store with minimal sales people to avoid non-deductible employment costs.
“It feels like a machine that makes libertarians,” he said.
Soon, however, that machine may grind to a halt.
During the Nov. 6 midterm elections, Michigan became the 10th state to legalize recreational marijuana. Missouri and Utah joined 31 others allowing medical use. House Rules Committee Chairman Pete Sessions (R-Tex.), a frequent stifler of cannabis-friendly legislation, lost his reelection bid. Another anti-weed Sessions, Jeff, resigned as attorney general at the request of President Donald Trump the following day.
“Marijuana got more votes than any politician that I’m aware of who’s running in a contested race. So this is where America is going,” Rep. Earl Blumenauer (D-Ore.), told Bloomberg Tax, when asked if momentum for cannabis policy reform, including tax policy, will pick up under a Democratic House.
On Oct. 17, Blumenauer released a “blueprint” for marijuana legalization in the 116th Congress. At the bottom of the list, he highlighted the consequences of Section 280E, under which cannabis businesses can only deduct expenses directly associated with the product they sell, such as seeds, oil, labor, and other items used to create inventory—also known as the cost of goods sold.
In Cullen’s case, the IRS focused on discrepancies between his view and the IRS’s of what’s considered advertising, the number of employees involved in the sale of cannabis, and the square footage of his stores.
The Small Business Tax Equity Act, introduced by Sens. Ron Wyden (D-Ore.) and Rand Paul (R-Ky.) “would create an exception in the tax code” allowing state-legal businesses to claim deductions and tax credits “like any other legal business,” the memo noted. Blumenauer and Rep. Carlos Curbelo (R-Fla.), who lost his reelection bid, introduced the House version.
Rep. Jim McGovern (D-Mass.), who is in line to become Rules Committee chairman with the Democrats’ takeover of the House, told the Boston Globe shortly after the election that he is “not going to block amendments for marijuana,” calling existing federal cannabis laws “way behind.” Pete Sessions’ office didn’t respond to multiple requests for comment.
Lobbying on the issue has gained traction.
At least three firms registered to lobby specifically on Section 280E last year, according to the Senate lobbying disclosure database, including a subsidiary of McGuireWoods LLP on behalf of “wellness"-oriented vape pen seller Surterra Holdings Inc. in the third quarter of 2017. Holland & Knight LLP lobbied on the STATES Act, a bill that could eliminate the issue, on behalf of marijuana delivery service Eaze Solutions Inc. in the second and third quarters. Invariant LLC lobbied on the same bill for Constellation Brands, the maker of Corona beer and Svedka vodka, for the past two quarters as well.
The supply of lobbyists with a handle on the topic is growing, industry professionals said.
“A few years ago it was hard to find a qualified lobbyist for the space,” said Derek Peterson, CEO and of chairman of Terra Tech Corp., a publicly-traded medical cannabis and agriculture company, adding that advocacy once concentrated at the local level has seen a rise to the federal level as well.
“We have a far more powerful lobbying voice than we have had in the past decade,” he said.
Business owners have voiced their concerns to lawmakers. Cullen, for instance, said he has spoken to Sen. Cory Gardner (R-Colo.), who introduced the STATES Act with Sen. Elizabeth Warren (D-Mass.) in June. Blumenauer and Rep. David Joyce (R-Ohio) cosponsored its twin in the House.
Gardner told Bloomberg Tax that “this all comes down to education.” He disputed the notion that getting rid of Section 280E was more likely with Democrats in control of one house of Congress, because for the GOP, “it’s at the very heart of the states’ rights movement.”
Joyce, speaking with Blumenauer at a cannabis law event in September, said he believed there were “a lot of pent-up votes” on pro-marijuana legislation that committee chairs had blocked.
“I agree that we’re about to turn the corner,” he said. “Given the opportunity, the next congress will be able to step forward and do what they need to do.”
‘Subsidy to the Black Market’
For state-legal cannabis businesses, relief can’t come soon enough.
Congress added Section 280E to the tax code in 1982 in response to a U.S. Tax Court decision that allowed a drug dealer who filed a tax return for his income on sales of marijuana, cocaine, and amphetamines for the 1974 tax year to deduct the cost of those goods as business expenses. The section applies to Schedule I and II drugs under the Controlled Substances Act. Decades later, the Tax Court rejected the argument that it shouldn’t apply to state-legal businesses in two cases: Californians Helping to Alleviate Medical Problems (CHAMP) v. Commissioner in 2007 and Olive v. Commissioner in 2012.
“The unfortunate thing about it is it was supposed to be a tool in the war on drugs,” said Rachel Gillette, chair of the law firm Greenspoon Marder LLP’s cannabis law practice in Denver.
Since then, Section 280E has evolved into “a federally-supported subsidy to the black market for marijuana,” she said.
“We’re now in a situation where we’re applying this archaic, outdated provision of the tax code” to today’s legal businesses, Gillette said. “Meanwhile, they’re ignoring these people on the black market that the law was intended to target. I call that a subsidy.”
William Moschella, a shareholder of Brownstein Hyatt Farber Schreck LLP in Washington who has lobbied on behalf of the Cannabis Trade Federation, said “one reason people want this fix is they want to put the black market out of business by legalizing marijuana,” but the black market “can still be competitive if you have the legal businesses still having to pay a 70 to 80 percent effective tax rate due to this provision.”
Jon Baumunk, a professor at Evergreen State College who teaches a course on the business of cannabis, said he has seen companies split into different entities to maximize the operating expenses they can write off.
“280E is the big elephant that impacts the way people may characterize their costs,” he said.
Potential entrepreneurs don’t necessarily see it as a barrier to entry into the market, as they tend to anticipate the industry will be taxed at high levels, said Emmett Reistroffer, cannabis industry investor Lighthouse Strategies LLC’s director of manufacturing for Las Vegas. But it does cause business owners to think twice about opening another shop, hiring more employees, or investing in some new equipment, he said.
“In the eyes of the IRS, that equipment is used to create a controlled substance,” and therefore its cost cannot be written off, Reistroffer said, adding that the agency has been reticent as to which items should actually count as “cost of goods sold.”
Late last year, Gardner submitted an amendment to the 2017 tax act inserting an exclusion for state-legal marijuana businesses into the text of Section 280E as lawmakers hastily crafted the legislation, but later withdrew it. He told Bloomberg Tax that the goal was to get an idea of who would support it, along with a budget score.
Steve Bell, executive associate of the cannabis industry advisory firm Electrum Partners LLC, said he’d like “specific legislative relief to say, ‘If the state legalized this, 280E does not apply.’”
But Gillette said the answer could be much simpler.
“The government could choose to essentially not enforce this,” she said.
Or, she said, lawmakers could swap out a single word in the tax code section, outlawing deductions for the “trafficking of controlled substances” that are “prohibited by Federal law and the law of any State” where the business is conducted, instead of “Federal law or the law of any State,” as it currently reads.
“If it’s illegal under state ‘and’ federal law, that kind of solves the problem,” she said.
Liz Coles, a CPA who works for Sweet Cannabis in Portland, Ore., said if lawmakers were to take a middle-ground approach, given the desire to tax the product heavily as a bargaining chip for legalization, they could perhaps allow for some deductions, if not all.
“What are things we should be allowed to deduct?” she said. “What are some things we’d be okay with” not deducting, “like marketing, entertainment expenses?”
Cullen— who started his business as a way to help assuage the pain of Crohn’s disease, which his father suffered, and which Cullen himself would later develop—rejected the idea of such a compromise, suggesting a flat federal tax instead.
“These businesses have to be treated like every other business in America,” he said. “Or, change the rules and subject everyone to a random tax evaluation that they can never plan for and see how that flies. It’s just absolutely not fair.”