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Weed Industry Sees Potential in ‘Opportunity Zone’ Breaks

March 13, 2019, 8:45 AM

The question has bubbled up at various trade conferences in recent weeks, and the IRS doesn’t yet have an answer: Can investors use the 2017 tax overhaul’s “opportunity zone” incentives to fund a cannabis upstart?

The issue may boil down to a more biblical query—namely, whether something federally illegal can be considered a “sin.”

The 2017 law allowed investors who place capital gains in opportunity funds to defer capital gains taxes, and even reduce those liabilities if they hold their investments for more than five years under tax code Section 1400Z-2. If investors park money in the projects for a decade, they can completely avoid capital gains tax on gains from the sale of those investments.

One of the two opportunity zone sections of the tax code references a list of certain types of businesses, including liquor stores and tanning salons, that aren’t eligible investments. Marijuana dispensaries and other cannabis-related businesses aren’t on that list, leaving their status up in the air.

The question of their eligibility isn’t an entirely hypothetical one. Tax professionals who cater to the industry say some clients have shown interest in leveraging the program for state-legal weed enterprises, and a cannabis business incubator is already preparing to launch its own opportunity zone project in Los Angeles.

The IRS didn’t respond to requests for comment on the issue. The agency is still working on regulations governing the opportunity zones program: a second set of proposed rules were submitted to the White House Office of Management and Budget for review on March 12.

Original Sins

Some tax and investment professionals worry the program’s guardrails—or federal drug laws, for that matter—could disqualify state-legal cannabis startups.
Still, there is hardly consensus, even among current and former government officials.

The question came up March 11 at a Washington conference held by the National League of Cities. Dan Kowalski, counsel to Treasury Secretary Steven Mnuchin, had a four-word answer: “I wouldn’t advise it.”

The issue also came up days earlier at a March 8 Federal Bar Association conference in Washington.

Lisa Zarlenga, a partner at Steptoe & Johnson LLP, during an overview of the many guardrails and requirements for opportunity zones, noted that opportunity funds don’t qualify if they invest in so-called “sin businesses.” These include golf courses, country clubs, tanning salons, massage parlors, hot tub facilities, gambling venues, and liquor stores.

“Glad to see cannabis is not a sin,” called out a member of the audience.

Zarlenga, former tax legislative counsel at the Treasury Department, winced a little. It’s still a risk, she said.

“Where? It’s not in the list,” the audience member countered.

Jeremy Aron-Dine, a law clerk in the IRS Office of Chief Counsel’s corporate division, told Bloomberg Tax after the panel that “It’s true that it’s not listed in the statute,” but that he hadn’t considered the question of whether cannabis businesses should qualify.

Zarlenga pointed to the drug’s presence on Schedule I of the Controlled Substances Act, a list that also includes heroin, ecstasy, and LSD.

“It’s beyond a sin business—it’s an illegal business,” she told reporters after the panel. “I think there’s a big risk. I just think it’s a risk because it’s not a legal business federally.”

It is also a heavily-taxed one, and not just at the state level. Under tax code Section 280E, state-legal cannabis businesses can’t take ordinary deductions, and can only reduce their taxable income by the cost of goods sold, or inventory minus sales. The restriction can drive their effective tax rates above 70 percent.

‘Quite a Stretch’

Even though marijuana businesses aren’t on the list of prohibited investments, there is concern that the IRS could fold a marijuana dispensary into the definition of a liquor store when interpreting the opportunity zone restrictions, said Beth Mullen, a CPA and partner at CohnReznick LLP in Sacramento, Calif. Producers of weed, oils, and edibles might be better off, she said, as they could instead be considered a manufacturer.

“I’m out in southern California, so we actually have people who really do want to figure out how to do this,” Mullen said during a panel discussion at a March 5 Washington conference on opportunity zones. “Right now there’s only seven sin businesses and one of them is liquor stores, so the fear would be that they would define a dispensary as a sin business.”

James Mann, a partner at Greenspoon Marder LLP in New York, described such suggestions as irresponsible.

“It’s quite a stretch to take this list and say, ‘This is a list of things that are sinful. Cannabis is sinful. Cannabis should basically be on this list,’” he said. “A golf course isn’t sinful.”

Perfect Marriage

Not everyone is feeling so cautious. Jack Boyajian, CEO of BaseCanna, is launching a cannabis business opportunity zone project in downtown Los Angeles.

BaseCanna helps cannabis businesses set up real estate entities and navigate the industry. It is pitching a 25,000-square-foot lot just south of L.A.’s Fashion District, which it plans to lease and develop into a cannabis manufacturing, packaging, cultivation, and distribution business, according to the company’s investor presentation.

Marijuana’s legality at the state level makes for an ideal pairing with the incentive program, industry professionals say.

The law requires that 90 percent of the fund’s assets and “substantially all” of its property fit within the census tract designated for the favorable tax treatment. The IRS proposed rules (REG-115420-18) that would define “substantially all” as 70 percent, and would mandate that 50 percent of the opportunity zone business stem from activities it conducts within a zone.

That means the incentives make the most sense for investing in small, localized outfits—not unlike much of the marijuana industry—instead of nationwide conglomerates.

The cannabis opportunity zone business, Boyajian contends, will likely beat out residential real estate ventures—to which the incentives appear to be best geared—when it comes to return on investment.

Asked about his industry’s eligibility for the new tax incentives, Boyajian said the issue was far down on his list of concerns.

“That is the least amount of my risk,” he said. “The strongest argument I’ve heard is, ‘You’re still on Schedule I.’”

To contact the reporter on this story: Lydia O'Neal in Washington at loneal@bloombergtax.com

To contact the editors responsible for this story: Patrick Ambrosio at pambrosio@bloombergtax.com; Colleen Murphy at cmurphy@bloombergtax.com