The Tax Aspects of Legal State/Illegal Federal Activity

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The 2014 midterm elections signaled voters’ growing support for the legalization of marijuana. To date, a total of twenty-three states and the District of Columbia have laws legalizing medical cannabis.

The U.S. medical cannabis market has been estimated at $1.7 billion in 2013. As the number of states passing pro-medical marijuana laws multiplies, analysts predict that the market will quadruple in size over the next five years.

This expanding industry has attracted a growing number of corporate players. Privateer Holdings Headquartered in Seattle, Washington is America’s first private equity firm to focus exclusively on the medical cannabis field.  In San Francisco, ArcView aims to be the next premier hub for marijuana investment, data and progress raising over $17 million since 2010.

However, despite the industry growth and widespread state legalization, there remains one troublesome issue.  Namely, medical marijuana use is still prohibited by the federal government! This is problematic because according to the Supremacy Clause in article IV of the U.S. Constitution, any state or local laws in conflict with a federal law must be invalidated.  

The legal issue came before the Supreme Court in 2005 in Gonzalez v. Raich.  There the court held that an elderly California resident could not consume home grown cannabis for medical purposes because only the federal government had the authority to regulate it under the Commerce Clause and the Controlled Substance Act, even though medical marijuana was legal in California at the time.

Nonetheless, the States continue to approve cannibus production and distribution while the Federal government grapples with the issue. This creates concerns for businesses filing federal tax returns.  Namely, it is not clear whether certain operating costs are deductible on business returns.  

IRC Section 280E:

This code section provides: 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 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 understood that, the cost of goods sold is always deductible even if the business is say selling cocaine or methamphetamine. The real issue lies with the operating expenses.  Generally, per section 280E they are non-deductible. Nonetheless, there are potential tax planning techniques available. Some of these are identified below:

1. Use the Cloud:  Not being able to deduct SGA might be an advantage in today's business environment since many functions needed by businesses are now available through the cloud with low-cost SaaS (Software as a Service) offerings.  This includes invoicing, accounting, IT and HR services.

2.  Inventory Capitalization: Where ever permissible, capitalize into inventory all expenses on full absorption basis. As stated above, the cost of goods sold should remain deductible.

3. Separate Accounting for all Legal Product Lines:  There may be adjunct product offerings in the business that on a stand lone basis are legal for federal purposes and eligible for normal tax treatment.

4. Strive for Variable SGA Costs: Since SGA is not deductible, the strategy should be to minimize fixed SGA. For example, sales people that earn high commissions rather than fixed salaries will insure that there is a higher contribution margin available to absorb the sales commission cost which can only be deducted on a pretax basis.

The issues related to the legal state and illegal federal businesses are unique and complex meaning advisors should be informed and proceed cautiously.    

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