The Unique Tax Burdens on Legal Marijuana Providers
Every business relies on the necessary and ordinary business expenses deductions allowed by the IRS to limit their tax burden. Imagine the problems it would cause for corporations across the country if the IRS disallowed common deductions for expenses such as wages, rent, or mortgage payments. If you are planning on opening up a marijuana dispensary, consider the risk that unequal tax burdens that are a rampant problem in the industry. According to the Internal Revenue Code, no deductions or credits are 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.” The controlled substances that are referred to by this law specifically includes Marijuana, even if a physician recommends it as beneficial to a patient’s health!
What is the Legal Status of Marijuana in Your State?
Since California became the first state to legalize marijuana for medical use in 1996, 18 other states plus Washington D.C. have done the same. On January
1, 2014 marijuana officially became legal in Colorado for recreational use by an amendment to the state constitution. With other states looking at similar legislation it is very likely that other states will follow suit. Although the negative effects of marijuana abuse are a serious concern for legislators, legalization has gained momentum and popularity because the potential economic benefits may outweigh the potential harm. Recreational marijuana could evolve into a booming industry that creates jobs and tourism. Local governments see the industry as a lucrative source of municipal tax revenue. However, as the marijuana industry gains steam, it will be important to make legislatures aware of the tax issues involved.
If Tax Reform Comes Soon, Expect Vast Growth of the Marijuana Industry
Since their inception, many medical marijuana dispensaries have struggled to stay alive, even ones that have a steady stream of income. According to an article published by NPR, federal and state income tax rates for dispensaries in Colorado can soar as high as 70 percent because they are not allowed to make simple business deductions that companies in other industries rely upon. The law was originally written for illegal drug traffickers in response to a U.S. Tax Court case that actually allowed a taxpayer to deduct expenses in an illegal drug trade. Now, the leading case on the issue is 2007 U.S. Tax Court case Californians Helping to Alleviate Medical Problems Inc. v. Commissioner. In CHAMP, the court held that the provision of medical marijuana is considered trafficking, thus companies are prohibited from deducting anything related to the sale of the medical marijuana, such as rent, advertising costs, and even wages. However, there are signs that the U.S. Tax Court recognizes the concern of marijuana dispensaries, and that they may be open to cutting them a break. In 2012 case Olive v. Commissioner, the U.S. Tax Court held that an operation called the Vapor Room could subtract the cost of goods sold (including marijuana purchases) from their revenue.
While Olive was a favorable holding for the industry, the impact of a high federal tax burden will continue to hurt medical marijuana dispensaries. Even more businesses may be affected now that Colorado has expanded to recreational use. Business owners in the medical marijuana industries are facing much higher tax rates compared with those in other small businesses. The issue could be even worse for recreational dispensaries. A loophole in Colorado state tax law gives the caregivers and medical marijuana dispensaries a significant advantage over the newly opened recreational cannabis shops, which pay higher local and state taxes, and have complex inventory tracking systems. Medical marijuana dispensaries pay 2.9% state tax on their cannabis sales, while retail sales of recreational marijuana carries with it a 25% state tax, in addition to local taxes.
How You Choose to Incorporate Matters
When first starting a business, one of the most important decisions that you need to make is what form of incorporation you will choose. S corporations, Partnerships and LLC’s all offer pass-through taxation. This means that the company’s revenue is passed through the company, and is taxed only once at the shareholder level. C corporations, in contrast, have double taxation. This means that the corporation is taxed first on its profits, and then the individual shareholders are taxed again on their dividends. Even though pass through taxation is desirable in many cases and often leads to a lower tax bill, the risky nature of the marijuana industry makes the C corp. form the best option for tax purposes. If the company is structured as a C corp. instead of an S corp. or an LLC, then in the event of an audit by the IRS, shareholders will not be personally liable for taxes to the business. In an entity that uses pass through taxation however, because all income is passed to the individuals, this means that in the event of an audit, individuals will be liable to the IRS.
The blossoming Marijuana industry sounds like a good opportunity to grow one’s wealth. But before you make any investments, or decide to open a marijuana business, consider the uniquely excessive tax burden that other industries do not bear. Furthermore, in Michigan and in various other states, the state tax laws are based on the federal income tax laws. This means that any business deductions that are disallowed on the federal level, will usually be disallowed on the state level as well. At the moment, there are still a lot of unique risks associated with the industry, and before the industry can reach its full potential, there will have to be some considerable tax reform nationwide.