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The Current State of Cannabis Business

A business person counts cash as part of their taxpaying procedures.

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One of the first things you learn in high school civics class is that there is federal law, and then there is state law. There are times where these two worlds collide; the collision is particularly bad when it comes to cannabis.

Currently, we have 29 states plus the District of Columbia that have legalized cannabis for medical and/or recreational use. Problems arise because the federal government considers cannabis to be a Schedule 1 drug — the most restrictive category possible — which presents a quagmire for those in the industry when it comes to banking and taxation.

Into the Tax Court, we go

First, let’s tackle taxes. There was a famous U.S. Tax Court Case, Edmonson v. Commissioner in which Jeffrey Edmonson was a drug dealer. He sold amphetamines, cocaine, and marijuana — and for his crimes, he was sent to federal prison in 1974. When he was released, the Internal Revenue Service reconstructed his income and sent him a Notice of Deficiency. Edmonson took the IRS to Court in 1981. He reasoned that if the government was going to treat his drug sales as a business, then they should also consider his business expenses.

Drug dealers didn’t keep records, so by using something called the Cohan Rule, Edmonson testified that he sold his drugs on consignment. He wanted to take expenses for the cost of the drugs. However, he had to travel as well, and he had a dedicated telephone line, all of which the Tax Court considered and gave him credit for those expenses. Congress hated this, so they came up with an amendment to the Internal Revenue Code, Section 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.

Section 280E is still in force today. If you are a cannabis business owner, you are probably aware of this, for even in a state where cannabis is perfectly legal, when you file your taxes, all you can do is take an expense for the cost of the cannabis.

Consider the case of Californians Helping to Alleviate Medical Problems Inc. v. Commissioner in 2007 — a.k.a. CHAMPS. What this company did was sell subscriptions to anyone that had a medical marijuana card. They offered a monthly membership which included cannabis, but it also covered caregiving that would help their patients through the conditions that ailed them. The Court reasoned that there could be two businesses under one roof and it was mathematically easy to figure out how much of the expenses would be billed under caregiving and what would be billed as cannabis.

BINGO! We had found a way around Section 280E — but it’s not actually that simple.

Relying on experts to help you navigate the complicated waters of cannabis business will make your life as an entrepreneur much easier.

Section 280E finds a way

In 2012, a company called the Vapor Room found themselves in Tax Court. The case, Olive v. Commissioner, showed us that we couldn’t just throw two businesses together and deduct expenses to get around Section 280E. In Olive, using the principle of CHAMPS, the Vapor Room was selling medical marijuana, but then just giving away things like movie nights with popcorn and Yoga Classes. But here is the problem: there was no aggressive pursuit of income for that part of the business, so Tax Court quickly disallowed these expenses. And because their tax bill was so high, the Vapor Room went out of business.

I can’t tell you how many Olive-type dispensaries I see in a year. Somewhere along the way, someone who claimed they specialized in cannabis taxation would advise splitting into two businesses by basically just throwing them together and seeing if it would fly. The validity of that tactic couldn’t be less feasible. I’ve seen dispensaries with a setup where they sold cannabis and some T-Shirts and thought that they were operating under CHAMPS. The cannabis business is one of the most audited industries and, if you are in it, you really need a person that specializes in cannabis taxation. Not someone that says they do, but someone with proven experience and the knowledge to back it up.

This story doesn’t end there. Federal law strictly imposes its ‘hands-on’ banking policies for cannabis entrepreneurs as well. Unless you have some connections or lie about the nature of your business, opening a bank account is literally impossible. While it’s legal for banks to open such accounts, banks are not usually willing to engage with the cannabis industry because of the tax and legal ambiguities.

So, you have these businesses that have to operate in all-cash, and with cash comes theft. I’ve been in practice for 23 years and I know that businesses that operate with mostly all cash are going to see employee theft. You have to think about security — and it’s not just the employees that pose a security risk, it’s the general public as well. As a result, most dispensaries require some kind of armed and/or trained security on the premises.

Joining the right team

You have the Tax Code that is against you and you have a business that is all cash, what are you supposed to do?

The easiest thing to do is do your research. Find an accounting firm that actually specializes in cannabis. In the business of marijuana, you need to rethink how you want to enter the marketplace, how you want to handle taxes, and how you want to deal with cash.

An accountant that specializes in cannabis will have connections. For instance, they would have established a “team.” They will have a cannabis attorney (you’ll need one). They will have several banking solutions for you so your cash-use is minimized. They will have solutions to the issues you will undoubtedly encounter.

For instance, because regulations regarding cannabis are generally created by the state legislature, your team will need to know the different nuances of your state. For example, if you are a dispensary in Nevada, all you can do is sell cannabis — so the two-businesses-under-one-roof strategy won’t work for you. You will need another solution to your tax problem.

Depending on your state, there may be some banks and merchant companies that will take you on as a customer. The point is that cannabis is the new gold rush, and just because someone says they specialize in cannabis doesn’t mean they do, so do your homework.

New developments for taxes and banking

For cultivators, Section 280E doesn’t take that big of a bite, taxwise. For instance, the cost of growing cannabis includes most of their expenses. Yet, even hemp farmers are under the control of Section 280E.

There are some new developments on the tax and banking side, however. In the House, they have introduced H.R.1810 – Small Business Tax Equity Act of 2017, which would get rid of Section 280E. The Senate even has a companion bill — but both bills are stuck in committee. In the Senate, they have also introduced S. Rept. 114-280 – Financial Services And General Government Appropriations Bill, 2017, which would end the industry’s banking restrictions.

Until then — before you spend the money on a license to grow, cultivate, or open a dispensary — meet with someone that specializes in cannabis taxation. You may need to go back to the basics.

First, study your state laws. Second, sit down for a consultation with a cannabis tax specialist. Tell them your idea and let them work around it. They should be able to offer you several different options. Together, you can figure out what banking options are available; there are some small banks and even merchants that will work with you, but, for the time being, you will need the right team behind you to help guarantee a cannabis tax and banking workaround.

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