Forbes: Marijuana Industry Faces Challenging Tax Regime

The Tenth Circuit had bad news for most of the state legal pot industry in its recent decision-Alpenglow Botanicals LLC.  Some of the service providers to the industry might not be that disappointed, though.  That is probably a reflection of Reilly’s Third Law of Tax Practice – Any reasonably complex tax matter involving significant dollars, regardless of whatever else it might be, is a white collar jobs program.  As is common, the story behind the story is more interesting than the decision in itself, but we should tackle the decision first.

About Alpenglow

Alpenglow Botanicals runs marijuana dispensaries

Alpenglow Premium Cannabis provides the only “Farm to Flame” experience in Summit County, Co.  We strive to produce the highest quality product and make it available at the best prices.  Over 30 strains are locally grown and produced in small batches in Breckenridge, Co. at 9600 ft. above sea level and are only available at our two Summit County, Co. locations.  Visit one or both locations to experience the high of 9600ft.

Alpenglow was founded by father and son Charles and Justin Williams.  You can infer from the tax returns that are part of the case record that Charles provided the financing.  Googling will tell you that Justin is more the public face of the company.  At least in the years 2010, 2011 and 2012, which are the subject of the litigation they each owned 50% of the company, which was treated as an S Corporation.  Revenue grew quickly as was pretty common in the industry according to Jim Marty who prepared the tax returns.

The Audit

The big tax problem of the marijuana business is that even though twenty-eight states and the District of Columbia allow the regulated sale of either medical or medical and recreational marijuana, it remains a controlled substance under federal law.  And Code Section 280E enacted as part of TEFRA in 1982, the days of Nancy Reagan’s ‘Just, say no’ campaign, denies deductions to those involved in the trafficking of controlled substances.

Just because your business isn’t legal, doesn’t mean it is not taxable. I mean, after all, that is how they got Al Capone.  So presumably 280E might have made it harder on traffickers when they were caught.  There is a subtle constitutional point though.

Traffickers are not taxed on their gross receipts because of 280E.  They are entitled to a deduction for what they pay for their product – cost of goods sold – because we have an income tax, not a gross receipts tax.  The deduction for ordinary and necessary business expenses (Code Section 162)- like gas for your vehicles, bribes to the police, bullets and rent on safe houses- is a matter of “legislative grace” and can be denied because, you know, drugs are bad like they teach you in the DARE program, that my kids had in elementary school.

So even though the Obama administration Justice Department took a “fight crime someplace else” attitude toward enforcing federal law on marijuana in states which had strong regulatory systems, the Obama administration IRS enforced 280E against state legal,, federally tolerated operations like Alpenglow.

The resulting audit was expensive for Charles and Justin, a total tab over $50,000,  but they could afford to pay it which allowed them to sue for a refund in a district court, where they lost, and appeal to the Tenth Circuit, where they also lost.

The arguments, which went nowhere were that the IRS did not have the authority to determine that they were trafficking in a controlled substance (IRS is the tax police, not the drug police), that the Sixteenth Amendment required the allowance of ordinary and necessary expenses and an Eighth Amendment argument that 280E represents an excessive fine.  Jim Marty told me that there are businesses that face effective tax rates over 100% because of 280E.  There was also a “dead letter” argument to the effect that the IRS could not deny a deduction since DOJ was not enforcing the law when it came to marijuana in Colorado.  No luck with that one either.

Maybe Not Such A Bad Thing For The Industry

Even if you are not allowed to deduct your ordinary and necessary business expense, you can still make money after tax, if your gross margins are strong enough.  And if you are dealing with your cost of goods sold being deductible, but other necessary expenses not being deductible, what you really need to be sensitive to is “cost accounting”.  I found “cost accounting” pretty fascinating when I studied it, but have not had to use it a lot in my career.

Those are the type of issues that have been so good for the business of Bridge West “CPAs and advisors to the cannabis industry”:

“Founded in 2012, Bridge West was the first accounting firm in the world to focus solely on the cannabis industry.

Since then, our CPAs and consultants have guided hundreds of U.S. and international cannabusinesses through what can be a very challenging business and regulatory environment. From preparing audited financial statements to minimizing the effects of IRS 280E, our services address the industry’s unique and ever-evolving issues. A team of more than 100 professional advisors means our clients always have the support they need.”

Jim Marty, Founder of Bridge West, strikes me as one of those people who has had greatness thrust upon him. A 1979 graduate of U Mass Amherst, after a stint in the not quite big 4 (I think it was still eight back then) he and his wife moved to Colorado and opened up a local firm.

As Pot Grows So Grows Public Accounting

As cannabis started budding in Colorado after the Obama DOJ announced its hands-off approach, his clients were asking him about doing business with industry players and considering opening their own dispensaries.  Before long he found that cannabis clients were more than half his practice so he segregated it and merged the rest of his practice with another firm founding Bridge West as part of the process. Bridge West is now affiliated with a 100 person plus regional CPA firm allowing it to provide complete service including audited financial statements.

Jim did not seem that displeased with the Alpenglow decision, even though it did not go the way he preferred.  He does not expect that it will be appealed to the Supremes.  The upside is that everybody knows where they stand.  At least, for now, 280E is something that dispensaries have to work with and around.  I asked him if there was a kind of rule of thumb gross margin that could make things work.  His answer was that there was nothing which was not proprietary information.

One hint that he was free with was that he had his clients stay away from the S corporation form, since an S corp has to pay salaries, some of which will not be deductible.  Thanks to the lower rate, C corporations are worth looking at.  He talked about there being a kind of mission creep on the part of the IRS. IRS takes the position that you cannot use expensing provisions on equipment in figuring cost of sales and that some expenses required to be inventoried are still subject to 280E.  It will be interesting to see if cannabis shows up one way or the other in the eagerly awaited 199A guidance.

Other tips that Jim offered were that the cannabis industry probably has a lot to learn from the tobacco and alcohol industries and that dispensaries rather than thinking in terms of sales per square foot need to think in terms of margin per square foot.

Other Coverage

I found the oral arguments a pretty entertaining listen.  The attorney for Alpenglow threw a sort of “Hail Mary” pass by bringing up a Supreme Court decision that had come down the previous day, but to no avail.

Jennifer Benda covered the case in a comprehensive post – Cannabis Businesses Litigation The Lessons Learned.

“Without evidence that the IRS is using information gathered in IRS civil audits to initiate criminal proceedings or inform other law enforcement agencies of criminal activity, the courts have been unwilling to intervene in IRS civil exams.”

Follow Peter on Twitter @peterreillycpa. Non-tax matters check out We Are The Future Generations. Tax stories not quite forbes worthy on Your Tax Matters Partner.