Essential Tax Considerations for Cannabis Investors
As the cannabis* industry has become more widely accepted as mainstream over the past several years, many states have legalized cannabis not only for medicinal use, but also for recreational use. While it remains a controlled substance, illegal under federal law, currently 37 states have legalized medical marijuana usage and 18 have legalized both medical and recreational cannabis usage. Just this year, New York, New Jersey and Connecticut joined the growing list of states that have legalized both medical and recreational marijuana. This increase in the number of states legalizing marijuana presents an opportunity for investors to gain early access into a rapidly expanding national market expected to generate billions in sales.
While the opportunities presented by investing in early-stage state-legal marijuana businesses may be apparent, there are risks associated with participation in an industry that is simultaneously illegal for federal purposes and legal in many states. This unique dichotomy between federal and state laws has become the new frontier in tax compliance and enforcement. Evolving marijuana laws present a moving target. Below are some key aspects of the current tax laws and their complexities from both a federal and state perspective of which investors need to be aware.
Are marijuana businesses required to pay federal income tax even though marijuana is federally illegal?
Yes. For federal tax purposes, businesses within the cannabis industry must still pay tax on their income from illegal activities. These activities include growing, manufacturing, distributing and selling marijuana.
Are there any unique federal tax considerations for the marijuana industry?
Yes. One area of much consternation in the cannabis industry is that, under the Internal Revenue Code, taxpayers involved in the trafficking of certain controlled substances are prohibited from deducting business expenses regardless of whether the taxpayer is in compliance with state laws. By definition, trafficking includes actions such as growing, distributing, selling and more. Therefore, a taxpayer carrying on a marijuana business is not permitted a deduction for expenses incurred in connection with the substance’s illicit trade.
Is there an opportunity for marijuana businesses to mitigate some of their federal tax exposure?
Yes. Cannabis taxpayers may reduce their gross income by making special considerations regarding their costs of goods sold (COGS) when computing their taxable income. While specific COGS vary by business, typically they will include the cost of the merchandise and any transportation expenses. However, for cannabis growers, the COGS may be more expansive and include raw materials and direct labor, as well as various indirect production costs necessary in the production process. Copious attention, analysis and recordkeeping of COGS is very important to support any deduction claimed.
Are there other opportunities to reduce a cannabis taxpayer’s federal taxes?
Possibly. Recently, the Internal Revenue Service (IRS) began a new Cannabis/Marijuana Initiative to address the evolving concerns of the industry. Specifically, there are many lingering questions concerning tax provision application for which there is little guidance. For example, when the case can be made that multiple businesses exist, businesses may be able to separate a non-marijuana business from a marijuana business, thus enabling non-cannabis related expenses to be deductible under federal tax law. Separating these businesses may offer an array of tax planning opportunities, particularly when the records are substantiated and there are facts to support the existence of separate business operations. Unfortunately, there is little guidance on how to properly segregate the businesses and what scrutiny is required to ensure that these expense deductions will be permitted.
Are there any unique tax issues to be aware of from a state perspective?
Yes. Until the sale of marijuana is federally legalized, its interstate sales are prohibited regardless of whether adjoining states have legalized marijuana. Therefore, when a business conducts activities in multiple states, it can only operate within each state independently from its operations in another state, and multi-state operators cannot apportion their sales between states in the same fashion that another business generally does.
Do state income taxes also limit marijuana-related business expenses?
Yes. Most states use federal taxable income as the starting point to determine state taxable income. Therefore, since most expenses are not deductible for federal tax purposes, they are not available for state income tax purposes either. Some states have identified this issue and have subsequently decoupled marijuana and non-marijuana related income for the federal disallowance and permit cannabis businesses to deduct these expenses for state taxes. However, at present neither New York nor New Jersey have decoupled from the federal law restricting the deductibility of these expenses.
Are there other notable aspects of New York’s and New Jersey’s recreational cannabis laws?
Yes. New York is anticipating its first cannabis sales to commence in 2023. The state will impose different taxes on wholesale and retail sales. At the wholesale level, applicable excise taxes will be imposed based on a type of product’s THC potency measured in milligrams (mg). For example, cannabis edibles will be taxed at $0.03 per mg, concentrates (e.g., vaporization oil) taxed at $0.008 per mg, and cannabis flowers (e.g., pre-rolls) taxed at $.005 per mg. When it comes to retail sales, a 9% state and 4% local excise tax will apply, although they are not applicable to medical cannabis sales.
New Jersey is expecting in-state marijuana sales to begin in early 2022. However, only the usual 6.625% statewide sales tax will apply to recreational sales. Local cannabis taxes are permitted, but must be less than 2% for cannabis cultivators, manufacturers and retailers, and 1% for wholesalers, and cannot be levied on delivery services or bulk transportation.
As state cannabis legalization continues to grow across the country, the tax rules associated with the industry will become a greater concern. Understanding these laws can help investors avoid additional unnecessary risks and exposure in a trade that is already under intense scrutiny. Marijuana-related businesses are stuck in a unique divide between federal and state legalization laws that differ widely. In spite of these challenges, many investors are seeking opportunities within this growing industry. If you have questions regarding the tax implications of your investments in the cannabis industry, please contact your Anchin Relationship Partner, Alan Goldenberg, Principal and Leader of Anchin’s Tax Controversy and State and Local Tax groups, or Elana Tamas, a tax advisor in Anchin’s Cannabis Industry Group.
To stay informed about marijuana industry updates, sign up for Anchin’s Cannabis Industry Group email list here.
*Both marijuana and hemp fall under the definition of cannabis. Cannabis containing less than .3% tetrahydrocannabinol (THC), the psychoactive ingredient in the plant, is known as hemp and is legal under federal law. This article focuses on cannabis with higher THC levels, known as marijuana, and uses the term cannabis and marijuana interchangeably.