Cannabis Taxation

As one would expect, legal cannabis-related businesses in New York will have to comply with both state and federal tax laws. One is easy, the other hard!

New York Taxes

            This is the easy part. New York’s Marihuana Regulation and Taxation Act (“MRTA”), signed into law on March 31, 2021, sets forth tax rates for different points in the distribution and sale process.

1. Tax on Distributors.

Upon sale to a retail dispensary, the distributor must pay a tax based on the total THC content of the product and its form:

• Cannabis Flower:        $.0005 per mg
• Concentrates:              $.008 per mg
• Edibles:                       $.03 per mg

The exception is where the distributor is also the retailer, in which case the THC tax is payable upon the retail sale.

2. State Excise Tax.

Upon sale to a retail consumer, a state excise tax of 9% of the sale price kicks in.

The taxes collected by the state (including the THC tax) are deposited into the New York State Cannabis Revenue Fund, and are used in the first instance to cover the cost of administering and carrying out the MRTA, including funding the Office of Cannabis Management, the training of “Drug Recognition Experts,” and implementing incubators and workforce development for social and economic equity applicants. Whatever is left over is to be divided as follows:

• 40% to the State Lottery Fund for education
• 40% to the Community Grants Reinvestment Fund, for grants to non-profit and community-based organizations in communities affected by the war on drugs, and other social equity initiatives
• 20% to the Drug Treatment and Public Education Fund for the development and administration of public education campaigns and substance use treatment programs

3. Local Excise Tax.

On top of the state excise tax, an additional 4% of the sale price to the retail consumer is levied. Of this 4%, one-quarter goes to the county and three-quarters goes to the cities, town, or villages within the county in proportion to each polity’s cannabis sales. If a town and a village within the town both allow cannabis sales, their share is distributed in accordance with an agreement between them; if no such agreement exists, then the revenue is evenly split between the town and the village.

Federal Taxes

            Here’s where things get interesting. As an illegal substance under Schedule I of the Controlled Substances Act, marijuana is not subject to excise or other taxes imposed on its sale. However, tax must still be paid on income derived from the any marijuana-related business – regardless of whether that business is or is not legal under state law. (Remember Al Capone!)

Income tax is payable on the net profits of the enterprise, but not all expenses can be deducted. Internal Revenue Code Section 280E (Expenditures in connection with the illegal sale of drugs), 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.

            IRS guidance regarding the taxation of marijuana-related income states that income means the “gross income” of a producer or retailer, not the gross receipts; “[w]hether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.” New Colonia Ice Co. v. Helvering, 292 U.S. 435 (1934).

Crudely stated, the gross income of a manufacturing or retail business is generally gross receipts less the cost of goods sold (“COGS”), which is the adjusted basis of merchandise sold and from which all ordinary and necessary business expenses are deducted to derive net income. However, in a marijuana-related business the deductions from gross income are disallowed under Section 280E – even if such business expenses are otherwise legal – with the result that gross income, not net income, is the taxable income of the marijuana-related business.

            The challenge, therefore, is to include as much as possible from all points in the production process into COGS to reduce taxable income. COGS embraces expenditures necessary to acquire, construct or extract a physical product which is to be sold, and includes raw materials, items purchased for resale, freight-in costs, purchase returns and allowances, trade or cash discounts, factory labor, parts used in production, storage costs, and factory overhead. COGS does not include selling, general and administrative expenses, office rents (as opposed to production facility rents), advertising, accounting and legal fees, and management salaries, among other items.

            Here we get into some accounting arcana. A cash-method producer or farmer of a Schedule I controlled substance will typically deduct all production costs in the taxable year paid and, thus, will not have any adjusted basis in the product it produces. When Section 280E is applied and all deductions from gross income are disallowed, the producer’s taxable income for each taxable year will be significantly higher than what it would have been if the producer used a permissible “inventory” method and recouped its production costs through COGS.[1] In the cash-method case, there is no adjustment to the cost basis of the inventory, whereas in the inventory-accounting method COGS are capitalized and reduce the cost basis of the inventory and consequently the gain that is realized upon its sale.

IRS guidance states that, in the case of a producer, inventory-costing rules typically allow the capitalization of costs that are “incident to and necessary for production or manufacturing operations or processes,”[2] or costs that “can be identified or associated with the particular units or groups of units of specific property produced.”[3] Thus, a marijuana reseller using an inventory method will capitalize the invoice price of the marijuana purchased, less trade or other discounts, plus transportation or other necessary charges incurred in acquiring possession of the marijuana. Similarly, a marijuana producer using an inventory method will capitalize direct material costs (marijuana seeds or plants), direct labor costs (e.g., planting, cultivating, harvesting, sorting), certain indirect costs (including repair expenses, maintenance, utilities, rent, indirect labor and production supervisory wages, indirect materials and supplies, tools and equipment not capitalized, the costs of quality control and inspection), and possibly certain indirect production costs depending upon their treatment in the taxpayer’s financial reports.

Clear as mud, right? The bottom line is that attributing expenses to COGS – to the extent permissible – is a key to ameliorating some (but not all) of the effects of Section 280E’s ban on deductions and credits for marijuana activities under federal law.[4]

Another strategy is to separate out the non-“flower touching” aspects of the business into one or more separate entities: a marketing company, a distribution company, a real estate company, and so forth. To the extent these businesses are not seen as inextricably tied to the flower-touching enterprise, it may be possible to deduct expenses in the ordinary fashion from these other entities without running afoul of Section 280E.[5]

Note that the above concerns apply to federal income tax calculation, not NY state income tax, which presumably will permit the full range of deductions in connection with the cannabis industry. (The MRTA is silent on the topic.)

Audits

All marijuana-related businesses should expect to be audited, and so all such businesses should be “audit ready” at all times. The key? Document all purchases and sales, track the product from seed to retail sale to show when and where taxes have been paid along the way. There is specialized software available specifically for the cannabis industry to assist in compiling all of this information.

The possibility of an audit may influence the choice of entity. Whereas the profits and losses of pass-through entities, such as LLCs and S corporations, are reported on the tax returns of the individual members or shareholders and taxes paid by those individuals, C corporations are taxed at the entity level, not at the individual level, and the individual shareholders receive income in the form of dividends or wages (if they are also employees), and such income is then taxed again in the usual fashion. As business taxes are paid by the C corporation, audit risk related to the operation of a cannabis-related business should remain at the corporation level.

Jonathan S. Berck

The foregoing is informational only and is not intended to be legal advice, which can only be provided by a lawyer retained for that purpose.

Jonathan S. Berck is a member of the Cannabis Law practice group of Catania, Mahon & Rider, PLLC. The Cannabis Law practice group advises clients on the full range of cannabis-related issues, from licensing to land use concerns to mergers and acquisitions in the cannabis sector. The Cannabis Law practice group works closely with the firm’s other practice groups to provide an integrated, business-minded approach to issues relevant to the industry.

[1] Note that using an inventory method requires accrual, rather than cash, accounting.

[2] Treas. Reg. Sec. 1.471-11(b)(1).

[3] Treas. Reg. Sec. 1.263A-1(e)(2).

[4] Another possible area for savings is the utilization of the qualified business income deduction under Section 199A of the Code, available to pass-through entities such as sole proprietorships, partnerships, LLCs, S corporations, and trusts and estates. This deduction, created under the 2017 Tax Cuts and Jobs Act and scheduled to sunset at the end of 2025, allows non-corporate taxpayers to deduct up to 20% of their qualified business income, or “QBI,” plus up to 20% of qualified real estate investment trust (“REIT”) dividends and qualified publicly traded partnership (“PTP”) income. There are, however, significant restrictions too complex to discuss here.

[5] See Californians Helping to Relieve Medical Problems v. Commissioner, 128 T.C. 173 (2007).