Marijuana Regulations and Taxes – So Weird, Man

Medical_marijuanaThis post features obscure business tax accounting rules you’ve never heard of and (hopefully) will never encounter.

(Do I know how to write a blogpost lede, or what?) And pot. It’s about pot. Did I forget to mention that?

Ok, nobody thinks they want to know about obscure accounting rules but maybe – like me – you get a kick out of learning the unexpected consequences of imperfect regulatory and taxation systems? Come along with me, this will be fun, I promise.

Business Opportunity

My high school buddy Brian sent me an email about a month ago with an intriguing business investment opportunity. Would I like to invest in his licensed medical cannabis farm in New Mexico?

He has acquired – through an expensive upfront investment and a rigorous application process – one of only 35 licenses to operate a medical marijuana operation in his state. His business is expanding like a weed (heh) to grow his full allotment of 450 plants on a 16-acre farm, meeting the demand of an estimated 20,000 licensed New Mexicans with medically-approved conditions for marijuana consumption.

My literal answer to his query was “no.” On the other hand, I do love learning about startups, especially in a fast-growing, complicated, business like his. So we talked.

Marijuana, Officially

If you haven’t been paying much attention to the slow rollout of legal marijuana in the United States, here’s your quick update, before telling you about my buddy’s obscure business tax problem.

The federal government considers marijuana – alongside heroin, LSD, and Ecstasy – as a “Schedule I” substance, meaning it’s classified as one of the most dangerous of all drugs, with a high potential for abuse, and no currently accepted medical use.

legal_marijuana

Meanwhile, between 2012 and now, five geographies declared marijuana legal to produce and consume in a highly taxed and regulated way: Colorado, Washington, Alaska, Oregon, and Washington DC. Another 36 states, including New Mexico and Texas, have opened up legislative windows for some legal, medically-approved, use.

Even Texas?

Legalization, for example, is coming to Texas faster than you expect. As reported in the San Antonio Express News the law passed last year and signed by Governor Abbot created conditions for approving the use of non-intoxicating cannabis oil for epileptic patients. Entrepreneurs are already gearing up to apply for licenses and provide product. That looks to me like “gateway” legislation that will lead to heavier legalization in the future.

Specific challenges

Entrepreneurs navigating this emerging industry – like my friend Brian in New Mexico – face a unique set of problems.

The state auditing of everything is enormous. In some states, banks essentially refuse to engage with marijuana businesses. Licensing imposes severe restrictions. Like, The Man is making it tough all over, man.

Then we got to talking about obscure tax codes and my ears perked up.

As Brian explained to me, the fear of prosecution for underpayment of income taxes is a serious business hazard specific to his industry.

Don’t be Al Capone

One of the most interesting problems of producing and selling a product the federal government considers illegal – a “Schedule I” drug – is that even while the federal government considers your business illegal you still owe taxes on any illegal income.

Remember how Prohibition-era gangster Al Capone famously wasn’t convicted of murder and extortion, but rather, tax evasion?

When you make money illegally, you still need to pay taxes on your income. In fact you need to pay more than your usual share of taxes.

In the 1980s the IRS helpfully created tax code 280E to clarify how federally illegal businesses can – and cannot – account for expenses. The effect of the code is to dramatically raise the effective tax rate on illegal businesses. Or in this case, businesses legal in their own states, but illegal and liable for taxes at the federal level. I know, it’s awkward.

Limited “business expensing”

Under 280E, marijuana producers may not deduct ordinary expenses available to other businesses, like marketing, rent, packaging, transportation, and service providers like your attorney and accountant, not to mention such typical business expenses as travel and entertainment.

Marijuana_280e

Marijuana producers may deduct a limited number of expenses related exclusively to the production of their specific product – what an accountant would describe as the “cost of goods sold” – such as seeds, electricity, and some labor. The IRS forbids any other expenses to offset marijuana revenues.

The effect of 280E is that marijuana businesses pay a much higher effective federal tax rate than other businesses.

How big is 280E?

In a fast-moving industry spreading from state-to-state, we can only guess, and maybe your guess is as good as mine.

The industry should generate more than $6 Billion in legal retail sales in 2016.

Will the businesses, in aggregate, generate a 10 percent profit, or $600 million in legal taxable income? That’s probably conservative, but stick with me a moment here.

I spoke with Taylor West, Deputy Director of the National Cannabis Industry Association who estimates that legal marijuana businesses pay effective corporate income tax rates ranging from 50% to 85%, compared to 15 to 35% for traditional businesses.

Let’s keep the math easy and say they pay an average of 20% more in income taxes than a traditional corporation, or an extra $120 million over what businesses pay in other industries.

I ran my $120 million estimate past West, who told me she’s unaware of any other estimates. I have no particular confidence that I’m right about my estimate, except I am confident about the following statement:

The single largest financial beneficiary of the burgeoning marijuana business is the federal government itself, through this extra federal income tax paid for illegal businesses.

I’m not sure what Alanis Morissette would say about that, but I’d call that ironic.

And that one statement is what I wanted you to know about obscure tax codes and the unintended consequences of an imperfect tax and regulatory system as it affects a fast-developing industry.

 

A version of this appeared in the San Antonio Express News:

 

Please see related post:

Why States Will Legalize Pot – The Money Reason

 

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Legal Pot in Texas? The Money Case

legal_pot_in_texasWithout giving it much previous thought, I’ve historically been mildly opposed to the legalization of marijuana. I’m not a user, and on balance I haven’t seen ‘more pot in the world’ as something to advocate for.

However, I find my views shifting in recent years, and I’m likely falling behind the (high) times. I mean, from what I gather, munchies-seeking zombies are not currently overrunning the states of Colorado and Washington. And if their green light to legalization leads to a slow-rolling legalization in other states, that seems increasingly like an ok application of the Tenth Amendment and our ‘laboratories of democracy’ idea.

In fact, the steady process of legalization has significant momentum throughout the country, not only in states but also in cities. Earlier this month, Washington DC’s city council voted to study expanding the current legal private use of marijuana to ‘pot clubs.’

Oregon and Alaska, with little fanfare, decriminalized recreational use over the past two years.

In a sign of the mainstreaming of the industry, Privateer Holdings – a Seattle-based cannabis branding, production and advocacy group – raised $75 million in private equity last year, setting a high-water mark for financing of the industry.

Follow the money

Since I’m a “follow-the-money” guy when it comes to public policy, I have to hand it to the legalization folks for building up the financial base for their case.

pot_zombie
Pot Zombie

One of the advantages of exploiting the medical-use loophole for marijuana products over the past decade is that – as more legal companies got in the game – a legal business lobby has new resources for the fight. But private-industry lobbying only forms only one pillar of the industry’s financial strength.

The more important pillar is that state tax revenues derived from the business – and dedicated to some public purpose – form a difficult habit for governments to break.

Colorado and Washington

I downloaded and tallied state tax receipts in Colorado. These include a 2.9 percent tax for retail and medical marijuana, 10 percent special retail tax, a 15 percent excise tax, plus licenses and fees.

Summing these up we can see that tax revenues in Colorado from marijuana have grown faster than hothouse hydroponics under continuous ultraviolet rays.

In the last full fiscal year Colorado reported $102 million in total receipts from marijuana-related taxes and fees, with a year-over-year growth rate above 60 percent, suggesting significantly more money to come to the state in future years.

Washington State – with a 30% retail tax on marijuana sales, has had a similar experience. Bloomberg reported that Washington expected $135 million in tax receipts in 2015 at the state, county and local levels, with year-over-year growth above 100%.

I don’t know much, except this: When you have a massive revenue stream like this going into otherwise needy public coffers, there’s no going back.

In previous decades states got addicted to lottery revenues. This past decade has seen the burgeoning of casinos with their hefty state tax revenues. It seems highly likely that marijuana-tax revenue will follow in many more states in the next few years.

Texas – $500 million?

If you compare the populations of Colorado and Washington to Texas you begin to see the tax revenue potential of legalization here.

The per-capita marijuana tax revenue of Colorado, adjusted for Texas’ population, would be $519 million. Now, you might just argue to me that – culturally at least – the Mile-High state isn’t a good comparable for Texas. And I might just argue back to you that everything’s bigger in Texas.

Meanwhile, per-capital tax revenue of Washington State, adjusted for Texas’ population, would be $516 million.

These amounts understate the financial potential since they reflect less than two years’ data, and the numbers keep growing rapidly. I’m confident we’re looking at –conservatively – an estimated $500 million in incremental tax revenue per year for Texas from marijuana taxation.

Back To Reality

I know what you’re thinking – what is this guy smoking? In Texas, we see little evidence of a statewide push for marijuana legalization. In the near future, however, we could imagine a rainbow coalition of Libertarians, Rastafarians, small business owners, and fiscal conservatives each puffing from the same pipe on these issues. I’d say given the rapid spread of legalization to other states and cities, the formation of that coalition in Texas is not a question of if, but when.

My policy advice

My advice to the pro-stoner crowd – who should, by the way, never take political advice from a finance columnist – is to exploit Texas’ financial weakness on the state revenue side. Without a state income tax, important policy initiatives go unfunded all the time, starved for new revenue streams.

Add in one more key constituent group – let’s say the liberal public education crowd – and you’ve got yourself a winning statewide coalition here. Do you think the education-policy folks could find a use for an extra $500 million? As my close personal friend Sarah Palin might say, ‘You Betcha!’

Wait! Hold on. Deep breath. Inhale with me on this vision for a moment. With a tax on marijuana, what educational programs could suddenly happen? Picture the expansion of San Antonio’s well-known “Pre-K for SA” statewide, for example, but now with a dedicated revenue stream.

When you name it “Tokes for Tots,” how could anyone object?

Think of the children!

Ok, obviously I’ve gotten a contact high just thinking about this. Disregard my loopy political advice. But the rest is serious.

 

 

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