State Marijuana Law Effects On Federal Tax Liability

We are nearing the end of the year, when most marijuana businesses are also ending their fiscal years. That will be the start of an arduous process: dealing with the federal tax situation. The ramifications of Section 280E of the tax code have been analyzed to death on this blog and in many other publications. In short, under the current tax structure, marijuana businesses may not take regular business deductions, but they may still subtract from their taxable income their total cost of goods sold. The next several months will provide a good opportunity to see how many new businesses in Washington, Colorado, and other regulated states will have planned wisely and have enough cash on hand to pay what they owe. Today, we want to take a look at how the state regulations themselves can affect the tax liabilities of the market participants.

The laws in Washington and Colorado differ in one key area that will affect federal tax liability: vertical integration. Washington adopted the traditional liquor model with a three-tier structure that does not allow cross ownership between marijuana retailers and marijuana producers. Colorado took the opposite path, mandating that retailers manufacture at least 70% of everything that they sell. As new states implement regulated medical and recreational regimes, it is worth considering whether there is a significant difference in overall taxation between the two models.

In the abstract, the form of transactions shouldn’t matter. IRS rules are generally written to be consistent with the distributive property of math. If production, advertising, transportation, and other costs remain the same, the federal government should end up with the same amount of tax dollars whether a business is vertically integrated or not. Sure, the profits and taxes would be split up among different entities, but the numbers in aggregate should remain the same.

However, vertical integration doesn’t exist in a vacuum. While the actual cost of goods sold tend to remain the same, those non-deductible expenses tend to be lower for the system overall when the same person or group owns both the manufacturing and retailing arms of the business. This makes sense, of course. Separate businesses require their own management teams, advertising budgets, software licenses, etc. When they are combined, redundancies can be eliminated, decreasing the overall business expenses. And that leads to the goal for those doing accounting in the marijuana space. It costs what it costs to produce the goods, but a business that can keep its other expenses at bay is one that can survive in the industry. Vertical integration allows for that flexibility.

On the other hand, allowing vertical integration of marijuana businesses can have the unintended effect of making the industry too expensive for a true mom & pop to get established. It takes significantly more capital to get a marijuana cultivation business off the ground than it does to get a retail business off the ground. A vertically integrated business whose effective tax rate is relatively reasonable will simply outcompete a standalone retail shop, all other variables being equal.

This outcome has been apparent in states that allow businesses to choose whether to vertically integrate or not. In both Illinois and Nevada, for example, large numbers of applicants sought to get both production and cultivation licenses. While the final decisions won’t be made for a while in those states, it looks likely that a number of those applicants will succeed in getting both and vertically integrating.

As new states like Oregon and Alaska move forward with developing rules, it will be interesting to see which model they adopt. The states are doing a pretty good job so far at learning from each other’s mistakes, and we hope that they continue to keep in mind all of the consequences of their decisions.