State law fix for 280E problem? Update 13 August 2015

An IRS ruling has changed everything and made most of the post below obsolete. More here or at https://newrevenue.org/2015/08/02/whats-next-for-280e/

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Start here:

“States could unilaterally correct this problem by changing the type of taxes they place on the marijuana industry. IRS treatment of sales taxes depends upon how a state defines the tax. If the state defines the tax as being levied on the seller, the tax is included in gross receipts. On the other hand, if the tax is defined as levied on the buyer, the seller is treated as a mere collector custodian of the state’s revenue and the amount levied is not properly included in gross receipts. For most businesses this is a distinction without a difference; sales taxes levied on a seller can be deducted as an expense. However, for dispensaries denied deductions by § 280E, this distinction could reduce federal tax exposure by huge amounts. Creative legislators could even redefine license fees as custodial sales taxes, by requiring retailers to collect the license fees from consumers instead of charging them directly to retailers.”

New explanation  at  http://taxfoundation.org/blog/one-simple-state-tax-code-tweak-favor-marijuana-taxpayers-over-tax-evaders?mc_cid=a792bd624c&mc_eid=c12785538d

“Such redefinition wouldn’t lower a state’s marijuana tax income, but might instead increase tax revenues by helping to level a playing field artificially tilted toward the tax evading black market alternatives § 280E was intended to punish.”

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Thanks to Chris Law for sending that — author is James W. Kennedy.

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Now for a tacked-together agglomeration of all I could find.  (Notes for an article, maybe.)

The recent WA fix shifting tax burden from seller to buyer is in section 205 on page 8 here, or at http://leg.wa.gov/Senate/Committees/WM/Documents/2136%20AMS%20-%20S-3153%201.pdf.  That’s the buyer pays approach (Nebraska sales tax rule), mentioned at the end. TAM withdrawal is noted below.  280E and canopy taxes are discussed here or at https://newrevenue.org/2015/04/15/280e-and-fees-arkley/.  That this problem exists, and has not been fixed everywhere, shows the primitive state of marijuana tax design.  Not deducting taxes is as primitive and zany as taxing by price, railed at and disparaged here.  I myself let this deductibility issue slip a long time.  It was such a crazy result, I didn’t think it possible.

THE STORY:  Maybe  a quick and tiny tweak to Washington’s state marijuana excise tax statute (and similar statutes in other states) could save businesses a lot of federal income tax under 280E, which lets federally illegal drug sellers deduct only cost of goods old.  Now I kind of like 280E, insofar as it prohibits deductions for advertising, marketing, point-of-sales displays, and the like (disfavoring those activities in a way that does not allow any argument about freedom of speech), but can’t imagine why federal taxpayers shouldn’t be able to deduct state excise taxes.  The industry complains mightily about 280E, but getting Congress to fix tax problems, or to help the marijuana industry, is not the work of a moment.

Luckily for the industry, no federal fix seems needed for this one signficant part of the 280E problem. The Washington Legislature (and Legislatures of other states with the same problem) should be able to make excise taxes federally deductible with the stroke of a pen, I think, and try to explain below.

And maybe a quick fix is possible.  The Legislature has already shown it can act expeditiously to fix the Washington marijuana statute: “During the 2014 Legislative Session, I-502 was amended to explicitly allow the sale of extracts and concentrates.” http://liq.wa.gov/marijuana/faq_rules — that link is busted:  Try http://lcb.wa.gov/mj2015/faqs-rules. Cutting the federal tax bill of a marijuana industry that’s struggling to beat the black market, at zero cost to the state, seems like an easy fix that might sail through on its own – even less controversial than allowing concentrates.

Here’s more:

1.  Washington’s 25-percent taxes are includible in income but not deductible under federal tax code section 280E.  That’s what folks in Washington state tell me, and you can infer that from this report:

[Senator Jeanne] Kohl-Welles said the tax would be renamed “so businesses involved would be able to deduct expenses from federal taxes.” Right now, marijuana businesses pay federal tax on gross sales, which can include state excise taxes.   

http://blogs.seattletimes.com/pot/2014/11/21/state-sen-kohl-welles-outlines-bill-to-transform-marijuana-regulation/

[Update:  This article by Bill Lucia tells the story cogently: “Because of the 280E provision this excise tax expense cannot be written off.”   http://crosscut.com/2014/12/08/politics-government/123042/pot-marijuana-excise-taxes-washington-state-280e/.]

The problem appears, for instance in

“NEW SECTION. Sec. 27. (1) There is levied and collected a marijuana excise tax equal to twenty-five percent of the selling price on each wholesale sale in this state of marijuana by a licensed marijuana producer to a licensed marijuana processor or another licensed marijuana producer.” http://app.leg.wa.gov/rcw/default.aspx?cite=69.50.535.

That tax is income to the seller, who pays the tax, but not cost of goods sold to the seller, so the seller can’t deduct it because of 280E.

2.   I have not seen Senator Kohl-Welles’s proposal, but think the following technical solution would work: To lessen the federal tax burden on marijuana businesses, the state might structure any excise tax (on any base, like price or weight) to apply to production rather than sale, or to the privilege of growing or doing business.  In that way, the tax would be part of cost of goods sold, and federally deductible – even if collected at the time of sale.

That solution comes from Roche, Edward J., Federal Income Taxation of Medical Marijuana Businesses (August 12, 2013). Tax Lawyer, Vol. 66, No. 2, 2013; U Denver Legal Studies Research Paper No. 13-38. Available at SSRN: http://ssrn.com/abstract=2308946 or http://dx.doi.org/10.2139/ssrn.2308946.  Professor Roche’s article says “Excise taxes may or may not be includible, depending on whether the tax is imposed on completion of production or the sale of the product,” (emphasis added) citing  “T.A.M. 1979-220-33 (Jan. 26, 1979) (liquor excise tax included in inventory costs because it was imposed on the production of the alcoholic beverage, even though it was collected at the time of sale).”  Now a Technical Advice Memorandum is at the bottom of the barrel of IRS authority, but the reasoning seems right.   [NOTE:  On April 25, 2015, Law student Christopher Law wrote me to point out that that TAM was withdrawn without explanation in TAM 8232068 in 1982.]  And Professor Roche’s article, at this early point in the history of marijuana taxation, seems both the starting point for and the latest word on 280E.

The point of this solution is to put the cost of taxes into inventory, to associate taxes with cost of goods sold rather than the sale.  That way, they should be deductible to the seller under 280E.  (A business buyer doesn’t pay tax on these taxes either.  That’s the right result:  The taxes are part of the buyer’s cost of goods sold.)    Just changing the incidence of taxation would still allow (if the state wanted) collection of two or three tiers of taxes – now all made federally deductible to all companies.

An alternative fix here could make the buyer rather than the seller the taxpayer.  But I imagine that excise taxes typically apply to the seller rather than to the buyer under the earlier-the-better principle.  It’s easier to collect tax from one seller than from every buyer who buys from the seller.  I don’t know all the implications of shifting the taxpayer.  But a shift would solve the problem.  And I imagine it can be done without letting losing revenue.

[Update:  There’s also a proposal to replace the current tax with a business and occupation tax. I don’t see how that kind of tax could go into cost of goods sold, but maybe there is an explanation.  I’m leery of the notion of simply renaming the tax, on account of the form-over-substance doctrine.  Maybe renaming is shorthand for shifting who pays tax.]

Either fix should result in this change:

Current law After proposed fix
Producer sells to retailer $120 $120
Producer cost of goods sold $60 $60
Washington 25% excise $30 $30
Federal taxable income $60 $30
Federal income tax at 30% $18 $9
Producer’s total receipts $120 $120
Producer’s total outlays $108 $99
Producer’s profit after all taxes $12 $21

Other states’ excise taxes may create the same problem.  Someone told me about this problem a while back, but I didn’t pay attention to it.  The result seemed too crazy to believe.  But it’s hard to get things right the first time.

So the state fix can arrange a federal tax cut.  But maybe this fix won’t cut federal revenue, under this scenario:  Maybe more legal marijuana businesses will actually succeed, and take so much market share from the black market that they owe more federal income tax in the aggregate.

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It will be interesting to see how this plays out.  For instance, will Legislators rush through a fix (effective for transactions after date of enactment, which will save taxpayers money every day)?  Or will they wait for a big bill that addresses other issues?

Meanwhile, it looks like Oregon may have a statute that makes excises deductible under 280E:

SECTION 33. Tax on marijuana. (1) A tax is imposed upon the privilege of engaging in business as a marijuana producer at the rate of:

(a) $35 per ounce on all marijuana flowers;

(b) $10 per ounce on all marijuana leaves; and

(c) $5 per immature marijuana plant.

http://media.oregonlive.com/mapes/other/SP-2014-051.pdf

Here’s the argument:  You can’t produce marijuana without paying the tax, so the tax look could look like cost of goods sold —  deductible.  If the law says you owe tax, WA-style, because of sale of (rather than because of exercising the privilege of producing) the product, you may have no argument that the tax is part of cost of goods sold. Full disclosure:  I gave the OR folks some advice, as reported here, but I didn’t take this issue seriously until more recently.  I’m not responsible for any helpful language here — if it is helpful.

Update December 14:

Folks in Oregon point out that tax there is no tax unless there is a sale – so there is an argument that the tax in fact on the sale, on the basis of this statutory language:

(3) The tax imposed by this section shall be measured by the quantities of marijuana flowers, marijuana leaves, and immature marijuana plants produced and sold by any marijuana producer. The taxes specified in this section shall be levied and assessed to the marijuana producer at the time of the first sale of the marijuana flowers, marijuana leaves, and immature marijuana plants by the marijuana producer.

So if the marijuana were destroyed before sale, there would be no tax. That’s a good argument; one argument back is that the timing is irrelevant – that if tax were collected 30 days after sale, so what? And the time of sale is the trigger in the T.A.M. above.

More troublesome is the “produced and sold” wording. I would strike “and sold” – for sure.

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Buyer pays:  December 16 update:

If there is a problem, I’m wondering if this model, used by Nebraska for retail sales, would not solve it:

“(a) The tax imposed by this section shall be collected by the retailer from the consumer. It shall constitute a part of the purchase price and until collected shall be a debt from the consumer to the retailer and shall be recoverable at law in the same manner as other debts. The tax required to be collected by the retailer from the consumer constitutes a debt owed by the retailer to this state.”

http://nebraskalegislature.gov/laws/statutes.php?statute=77-2703

In lay terms:

Tax Imposed on Buyer, Collected and Paid by Seller

In Nebraska the sales tax is imposed on the consumer although the retailer is required to collect the tax. The sales tax required to be collected is a debt owed by the retailer to the state.

Absorbing the tax is prohibited. It is against the law in Nebraska to refund or offer to refund all or any part of the amount collected, or to absorb the amount of sales tax required to be added to the sales price and collected from the purchaser. As a seller, it is also against the law for you to advertise directly or indirectly that you will absorb the sales tax that is required to be added to the sales price.

http://www.bizfilings.com/toolkit/sbg/tax-info/sales-taxes/sales-use-taxes/nebraska-sales-and-use-taxes.aspx

 

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Author: patoglesby

From 1982 to 1990, I worked in tax policy for Committees of the United States Congress. In recent years, I was Adjunct Lecturer at UNC-Chapel Hill's Business School and then Adjunct Professor at its Law School.

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