21 Dec Marijuana Tax Reform | The Small Business Tax Equity Act of 2023
Since Colorado and Washington first legalized recreational marijuana in 2012, the marijuana industry has been lighting up. Despite the marijuana industry’s rapid growth over the last decade, marijuana is still classified as a Schedule I controlled substance by the federal government. The Department of Justice has elected to not enforce most of its marijuana-related policies, which has allowed marijuana-related businesses to thrive. However, the Internal Revenue Service has not taken the same laissez-faire approach. Keep reading to explore the evolution of tax laws and the Small Business Tax Equity Act of 2023.
Historical Evolution of Tax Laws
Historically, the IRS only collected a tax on income from “any lawful source.” However, when Congress adopted the Revenue Act in 1916, they excluded the word “lawful”. Allowing the IRS to thereafter collect taxes on “all income from whatever source derived.” After this modification, the IRS started cracking down on taxpayers who failed to report income derived from illegal activities. Today, marijuana-related businesses are thus required to report their income as if they were a legal business. Unlike legal businesses, however, marijuana-related businesses that are required to report their income to the IRS face one significant disadvantage. Marijuana-related businesses are prohibited from claiming business deductions.
For most businesses, business deductions allow businesses to subtract ordinary and necessary business expenses from their taxable income. This means that most businesses will typically only pay tax on the difference between the total amount of money they make and the business expenses they incur. In many cases, the allowance of business deductions will significantly reduce the tax owed by businesses. Business deductions were historically allowed to be taken by all businesses, regardless of their legality. However, Congress sought to preclude illegal businesses from taking deductions after the Tax Court allowed a convicted drug trafficker to take deductions for the expenses he incurred as part of his drug trafficking business. Congress subsequently enacted IRC §280E. Disallowing deductions and credits for trade or businesses involved in the trafficking of controlled substances. Because of this Code section, marijuana-related businesses are required to pay tax on their gross profits, rather than their net profits.
Impact of IRC §280E on Marijuana-Related Businesses
With the disallowance of deductions, marijuana-related businesses are left with an astronomically higher effective tax rate than traditional legal businesses. Assume, for example, that Business A makes $100,000 but incurs $80,000 of deductible expenses. That business will only pay tax on $20,000. On the other hand, if Business B were a marijuana-related business that had the same income and expenses. After the application of §280E, the business would be required to pay tax on the full $100,000. Assuming A and B are both corporations paying the flat 21% corporate tax rate and have no other applicable deductions, Business B would pay $21,000 in tax, while Business A would only pay $4,200.
This demonstrates the detrimental impact §280E has on marijuana-related businesses. For larger corporate marijuana businesses, this impact can be lessened by shifting business costs to related entities. Or even through colorful interpretations of other IRC provisions (namely §471). Unfortunately, many small businesses lack the resources to capitalize on such opportunities, and as a result, suffer from the effects of §280E. Fortunately for small businesses, there is a glimmer of hope in the form of a proposed bill that is currently pending in Congress.
The Small Business Tax Equity Act of 2023
The Small Business Tax Equity Act of 2023 seeks to exclude marijuana-related businesses from the extreme hardship currently imposed by §280E. If enacted, these business owners would be permitted to take a tax deduction for business-related expenses. Thus reducing their tax liability significantly. As demonstrated, by allowing marijuana-related businesses to claim the same deductions as their non-marijuana-related counterparts. This bill could have a monumental impact on small marijuana-related businesses that struggle to survive under the current tax regime.
This proposed act emerges as a beacon of hope. Offering potential relief and leveling the playing field for small businesses navigating the intricate intersection of legality and taxation in the evolving cannabis market. Symbolizing a small but significant step toward a more equitable future for this budding industry.
Written by Attorney Cody Townsend at KM&D Law
H.R. Rep. No. 63-3321, at 167 (1913).
H.R. Rep. No. 64-16763, at 757 (1916).
See eg. Commissioner v. Wilcox, 327 U.S. 404 (1946).