Two Kinds of Green

In 1969, Merle Haggard scored a #1 hit with his ode to middle American pride, “Okie from Muskogee.” As the Vietnam War was raging, protests were dividing communities, and soldiers were coming home to catcalls, he opened his song with a blunt declaration: “We don’t smoke marijuana in Muskogee.” Today, the devil’s lettuce is very much legal in Muskogee. The town boasts roughly 20 legal dispensaries. Oklahoma is one of 40 states that have legalized marijuana to one degree or another. Yes, Nancy Reagan told us to “just say no to drugs.” But drugs refused to take “no” for an answer, and here we are. (And where would Taco Bell be without late-night stoners?)

Of course, marijuana is still illegal at the federal level. That creates all sorts of problems for state-licensed cannabis businesses. For example, most of them can’t use commercial banks, which are wary of violating federal money-laundering laws. But much of that may be about to change. Last week, the Department of Justice submitted a proposal to the White House to reclassify marijuana from the most-restrictive Schedule I, where it sits with heroin, ecstasy, and LSD, to the less-restrictive Schedule III where it can be prescribed alongside Tylenol with codeine. That move would have all sorts of financial consequences for cannabis businesses. And, while marijuana fans would celebrate with bong hits, Uncle Sam would actually take a huge tax hit.

Here ’s the problem. Code Section 61(a) defines “gross income” to include income from illegal businesses. Ordinarily, those businesses can still deduct their operating costs, just like anyone else. (If you’re a burglar, for example, you can deduct 67 cents for every mile you drive to burgle someone’s house.) But, in 1982, Washington added Section 280E. That law provides that, “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 ).”

Section 280E includes a helpful loophole letting sellers deduct their “cost of goods sold” using the applicable inventory-costing regulations under Section 471 as they existed when Section 280E was enacted. But they can’t deduct any of the usual overhead costs that your neighborhood liquor and cigarette sellers can, despite widespread agreement that those products are actually more harmful than marijuana. That means no deductions for rent. No deductions for wages. No deductions for website development, advertising and marketing, or meals and entertainment.

A new breed of clever accountants have built specialty practices moving expenses from “overhead” to “cost of goods sold” to minimize the problem. Still, the bottom line is that cannabis businesses pay millions of dollars in tax on “phantom income” they never see, simply because they can’t deduct the usual expenses other businesses can. Whitney Economics, a cannabis industry research firm, found that in 2022, the industry paid $2.3 billion more in federal tax than it would have if they were selling a legal product.

Rescheduling marijuana will mean an end to those sorts of unproductive accounting games. Ironically, it would give them a leg up on alcohol and tobacco, which are subject to hefty excise taxes. (Senators Chuck Schumer, Cory Booker, and Ron Wyden have introduced legislation that would impose a similar tax at 25%.)

Letting cannabis businesses take billions in new deductions might mean they’ll need fewer of the proactive tax strategies we use to help all our clients pay less. But that’s OK, we know there are millions of Americans looking to pay less now. If you’re one of them, you know who to call!