Federal tax code really imperils new cannabis businesses
LONDON, 1966. A young cannabis enthusiast named George Harrison is riding high and feeling on top of the world. He is a Beatle, his band has conquered the world, he rakes in millions, and he enjoys a steady supply of cannabis
— or as he often referred to it, “reefer.”
And yet, one very pedestrian, prosaic problem snatches him down from his very groovy high: taxes.
Mr. Harrison discovers that Britain’s steep tax rates have absorbed a stunning proportion of the Beatles’ earnings. The emerging songwriter expresses his tax woes in verse, and the resulting instant classic, “Taxman,” leads off the Beatles’ “Revolver” album. It complains that even sitting and walking seem to be taxed and observes that we all work for no one but the taxman.
Fifty-eight years later, taxes still harsh the buzz of many cannabis enthusiasts. New Mexico’s cannabis licensees face a triple whammy of tax burdens that can threaten the basic viability of any unprepared business.
First, licensees must pay ordinary state gross receipts tax — around 8%, depending on the exact area — on sales of recreational cannabis.
Second, licensees must pay the cannabis excise tax on recreational sales — another 12%. Right off the top, licensees must build into their budgets some way to pay 20% of recreational sales to the state.
Then, licensees must confront the biggest challenge: Internal Revenue Code Section 280(E). This particular part of federal law says, “No deduction or credit shall be allowed for any amount paid or incurred” by a business “trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act).”
Basically, cannabis businesses — even those licensed by a state — cannot claim any tax deductions or any tax credits on their federal income tax. They cannot use the typical deductions that other businesses do, like payroll and rent. Thus, cannabis businesses, even those operating lawfully under state law, end up paying federal income tax on gross revenue, rather than net revenue.
Any responsible cannabis licensee must account for 280(E) in its basic business model. It must realize that the overhead, profitability, pricing, and debt load numbers that might work for a conventional business will not work for a cannabis business.
The consequences of 280(E) mean that cannabis licensees must act very strategically in planning for the longterm financial health of the business.
When New Mexico legalized recreational cannabis in 2021, the state’s legacy medical cannabis producers did have the advantage of tax knowledge and experience. The legacy medical businesses already knew about 280(E) and had built it into their budgets. Many had already experienced tax audits by the Taxation & Revenue Department or the IRS and understood the importance of careful bookkeeping.
I fear that many of the new, post-legalization licensees came into the market without adequate knowledge of the cannabis tax burdens and therefore did not adequately prepare. They may have taken on too much debt that leaves them unable to pay federal income tax. They may have used all-inclusive pricing models that obscure true revenues and confuse the state’s auditors. They may have assumed that ever-increasing sales would save them down the line. They may have forgotten that there are only two certainties in life.
For businesses already under pressure from market saturation, illicit competition and general inflation, a tax bill can be the last straw. If a cannabis business is in decent financial shape, the dreaded “Notice of Deficiency” from the state or the IRS may only trigger some creative reshuffling of resources.
For a cannabis business already on the edge, it can be the trigger to shut the door and fold up shop. New Mexico’s cannabis licensees are certainly not alone or unusual in this respect. Cannabis businesses from California to New York are embroiled in a wide variety of tax controversies at both the state and federal level.
George Harrison was not the only British rock star to bemoan high tax rates. Also in 1966, in the song “Sunny Afternoon,” the Kinks lamented that, after the taxman had taken all their dough, all they had was a sunny afternoon. If New Mexico’s cannabis licensees are not careful, they too will be left with nothing but a sunny afternoon.