Drugs

How the IRS Screws Legal Weed Businesses

The IRS targets legal cannabis businesses. Now the industry is fighting back.

by David Bienenstock; illustrated by Lia Kantrowitz
Apr 17 2017, 4:00am

As a co-founder of Greatland Ganja, a cannabis-growing operation in Alaska, Leif Abel has discovered that settling up with the state government that licenses his cultivation is a Kafkaesque mindfuck. This is because the Fed's prohibition on weed makes it pretty much impossible for pot businesses to open a bank account.

This inability to access the traditional banking system means Abel has to pay his taxes in cash. He could have crossed his fingers and put thousands of dollars of hard currency in the mail and hoped for the best. But he "doesn't like the thought of that." So he took a seven-hour road trip from the remote Kenai Peninsula, where he cultivates his plants, all the way to Anchorage, the only place in Alaska where you can make cash tax payments

Once in Achorage, he couldn't just hand those stacks of cash over to the tax man and bounce back to Kenai. He had to go to a special Department of Revenue deposit site, get the keys to open a drop safe, package his money inside a tamper resistant bag, put the bag in a special tray, and then lock it up. He did all of this without any human interaction. Surveillance cameras captured each step, including when the bag was later opened by state employees tasked with counting the cash.

The whole process is a security risk, an accounting nightmare, a logistical hassle, a waste of time and resources, and a slap in the face to a guy who is doing everything in his power to pay his fair share and follow the law. Not that Abel's complaining.

"I'm a second-generation cannabis cultivator in Alaska—this is what fed my family when I was a kid," he told me. "So when you consider that as a child I experienced helicopter raids of our home and had automatic weapons stuck in my face because my father wanted to use cannabis as a medicine. This is all a huge step in the right direction. My kid won't have to go through that."

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Unfortunately, there's a much bigger problem when it comes time to pay the IRS. One that, if not corrected, could bring down much of the industry without a single arrest. Again, federal law doesn't recognize state law regarding legal cannabis. So while the IRS expects payment in full from cannabis growers and dispensaries, a special tax code that was originally passed in the 1980s to combat drug traffickers prevents small business owners like Abel from taking basic business deductions that would be available to any other legally operating company—stuff like rent and labor.

"From my perspective, it's not fair," Abel said. "We're being asked to pay taxes and follow all kinds of regulations—like getting our cannabis lab tested—all of which I agree with 100 percent. But if we're going to be held to those standards, we should get the same protections under the law as any other business."

Steve DeAngelo, CEO of Harborside Health Center in Oakland, California—one of the nation's largest medical cannabis dispensaries—not surprisingly agrees. DeAngelo took the IRS to court last summer. The dispute goes all the way back to 2010, when federal tax assessors slapped Harborside with a $2.4 million bill after an audit. The feds disallowed deductions they claimed were not permitted due to Section 280e of the tax code:

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) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

On top of this multimillion dollar bill for back taxes, the IRS also sought access to financial records for a large chunk of Harborside's existence. DeAngelo believes this move could put the dispensary on the hook for more than $15 million if 280e is applied to those years. So he launched his legal case, which challenges the application of 280e to Harborside based on language in the tax code specifying that it applies to businesses whose trade "consists" of drug trafficking.

"Would it be accurate to say the city of New York consists of the borough of Manhattan?" DeAngelo asked me. "No, but it would be accurate to say the City of New York includes the borough of Manhattan. By the same token, it would be inaccurate to say the activities of Harborside Health Center consist of the exchange of cannabis for money, because we do many, many, many other things. We provide more than a dozen varieties of holistic health care—yoga, reiki, acupuncture, neuropathy, chiropractic, etc.—and we sell books, clothing, and a wide range of other fully legal items. We also spend money on, and derive revenue from, brand-building activities. And there's nothing about brand building that fits the definition of 'drug trafficking' in the Controlled Substances Act."

To drive home the point about the word "consists," Henry Wykowski, Harborside's lead counsel in tax court, actually brought a linguist to oral arguments in the case. A former assistant US attorney who specialized in complicated tax prosecutions, Wykowski is now the cannabis industry's go-to lawyer for dealing with the IRS. He said the intention of 280e was clearly not to target dispensaries, because it was enacted nearly 15 years before California became the first state to legalize medical marijuana.

The 280e code was first sponsored in Congress by Representative Pete Stark at the height of the Reagan-era drug war, after a coke and meth dealer in Minneapolis successfully argued that the IRS, when determining his taxes, must allow deductions for his reasonable expenses in running an admittedly illegal business. Stark has since denounced applying 280e to state-legal cannabis businesses, telling Congress in 2011 that the practice "undercuts legal medical marijuana dispensaries by preventing them from taking the full range of deductions allowed for other small businesses… [and] punishes the thousands of patients who rely on them for safe, legal, reliable access to medical marijuana as recommended by a doctor."

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Despite being a former federal prosecutor, Wykowski, meanwhile sees his support of Harborside as part of a larger, personal fight.

"I've always been a fan of cannabis. It's been very beneficial in helping me figure a lot of things out, and so I've always been a strong proponent," he told me when I asked why he puts his tax expertise to work defending the weed industry. "The IRS for whatever reason seems to be anti-cannabis. They could have agreed long ago that 280e was not meant to apply to medical cannabis in states that had legalized it, but instead they told us to get Congress to change the law. Unfortunately, it's very difficult to get a regulation changed that affects only one industry, particularly when that regulation generates added income for the government."

Wykowski notes that the IRS also refuses to set clear guidelines for the cannabis industry to follow when filing, leaving some businesses to pay crippling tax rates of 70 to 90 percent, according to industry experts. Typical businesses pay approximately 30 percent.

"What that has lead to is a lot of confusion," he said, "since it's hard to advise clients of what is and isn't appropriate."

A potentially precedent-setting decision in the Harborside case could still be months away, and so the cannabis industry faces the upcoming April 18 federal tax filing deadline under a cloud of uncertainty—even as the new Trump administration has sent some worrying signals that there may be increased law enforcement scrutiny on the horizon or even an attempt to roll back state laws.

Derek Davis, an accountant with California Cannabis CPA, describes a classic Catch-22 scenario.

"You're kind of stuck, because if you don't pay, you're evading taxes, which is a criminal offense. But if you do pay your taxes and you are compliant, then it gets a little gray in regards to the fact that you're in essence committing a federal crime," Davis said. He always advises clients to keep meticulous records and fully report their financials, because "if the IRS decides to crack down, why would they go after those following the rules and paying taxes?"

On March 30, the Small Business Tax Equity Act of 2017, which would allow state-legal cannabis businesses to take normal business deductions, was introduced in the House by Representative Carlos Curbelo (R-FL) and Representative Earl Blumenauer (D-OR), and in the Senate by Senator Ron Wyden (D-OR), Senator Rand Paul (R-KY), and Senator Michael Bennet (D-CO). But while support for federal reform of 280e and cannabis-banking access has grown significantly in the past few months—including the birth of the first "cannabis caucus" in Congress—the journey to creating meaningful change through the legislative branch is still an uphill battle.

In the meantime, Kris Krane, the founder and president of leading cannabis-consulting firm 4Front Ventures, advises clients to put aside 15 percent of all sales in a rainy day fund to hedge against audits.

"We advise folks in the industry that this is a long term play," Krane said. "Don't be worried about short-term profits, be worried about operating the right way and eventually things will open up and cannabis will be treated like a regular business. And when that happens, you'll be really well positioned."

David Bienenstock is the author of How to Smoke Pot (Properly): A Highbrow Guide to Getting Highand a frequent VICE contributor. Follow him on Twitter.