Ryan M. Holz
Ryan M. Holz

What happens when the federal government says the marijuana industry is illegally trafficking drugs? They tax it.

When Gov. J.B. Pritzker signed the 610-page Cannabis Regulation & Tax Act, he did more than just legalize recreational marijuana in Illinois starting Jan. 1. He also opened up a host of legal questions for the state.

This week, the Daily Law Bulletin is examining three of those current questions in Illinois law, looking for examples set by other states that legalized marijuana.

On Wednesday, we looked at the future role of K9 dogs that will still think marijuana is a crime. On Thursday, we looked at how the social-equity provisions of the act could fare if challenged in the courts.

And today, we’ll look at how the federal government taxes the marijuana industry, which while legal in some states, is still very much illegal on a federal level.

Although states are legalizing recreational marijuana, effectively creating a whole new legitimate business industry in their states, marijuana is still classified as a Schedule 1 illegal substance under federal law. This distinction has affected the kinds of federal tax deductions marijuana businesses can claim.

IRS Code 280E states 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 [S]chedule I and II of the Controlled Substances Act) which is prohibited by [f]ederal law.”

Alexander M. Leonowicz, a partner at Howard & Howard and the head of its cannabis practice group, explained that although the federal government considers the marijuana industry as a federally illegal activity, they still expect to receive the appropriate amount of tax dollars from that activity.

“Just because you do something illegal, that doesn’t mean you don’t pay taxes, it is actually the opposite. You have to pay taxes on all activity, whether it’s illegal or not,” he said. “You can’t write off anything other than cost of goods sold for cannabis companies.”

This realm of the IRS tax code particularly impacts dispensaries, so much so that a dispensary in San Francisco challenged 280E in court claiming that it is unconstitutional. The 2018 decision by the U.S. Tax Court in Patients Mutual Assistance Collective Corp. d.b.a. Harborside Health Center, v. Commissioner of Internal Revenue, upheld 280E saying, “Patients Mutual owns what may well be the largest marijuana dispensary in America. To the [c]ommissioner that just makes it a giant drug trafficker, unentitled to the usual deductions that legitimate businesses can claim.”

However, the U.S. Tax Court later found that the dispensary was not liable for its accuracy-related 280E penalties.

“I think, generally speaking, cannabis companies have priced that into their cost of doing business at this point,” said Ryan M. Holz, a partner at Locke Lord LLP who focuses on the cannabis industry.

Holz doesn’t foresee this type of issue being tackled in the courts in Illinois, but instead predicts a potential adjustment in tax law at the federal level.

“Congress is going to do something about banking and taxation here at some point, it may not be this year, but sometime soon, they will, in our opinion,” he said.

“When they do, I highly suspect 280E will disappear or be very much modified to allow state legal entities to get the same deductions as other companies do,” he said.

Beyond 280E, another issue the marijuana industry faces by selling a federally illegal substance is where it can conduct business at financial institutions.

The Financial Crimes Enforcement Network recently released a report of the number of depository institutions which are actively banking with marijuana-related businesses nationally. Between March 2018 and March 2019, the number rose from 411 to 633.

“Financial institutions are governed by federal laws and the FDIC is a part of these financial institutions,” Leonowicz said. “If you are found to have been doing work with cannabis facilities knowingly, that’s the right of the federal government to, to pull that right away from you to lend money.”

Leonowicz explained that because of this, smaller, state-chartered financial institutions and credit unions are willing to work with cannabis companies at this level and are able to charge more for these kinds of transactions.

“As long as they have a regulatory compliance within them, where they are reporting any sort of cash transaction for over $10,000, understanding where the money’s coming from, so you’re not taking money from the cartel or some other illegal organization, they’re willing,” he said. “There’s still a risk there. But for them, it’s a greater reward.”

In Illinois, House Bill 2980, sponsored by Peoria Democrat Jehan Gordon-Booth aimed to combat the penalties banking institutions could be charged with for doing business with the cannabis institutions. However, the bill was not heard in committee by the end of session deadline.