Cannabis taxation: Where we are now, what you should expect in the future
The legalization of cannabis in one form or another in individual states in the U.S. continues to increase. Over the past 50 years, public opinion on the legalization of marijuana has changed dramatically among the states from significant opposition in 1969 to approval over the past several years.
The results of the recent U.S. midterm elections continue to support that trend: In Michigan, voters approved the ballot that called for the legalization of recreational adult-use cannabis; and in Utah and Missouri, voters approved the legalization of medical marijuana. Only in North Dakota did voters turn away the legalization of recreational adult-use cannabis. Outside the U.S., Canada recently became the largest country in the world to legalize recreational marijuana.
However, this growth in legalization has brought complexity as each state develops its own set of rules for the tax and legal administration of these laws. In addition, the complexity is compounded because the federal and state governments are not yet “on the same page” with respect to all aspects of its tax and legal treatment—and conformity of any kind will not happen any time soon.
I am frequently asked for an analysis of where things stand today and how to prepare for future federal and state tax and regulatory actions that will continue to take place over the next several months and years.
On a federal level, cannabis is still classified as a controlled substance Schedule I drug which, according to the now former Attorney General Jeff Sessions, has a “high potential for abuse.” On the state level, however, the situation is much different.
• Recreational cannabis: The following states (including D.C.) at last count (not including recent voter approval in Michigan referenced above) have made recreational cannabis legal with differing regulatory rules: Alaska, California, Colorado, District of Columbia, Maine, Massachusetts, Nevada, Oregon, Vermont and Washington.
• Medical cannabis: For medical cannabis use, the number of states (not including the recent voter approvals in Utah and Missouri referenced above) is much larger, depending on how you count: Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Hawaii, Illinois, Maine, Maryland, Massachusetts, Michigan, Minnesota, Montana, Nevada, Oklahoma, New Hampshire, New Jersey, New Mexico, New York, North Dakota, Ohio, Oregon, Pennsylvania, Rhode Island, Vermont, Washington and West Virginia. There is some issue about Louisiana’s law at this point.
Each of these states has its own set of rules and that, of course, adds to the complexity. However, there’s one thing both the feds and the states have in common: Cannabis is and will continue to be heavily taxed, regulated and closely scrutinized at both levels of government.
A recent cannabis criminal case illustrates the point. The owner of several cannabis stores was recently convicted of failing to file income tax returns over several years, despite receiving professional advice over those years. Although cannabis retailers, distributors, wholesalers and growers have broad sales and excise tax obligations, this particular criminal case was about income tax violations. The person was a former member of the Oregon Liquor Control Commission’s Recreational Marijuana Technical Advisory Retail Subcommittee in 2018 who helped to advise the OLCC on adopting rules for the regulation of the industry. The case is instructive in showing just how aggressive tax authorities are when it comes to tax compliance in targeted areas like cannabis.
Cannabis supply chain—who are the main players?
Although the laws in each state are different and must be separately researched, broadly speaking, among the major players are:
Key cannabis-related taxes — California example
Each state has differing tax and regulatory laws for cannabis; however, California has been the most proactive recently in regulating cannabis by passing a comprehensive cannabis law that was effective Jan. 1, 2018. This relatively new law is useful to review and provides an excellent example of the key role that distributors play in how states administer cannabis taxation and regulation.
The main California taxes are:
Cultivation tax: There is a tax on harvested cannabis entering the commercial market, imposed on cultivators. Cultivators are required to pay the tax to either the distributor or a manufacturer. At last check, the rates range from $1.29 to $9.25 per dry-weight ounce of cannabis flowers, leaves and fresh plants. However, these rates are subject to change and must be researched often.
Cannabis excise tax: This tax is imposed on all purchasers of cannabis and cannabis products, including medical cannabis, at a current rate of 15 percent of the average market price of the retail sale. Retailers must collect the tax from the customer and pay it to the distributor. The purchaser must pay the excise tax at the time of the sale.
Sales and use tax: Those who sell cannabis and cannabis products to consumers are generally subject to sales and use tax. These taxes must be reported on a sales and use tax return. If the sales tax is included in the price of the items, it must be explicitly stated on the invoice. The above-described excise tax is also subject to sales tax.
• Exemption for resale: The sale of cannabis for resale is not subject to sales tax; therefore, the purchaser of products must provide a timely valid resale certificate to the retailer.
• Other tax exemptions: Certain retail sales of medicinal cannabis may be exempt from the sales and use tax. In addition, cannabis cultivators and manufacturers may qualify for a partial exemption on equipment and machinery used to produce or manufacture products.
Key tax and nontax role of distributors in California
Distributors play a pivotal role in the cannabis supply chain. In California, distributors are the only licensee that can transport cannabis products and coordinate testing. They also are responsible for the review of quality assurance packaging and labeling. They play a pivotal role in the taxation of cannabis and cannabis-related products and are required to:
• Register online for both a cannabis tax permit and a seller’s permit if appropriate;
• Collect the cannabis excise tax from retailers that the distributors supply to the retailer;
• Collect the cultivation tax from cultivators or manufacturers that send or transfer cannabis to the distributor;
• File both the cannabis and sales and use tax returns electronically and pay any amount due.
Key cannabis-related taxes — Colorado example
Colorado is another state that has a relatively well-developed legal and tax structure. Here are some of its key tax rules, which are further complicated because local jurisdictions may impose separate licensing requirements.
Incidence of tax: The excise tax is imposed upon the retail marijuana cultivation facility, which pays the excise tax to the Department of Revenue on the first sale or transfer of retail marijuana to a retail marijuana store or a retail marijuana products manufacturing facility.
Basis of tax: Retail marijuana sales tax is imposed on the full purchase price of all retail marijuana and retail marijuana product. The tax is calculated based on the category of the retail marijuana product (i.e., bud, trim, immature plant, wet whole plant or seeds) being sold or transferred.
Rates of tax: The tax is imposed at a rate of 15 percent of the average market rate of the unprocessed retail marijuana for transactions between affiliated retail marijuana business licensees, and at a rate of 15 percent of the contract price for unprocessed retail marijuana for transactions between unaffiliated retail marijuana business licensees.
Effective July 1, 2017, the average market rate for unprocessed retail marijuana is:
• Retail flower rate: $1,298/pound (previously, $,1471/pound);
• Retail trim rate: $426/pound (previously, $499/pound);
• Immature plant rate: $4/plant (previously, $10/plant);
• Wet whole plant rate: $227/pound (previously, $223/pound);
• Seed rate: $3/seed (previously, $6/seed); and
• Effective Aug. 9, 2017, contaminated product allocated for extraction: $403/pound.
Retail sales tax: The general state sales tax rate is 2.9 percent. However, sales of retail marijuana and retail marijuana products are exempt from the 2.9 percent state tax.
Licenses: Retail marijuana licenses are effective Jan. 1, 2014. Licenses are issued for retail marijuana stores, product manufacturers, cultivation facilities, testing facilities, and effective June 10, 2016, retail marijuana transporters and retail marijuana business operators. There is a schedule of license fees for medical marijuana businesses converting to or adding a retail marijuana establishment, in addition to new retail marijuana establishment applicants. Fees vary by facility type and production tiers (number of plants produced).
Local jurisdictions: To complicate matters even further, local jurisdictions may impose separate local licensing requirements.
Record keeping: Licensees are required to retain books and records of business transactions for the current tax year and the three immediately prior tax years.
Reports: Retail marijuana cultivation facilities are required to file a return with the Department of Revenue by the 20th day of the month following the month reported and remit the amount of tax due.
Retail marijuana sales tax returns: The additional state sales tax on retail marijuana and retail marijuana-infused products is filed on the Retail Marijuana Sales Tax Return.
Medical marijuana sales: Medical marijuana, medical marijuana-infused products and accessories are reported on the Retail Sales Tax Return. This return includes the 2.9 percent state sales tax plus any local sales taxes.
Penalties: Penalties are imposed for filing a false or fraudulent return or for the willful evasion of tax. The state licensing authority may impose a fine or suspend or revoke a license after holding a public hearing for any violations to the retail marijuana licensing laws.
Getting out in front of the opportunities and challenges of cannabis taxation
The legalization of cannabis in states like California and Colorado has led to state expectations in other states of a new source of revenue, especially financially strapped states. However, it is not clear at this point how much of a revenue opportunity this will be for states, as a recent article in Accounting Today pointed out. That will depend on many factors, such as the state’s choice of taxable base, as well as competition from the black market, as well as neighboring states.
Whatever the potential revenue opportunities for states may be, there are growing challenges as well. As each state develops its own set of rules for the tax and legal administration of these laws, this growing complexity will result in heightened risk of civil and criminal risk liability, as well as significantly enhanced audit activity — tax and legal — across the entire country by both federal and state authorities. The first line of defense for these more closely scrutinized businesses should be to proactively take steps to reduce the risk of legal and tax noncompliance liability — both corporate and personal — by first making sure that the legal, tax and accounting rules for cannabis compliance in each state are well understood by their tax staff and their advisors. Such an understanding will then enable them to advise and set up the procedures and systems needed to get and stay compliant, the sooner the better. Not only will such best practices reduce the risk of noncompliance among business and those responsible for running the business, but will also show “good faith” to state attorneys general, the IRS, the DOJ and others who will be increasingly “on notice” once a cannabis business registers in a state.