California may be a marijuana-friendly state thanks to the passage of bills like the Medical Cannabis Regulatory Safety Act (“MCRSA”) in 2015 and Proposition 64, or the Adult Use of Marijuana Act (AUMA) in 2016, but owners of cannabis dispensaries still face challenges when it comes to paying taxes, deducting expenses, and avoiding dreaded IRS, EDD, FTB or CDTFA tax audits.
It is critical for business owners to understand the tax requirements in California and how they are impacted by federal laws regarding the sale of marijuana. To make sure that your business is compliant with both laws and to protect yourself from unforeseen tax issues, you should consult with an experienced tax attorney or tax professional who understands the marijuana industry.
Rex Halverson & Associates does tax consulting with businesses in California and around the country on a broad range of tax issues, from sales and use tax, franchise tax, income tax, property tax, payroll tax and business license tax matters, and more. If you have questions about taxes that may impact your marijuana dispensary or cultivation, contact us at (916) 444-0015 to schedule a free initial consultation.
Under California law, and according to the California Department of Tax and Fee Administration (CDTFA) as of January 1, 2018, cultivators pay a product tax per ounce at a rate of $2.75 per dry-weight ounce of cannabis leaves and $9.25 per dry-weight ounce of cannabis flowers. Retailers are also required to charge customers a 15% excise tax on purchases of cannabis and cannabis products. In other words, this tax is on the purchaser.
Distributors of cannabis and cannabis products have to register with the CDTFA for a special cannabis tax permit to report and pay these taxes, in addition to holding a valid California seller’s permit.
Cannabis tax and sales and use tax returns must be filed electronically with the CDTFA, and a return must be filed even if none of your sales are subject to sales tax.
Although marijuana is legal for sale and purchase in California, there are some key tax issues that can cause headaches for business owners, including:
According to federal law, cannabis is still considered a Schedule I controlled substance. Under Internal Revenue Code section 280E, legitimate marijuana businesses cannot write off most standard business deductions, which leaves them with a higher than normal tax rate.
Simply put, this statute makes the common business expenses for a cannabis business (like lease payments, wages, and office supplies) non-deductible for federal tax purposes. Fortunately for business owners, business expenses that are part of Cost-Of-Goods-Sold (COGS) are not subject to this rule. These limited expenses can be deducted. So, owners of marijuana businesses can reduce their income and their taxes by taking advantage of this limited exception.
Some cannabis businesses have aggressively included expenses in the COGS; but, be forewarned that the IRS has issued Chief Counsel Advice (CCA) 201504011 to clarify stating that this practice will not be allowed. For dispensaries or resellers, the expenses that may be deducted as COGS include only the invoice price of purchased cannabis, less any trade or other discounts, as well as, transportation and other costs necessary to gain possession of the inventory. For producers, the expenses that can be included in COGS are production-related wages, rents and repair. Marketing and general business expenses remain nondeductible. In addition, indirect production costs that may be considered as COGS include but not limited to: maintenance, utilities, tools and equipment not capitalized, payroll taxes, and costs of quality control and inspection, but only if they are incidental to and necessary for the production of cannabis. So, if you have been aggressive or are considering taking that stance, please note that upon audit your business will be assessed additional tax, interest and penalties based on the IRS’ current position.
California’s Revenue and Taxation Code as it applies to corporations does not incorporate IRC section 280E but it does prohibit taxpayers from claiming deductions for any income received that is directly derived from any act or omission of criminal profiteering activity if the taxpayer is found guilty of the specified illegal activities in a criminal proceeding before a California state court or any proceeding in which the state, city, city and county or other political subdivision was a party. Accordingly, it would appear that dispensaries subject to the corporation franchise and income tax law would be allowed to deduct their trade and business expenses for California tax purposes as long as they are not found guilty of criminal profiteering. This tax treatment differs from the California personal income tax law which incorporates federal law (IRC sec. 280E) and disallows deductions for illegal drug trafficking expenditures and prohibits taxpayers from claiming deductions for any income received that is directly derived from any act or omission of criminal profiteering activity.
Even though the California state treasury estimates that sales taxes from the legal sale of marijuana will reach $7 billion in 2018, many marijuana dispensaries still cannot open or maintain bank accounts and must pay their taxes in cash.
Banks cannot accept marijuana money due to its Schedule I substance classification and the potential federal money laundering penalties they could face.
Because marijuana businesses cannot prove that they’ve accurately reported all of their income to the IRS or FTB, they run the risk of audits and accusations that they’ve underpaid their income taxes. This can result in both civil and criminal tax penalties. Federal civil tax fraud penalties can reach a staggering 75%.
Businesses may also be audited at the state level by the California Department of Tax and Fee Administration (CDTFA) which often audits cash-based businesses on suspicion of unpaid state sales and use taxes. Without receipts or clear and defined records of gross income, the CDTFA can simply assign an estimate of gross income and force the business to pay sales and use taxes based on such estimate.
Like any business, marijuana dispensary owners and managers must accurately classify workers to avoid tricky tax issues. Making the correct classification of a worker as an employee versus an independent contractor can be challenging, and misclassification of employees can lead to payroll tax issues with the IRS and/or the California Employment Development Department (EDD).
Cash-based businesses like cannabis businesses also face issues when it comes to the electronic payment of payroll taxes. The Electronic Federal Tax Payment System (EFTPS) requires employers to pay FICA, FUTA, and corporate income taxes electronically, but to remain compliant with the law (and avoid the 10% failure-to-deposit penalty) you need to have a valid bank account.
Many marijuana businesses simply pay the taxes in cash and risk the penalty, or voluntarily pay the 10% penalty. Recently, changes have been made to the IRS Penalty Relief Handbook that allows for businesses to apply for relief from penalties if they demonstrate that they made reasonable efforts to open a bank account but were unable to do so.
The experienced tax professionals at Rex Halverson & Associates understand the tax issues facing owners of marijuana-based businesses, and we’re here to help you understand the laws and your tax compliance obligations. We know the challenges and we’re here to help you stay compliant and protect you from undue harassment and penalties.
Schedule a confidential initial consultation with us today. You can reach us by calling (916) 444-0015 or by filling out our contact form. We look forward to talking with you.