With the creation of the Maryland Medical Cannabis Commission and the dispensary permitting process moving forward, Marylanders will soon have access to marijuana for medical use. Many anticipate that the legalization of the recreational use of marijuana is not far behind. In the most recent session of the Maryland General Assembly, multiple bills calling for legalization of its recreational use were introduced. Within those bills, legislators included provisions to impose an excise/sales tax of 9%, similar to what is currently imposed on sales of alcohol in Maryland. Those proposals cited the potential tax revenue increases associated with legalization of marijuana, the increasing (and majority) approval of such a measure by Marylanders, and the relatively insignificant health risks associated with the drug, as reasons for passing the legislation.
These developments raise a few questions: If distribution of marijuana for recreational use is legalized and Maryland imposes a state-level excise/sale tax, what impact will that have on other tax issues? In particular, how will this issue affect the federal taxable income of marijuana distributors? For those aware of the Internal Revenue Service’s position with respect to I.R.C. § 280E, there could be a concern that such taxes may not be deductible as a business expense as they relate to the trafficking of a substance prohibited under federal law (i.e., sales of marijuana). (For more information regarding the application of I.R.C. § 280E, please read “Deductions Up in Smoke? The Impact of Section 280E on the Marijuana Industry.”) Moreover, as Maryland taxable income uses federal taxable income as a starting point for its income calculations, how will Maryland account for the probable disallowance of significant indirect expenses by the IRS? Will these expenses be disallowed at the state level as well? If this industry grows into a near one billion dollar per year industry in Maryland, as it has in several other states, such issues must be considered.
Federal “Deductibility” of State Taxes Paid on Sales of Marijuana
While an answer regarding the deductibility of state excise taxes has not been specifically answered by Congress or by regulation, the Internal Revenue Service recently issued a memorandum summarizing its position on the matter in IRS CCM 201531016 (June 9, 2015). In that memo, the IRS addressed how a seller in the State of Washington – where recreational use of marijuana is now legal – should properly account for the payment of marijuana excise taxes for federal income tax purposes. The IRS concluded that the excise tax should be treated as a reduction to the amount realized on the sale of property. Much of the opinion of the IRS was based on the interplay of I.R.C. § 164 and I.R.C. § 280E.
In particular, while some “indirect” expenses of marijuana businesses will be disallowed under I.R.C. § 280E, the IRS will not interpret that statute to disallow items relating to the cost of goods sold (“direct” expenses). (For further discussion of the differentiation between “direct” and “indirect” expenses, please read “Deductions Up in Smoke?…) Looking to I.R.C. § 164(a), which concerns the deductibility of state taxes as a business expense, the IRS notes in its memorandum that the statute provides that “…any tax…which is paid or accrued by the taxpayer in connection with an acquisition or disposition of property shall be treated as a part of the cost of the acquired property or, in the case of a disposition, as a reduction in the amount realized on the disposition.” Accordingly, the IRS construes state excise or sales taxes on marijuana as direct expenses (or part of cost of goods sold) and not subject to the deductibility limitations of I.R.C. § 280E. In other words, an expense for these taxes is permitted in calculating federal income taxes for marijuana businesses.
Will Maryland Decouple Income Tax Calculations for Marijuana Businesses?
Aside from concerns relating to the deductibility of state sales and excise taxes, there is an unresolved state issue regarding the deductibility of certain expenses incurred in the production and sale of marijuana. Maryland law provides that adjusted gross income for state tax purposes is based upon federal adjusted gross income, subject to limited exceptions. In the case of marijuana businesses, the current interpretation of I.R.C. § 280E could (and likely will) result in the non-deductibility of significant indirect expenses at the federal level. And if left unchanged, Maryland law would similarly provide for the non-deductibility of these expenses, based on reference to the calculations of the IRS.
While the application of I.R.C. § 280E may or may not be merited as it relates to income from marijuana sales at the federal level, from a policy perspective, the non-deductibility of these expenses for state income tax purposes makes little sense. That is, if Maryland were to legalize the production and sale of marijuana, it makes little sense to penalize these same businesses for simply conducting a legal, regulated business (at least compared to other businesses that would be able to claim such deductions). It is yet unseen as to whether legislators will push to modify the state tax code to permit deductions otherwise disallowed by federal law. A likely solution would be for Maryland to create a statutory reduction to adjusted gross income for expense items disallowed under I.R.C. § 280E, assuming the business is licensed in Maryland. A change of this nature has already been passed in Oregon, where recreational use of marijuana is legal and where the tax regime operates in a fashion similar fashion to that in Maryland. On the other hand, as public sentiment and various states become more open to legalization of marijuana for recreational use, it is possible that the issue will be addressed first by Congress with the modification of I.R.C. § 280E. Only time will tell.
The Importance of Monitoring Developments in Tax Laws
The advent of the marijuana industry in Maryland poses many unique tax issues resulting from the conflicting positions of federal and state law on its distribution and consumption. Aside from the issues discussed herein, other developments could cause a differing tax treatment for marijuana businesses, depending upon where and how marijuana is produced (e.g., application of local taxes), to whom it is sold (e.g., medical versus recreational use), and if other taxes could apply (e.g., admissions and amusement tax). These issues could have as significant of an effect on the bottom line of marijuana businesses as other, more obvious, regulatory regimes. Accordingly, stakeholders in the industry need to seek tax counsel in this changing regulatory environment.
Rosenberg Martin Greenberg is experienced in all aspects of federal and state tax laws, including developments germane to the legalization of marijuana in Maryland. For a free consultation, please contact Brandon N. Mourges at firstname.lastname@example.org or 410.951.1149.