The Messy State of Cannabis Financial Regulation

An accountant weighs in on federal legislation, the IRS, and policy issues.

Financial-regulation-CSA-cannabis-mg-mg magazine

Because state-legal cannabis businesses operate in violation of the federal Controlled Substances Act (CSA), they face several significant challenges other legal businesses do not. Of course, even those in compliance with state law risk prosecution under the CSA, although the risk is relatively low. Operationally, though, these businesses run into myriad problems, including confiscatory taxes that constrain them in ways not faced by any other commercial sector.

The STATES Act, taxes, and banking
Those who are pushing for federal action always should keep in mind the maxim “Be careful what you ask for. You may get it.” Everything that comes from the federal government comes with a price, and if the full price were known, those who push for change might reconsider. Consider this: The Internal Revenue Service may not agree the STATES Act’s proposed changes to federal criminal law eliminate the impact of Internal Revenue Code §280E, which disallows a deduction that is not dependent upon determination the conduct is criminal. Because of §280E, cannabis businesses complying with federal law suffer an effective federal tax rate of 70 percent. Some believe in order to make IRC §280E inapplicable, either marijuana must no longer be classified as a controlled substance, or IRC §280E must be amended.

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In the 115th session of Congress, S. 3032 and H.R. 6043 are identical bills with the short title “Strengthening the Tenth Amendment Through Entrusting States Act” or the STATES Act. Effectively, and with some exemptions delineated in the act, “any person acting in compliance with state law relating to the manufacture, production, possession, distribution, dispensation, administration, or delivery of marihuana” shall not be in violation of the CSA or “any other provision of [federal] law.” Consequently, such activity can’t serve as a predicate for offenses under other laws; therefore, §280E of the federal tax code would not apply to such businesses.

Because of §280E, cannabis businesses suffer an effective federal tax rate of 70 percent.

Moreover, the STATES Act would allow banks and other financial services entities to transact business with cannabis companies without fear of violating money-laundering statutes.

Understanding financial institutions might want additional language to ensure there is absolutely no confusion about the operation of the STATES Act, the drafters included a “Rule of Construction” that provides conduct in compliance with the act. Manufacturing, selling, transporting, possessing, etc., within state-legal frameworks:

(1) shall not be unlawful;
(2) shall not constitute trafficking in a controlled substance under section 401 of the Controlled Substances Act (21 U.S.C. 841) or any other provision of law; and
(3) shall not constitute the basis for forfeiture of property under section 511 of the Controlled Substances Act (21 U.S.C. 881) or section 981 of title 18, United States Code.

If the foregoing is not enough for skeptics, the STATES Act contains one final provision specifically addressing interaction of the act with principal money-laundering statutes by providing:

The proceeds from any transaction in compliance with this Act and the amendments made by this Act shall not be deemed to be the proceeds of an unlawful transaction under section 1956 or 1957 of title 18, United States Code, or any other provision of law.

If the conduct in question is not unlawful, is not trafficking in a controlled substance, and cannot form the basis for civil asset forfeiture, any financial services entity should feel comfortable doing business with state-compliant cannabis companies.

Solving the confiscatory tax problem
The STATES Act insulates state-compliant cannabis businesses from §280E of the tax code, which provides 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 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.

Since business conducted in compliance with the STATES Act would not violate federal drug laws, such activity would not constitute “trafficking in a controlled substance” and would not trigger IRC §280E. However, if that was not clear from the substantive provisions of the STATES Act, the Rule of Construction makes it unambiguous by adopting language that parallels the language in §280E and provides conduct in compliance with the act “shall not constitute trafficking in a controlled substance.” If the activity in question does not constitute trafficking in a controlled substance, then §280E does not apply.

State taxes and policy
The simplistic answer given by many is cannabis taxes are too high and California’s cannabis regulations are too onerous. Failure of the California Department of Tax and Fee Administration (CDTFA) to require financial record-keeping and tax return reporting that ties into such financial record-keeping is a far more significant cause of the failure of CDTFA to collect taxes from licensed businesses. California cannot reasonably expect to collect the taxes it should if it does not require California cannabis businesses to keep accurate and complete financial records. California also has made it unnecessarily difficult to become a licensed and regulated cannabis business. No state can expect cannabis businesses to become taxpayers if the state does not simplify the process for becoming a regulated cannabis business.

Most of the policymakers who are molding California’s cannabis industry at present have forgotten, or never knew, that former Governor Jerry Brown very likely did more to shape California’s cannabis industry with his 2008 memorandum when he was the state’s attorney general than any other single policymaker. The principles expressed in that memorandum remain valid today. The rights Proposition 215 granted Californians were preserved in Proposition 64. Medical cannabis distribution will begin making a comeback in California as soon as the financial advantages of medical cannabis over adult-use cannabis again come to the forefront.

California should have adopted two principles. First, California’s cannabis regulatory agencies should have deferred all issues relating to land use and public health and safety to local jurisdictions to the maximum extent possible. Second, California’s cannabis regulatory agencies should have made it as easy as possible for California’s existing cannabis businesses that were locally acceptable to become state-licensed.

Tribal lands
Can Native American tribes legalize cannabis on their lands? In March, a Republican congressman from Alaska submitted a bill that would protect tribes who legalize cannabis from discrimination in matters of federal funding.

Generally, federal law applies on tribal lands because tribes are treated somewhat like independent nations but the land is “held in trust” by the United States government. Depending on the state in which tribal lands are located, state criminal law also may apply, thanks to Public Law 83-280 (PL-280), which to date has transferred federal law enforcement authority on tribal lands to the states of Alaska, Arizona, California, Florida, Idaho, Iowa, Minnesota, Montana, Nebraska, Nevada, North Dakota, Oregon, South Dakota, Utah, Washington, and Wisconsin. However, even in states that have PL-280 jurisdiction, some tribes remain exempt. Additionally, tribal lands have their own version of the Cole memo, known as the Wilkinson memo. (The Cole memo essentially stated Department of Justice personnel would not interfere with state-legal cannabis businesses.) The Wilkinson memo adopts eight policy goals from Cole—including keeping cannabis away from minors, cracking down on organized crime, and prohibiting interstate commerce—the DOJ wanted states to enforce in order to keep the federal government from intervening. The Wilkinson memo also contains a caveat: The feds will consult with tribal leaders before acting.

But Jeff Sessions repealed those memos while he served as U.S. Attorney General, right? Sort of. Although the memos no longer dictate which policies every U.S. Attorney must consider, Sessions, in his own memo, said each attorney should use his or her own judgment to balance enforcement priorities. In response, many attorneys said, “Okay, if I can choose my own policies, I’m just going to choose the policies outlined in the Cole and Wilkinson memos.”

While every tribe still must adhere to federal drug laws, some U.S. Attorneys choose not to enforce cannabis laws against those that maintain a well-regulated market within their territory. State criminal law applies to reservations within PL-280-regulated states unless the subject tribe is among those specifically excluded from PL-280. Those three, in Minnesota, Oregon, and Wisconsin, fall entirely under federal jurisdiction.

But yet another layer further complicates things. Because PL-280 gives states only criminal jurisdiction over reservations, the only state marijuana law that legally can be enforced is a law that makes it a crime to deal with marijuana. So, tribes in PL-280 states are exempt from any regulations or taxes that legalized states have put in place, but not exempt from a full-on ban. This also has the strange logical result that tribes inside non-PL-280 states that prohibit cannabis could legalize marijuana within tribal boundaries.



Jordan Zoot is a licensed certified public accountant in California, Florida, Illinois, New York, and Texas. He is known for his work with technical and transactional taxation of pass-thru entities, private equity and alternative asset funds, professional services, real estate, venture-funded tech start-ups, and the commercial cannabis industry in California. DopeCPA.cool

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