Legal weed businesses are worried the IRS could tax them out of existence
When California voted to legalize recreational marijuana use in November, few people were as thrilled as Steve DeAngelo. Sporting his signature porkpie hat and braided hair while seated in the massive grow operation he’s building south of San Francisco, the longtime activist and weed industry entrepreneur called legalization “the culmination of my life’s work.”
DeAngelo has many reasons to celebrate, not least being that he has positioned himself to capitalize on what is projected to be a $7.6 billion market for legal cannabis in California within the next four years. But the founder of Oakland’s Harborside, which claims to be the country’s largest medical marijuana dispensary, isn’t banking those billions just yet.
“The IRS,” he said, “is still trying to tax us out of existence.”
Marijuana is now legal for recreational use by adults in nine states and Washington, D.C., and approved for medical purposes in 29 others. It remains illegal on the federal level, however, and the U.S. tax code — specifically Section 280E — treats state-sanctioned pot businesses like illicit drug trafficking organizations.
The rules prohibit weed merchants from taking deductions for common expenses like rent, insurance, and electricity, which means they end up paying far more than the standard 35 percent corporate rate. These businesses can be taxed anywhere from 40 to 90 percent depending on how they operate. The IRS can also tack on stiff penalties when companies fail to comply.
In DeAngelo’s case, the IRS audited his dispensary’s tax filings for 2008 and 2009 and slapped him with a back tax bill of $2.4 million. He and his Bay Area attorney Henry Wykowski, a former Justice Department prosecutor who specialized in tax evasion, challenged the tax bill in court earlier this year. A ruling is expected in mid-2017.
“The trajectory with legalization is starting to look and feel more like booze.”
The stakes of this case are far higher than DeAngelo’s hefty debt to the IRS — the ruling could introduce a new precedent to how dispensaries are treated by the IRS in the future. Specifically, Wykowski aims to exploit a potential loophole in the wording of the tax law, which could open up a path for state-approved weed vendors across the country to pay the same taxes as most other American businesses. As DeAngelo put it, “Our objective here is to kill 280E.”
Though President-elect Donald Trump has said he’ll respect state decisions on legalization, his nomination of Alabama Sen. Jeff Sessions to lead the Department of Justice has raised concerns that the anti-weed hardliner could move to shut down the state marketplaces and prosecute those involved. Even so, the most pressing concerns center on the IRS, which would still be free to aggressively target dispensary owners – a scenario some experts suspect is likely.
“The trajectory with legalization is starting to look and feel more like booze,” said Hilary Bricken, lead attorney for the Seattle-based Canna Law Group. “In the end days, they pinched a lot of people by going after them for tax evasion, like Al Capone. It seems like in the end we may see more IRS tax audits and prosecutions than DOJ investigations.”
An IRS spokesperson declined to comment about the agency’s approach to the marijuana industry, but Derek Davis, a San Diego-based accountant who works with dispensaries, said that he expects the IRS to crack down on the emerging legal markets as more states join in.
“It’s not a matter of if, it’s a matter of when,” Davis said. “What we generally see with the IRS, they’re usually maybe two or three years behind the market trend. It’s going to be a huge audit area, especially when you’re throwing around numbers like the market being $5-7 billion in California alone.”
The root of the weed industry’s tax problem dates back to a 1961 Supreme Court ruling that says even illicit income is taxable. That allowed a Minnesota man busted for selling weed, cocaine, and amphetamines to successfully claim in 1974 that he could write off the cost of his packaging materials, scale, and other expenses. Congress struck back in 1982 by enacting 280E, which states “no deduction or credit shall be allowed” for any business that “consists of trafficking in controlled substances.”
Wykowski already challenged 280E on a technicality in a previous case, attempting to convince the judge that the word “trafficking” does not apply to state-sanctioned businesses. After losing that argument, he’s now working with a linguist from the University of California, Berkeley to attack the phrase “consists of,” claiming Harborside offers a range of services beyond trafficking marijuana, such as acupuncture, yoga, and an on-site chiropractor.
“If you apply it in its correct fashion, ‘consists of’ would not apply to Harborside or any other dispensary that does more than just sell cannabis,” Wykowski said. “If you live in New York, you wouldn’t say New York consists of Manhattan and the Bronx. It includes Manhattan and the Bronx, but it consists of all five boroughs.”
Whether or not a judge will buy that argument remains to be seen, but even if Wykowski and DeAngelo lose their case, there’s a push in Congress to overhaul the tax code to benefit legal weed businesses.
Last year, Oregon Sen. Ron Wyden co-sponsored legislation with Kentucky Sen. Rand Paul that would make state-approved pot sellers exempt from 280E. The bill stalled in committee, but Wyden has vowed to continue pushing for reform.
“We’re going to be able to expand our bill pretty dramatically based on the events of the last few weeks,” Wyden told VICE News. “California has 55 members of Congress, one of out five Americans now lives in a state with medical marijuana. I think we’re on the march.”
In the meantime, California dispensaries face an especially precarious situation. The businesses are currently required to operate as non-profits under the state’s old medical marijuana regulations, even though the IRS refuses to grant them tax-exempt status federally. California’s new law, which allows for for-profit dispensaries, won’t take effect until 2018, but savvy operators like DeAngelo have built complex corporate structures to skirt existing rules and keep an eye on the future marketplace.
One example of this approach: In addition to his role at Harborside, DeAngelo also serves as executive chairman of an organization called FLRish. Through this complicated arrangement, DeAngelo is able to charge his non-profit dispensary for a range of consulting services. The dispensary operations could eventually be rolled into FLRish, creating a holding company arrangement akin to Alphabet and Google. Such a move would transform what is technically a non-profit business into a for-profit one overnight.
“It is a completely novel and unusual structure that’s been made necessary by the sort of chaotic nature of cannabis regulations,” DeAngelo said,“it’s only position that I thought would leave me in strict compliance with California cannabis laws.”
Both Davis and Bricken said it’s not unusual for California pot companies to have parallel non-profit and for-profit arms, but the accountant and attorney both warned that the arrangement can easily veer into illegality if business owners aren’t careful.
“It’s a way that some California companies are trying to dance around 280E,” Davis said. “When you’re setting up these types of structures, you don’t want to do it in such a way that you’re evading taxes or money laundering, which obviously could be a huge criminal penalty.”
Wykowski jokes that “10 years ago the best way to avoid a 280E problem was don’t file taxes,” but he bristles at mention of the phrase “money laundering” when asked about Harborside’s current corporate structure. He insists that “it’s all on the up and up.”
“Money laundering is if you’re dealing drugs and in order to get that money into the system you also have a pizza parlor that has 10 customers a day but miraculously grosses $10 million a year,” he says. “But if a cannabis dispensary pays its accountant, pays it management, pays outside third parties to do things for them, I don’t think that’s money laundering at all. Basically, you’re paying for a service.”
Polls show 60 percent of Americans now favor marijuana legalization, but pushing weed-friendly laws through the Republican-controlled Congress could still prove challenging.
Regardless of whether he gets legislative reinforcements, DeAngelo says he’s prepared to keep challenging the IRS and any other federal agency that stands in his way.
“There are dyed-in-the-wool drug warriors who have been ingesting this [anti-marijuana] ideology for decades, and they’re no sooner to go away than Steve DeAngelo is going to go away,” he said. “It’s a fight to the death.”