Everyone needs to pay their fair share of taxes, including the cannabis industry. But there is nothing fair about how the federal government treats cannabis under an outdated provision put into the Internal Revenue Service tax code decades ago. It’s fueling the underground market for weed and reducing the tax revenues the federal government should collect.
Under Section 280E of the code, cannabis businesses are not allowed to take tax deductions on normal business expenses like employee salaries, rent and utility bills because the federal government considers their trade illegal drug trafficking — even where cannabis sales are legal under state law. As a result, the effective federal tax rate for legal cannabis businesses can reach 70% to 90%. No other industry has to operate with this very high tax rate.
Section 280E came into effect during the height of the drug war in the 1980s. A California cocaine dealer was gutsy enough to file his federal tax return with his drug income and expenses listed on it. When the IRS challenged the deductions for his illegal venture, the Tax Court sided with the dealer: There was nothing on the books to prevent him from doing so at the time. Congress and the IRS were outraged and swiftly passed 280E to make sure it would never happen again.
Fast forward to the present day when cannabis is legal in 33 states medically and in 11 states and the District of Columbia recreationally. For some legal cannabis firms, Section 280E is enough to force them out of business. Consider that California was home to about 2,000 nonprofit dispensaries prior to 2018. Legalization introduced regulations that increased the cost of operation. Bigger dispensaries were able to go to Canada and raise funds on the public market, but most legacy cannabis businesses could not afford to do that, and more than 65% of dispensaries shut their doors, resulting in loss of jobs, sales tax and income taxes.
For the remaining cannabis retailers, many had to raise prices to pay off their tax bills. Artificially increasing cannabis prices in the legal market just drives businesses – and consumers – underground. In fact, industry experts estimate that licensed cannabis sales of about $3 billion in California in 2018 accounted for only about 20% to 25% of all the marijuana purchased in the state.
Gov. Gavin Newsom has said that despite legalization unlicensed grow operations in Northern California have proliferated. Indeed, underground markets put progressive states in a precarious position. Legalization was meant to reduce heavy policing of cannabis. Instead, there are new calls for crackdowns on illegal sales.
A better approach would be to use market dynamics to fight the illegal markets. Reduce the taxes that artificially raise prices. Lower the barriers that prevent more growers from entering the industry. License more storefronts to give consumers real access. If lawmakers remove the financial incentives to participate in the unregulated market, they wouldn’t have to resort to force.
A legalization wave is sweeping across America because states recognize the positive benefits of cannabis and the social harms caused by criminalization. But the unfair IRS tax provision is one factor keeping the underground industry alive. Consumers still face unnecessary hazards because they don’t know what they’re buying. There are no legal protections for buyers or sellers. And of course, the government doesn’t get a cut of those revenues.