Much has changed in the cannabis industry over the last several years. While still illegal at the federal level, in almost 20 U.S. states, cannabis is fully legal and 37 states allow for the medical use of cannabis products. Recent polling shows 60% of U.S. adults say cannabis should be legal for medical and recreational use.
A draft bill, the Cannabis Administration and Opportunity Act, exists and many speculate it is only a matter of time until cannabis is legal under federal law. Some argue, though, the federal government is in no hurry to legalize cannabis because the cannabis industry generates more revenue than many mainstream industries due to §280E, which prohibits the use of standard business deductions for companies that traffic in federally controlled substances.
Despite being illegal at the federal level, cannabis income is still required to be reported and federal income tax is still assessed. Section 61(a) does not differentiate between income derived from legal sources and income derived from illegal sources.
In states where cannabis is legal, cannabis producers and retailers face many challenges – including banking and paying taxes. Currently, possession of cannabis remains a federal offense, punishable by up to one year in jail and a minimum fine of $1,000 for a first conviction. Removing federal penalties in states where recreational use is legal would solve many problems taxpayers face.
As a practitioner, have you given any thought to your clients and cannabis? NATP government liaison Larry Gray has insight into this interesting, and perhaps controversial, topic. All answers below are from Larry Gray in a recent interview with NATP.
Q: What should practitioners know?
A: Practitioners need to know the law, industry and their client.
Regarding the law, every state is different. For example, some states limit the number of plants medical cannabis growers may possess or limit the number of patients a caregiver may serve. Each state has laws regarding licensing and taxing. For example, California has a growers tax where tax is imposed on the cannabis flower, fresh cannabis plant and cannabis leaves. California requires all cannabis retailers, cultivators (growers) and manufacturers to obtain a cannabis license. California also has a sales tax on certain cannabis transactions. If a practitioner is practicing in California, the state laws will be different than a practitioner practicing in another state. Because of the regulation at the state level, taxpayers generally are compliant as they don’t want to risk losing their business license and livelihood. It is the income from non-business taxpayers that practitioners need to be on the look-out for.
As a result of the disparity in federal and state law, many engaged in the cannabis trade or businesses are keeping a second set of books – one for federal purposes and one for state purposes. From a federal standpoint, record keeping is easy as cost of goods is the only deductible item. For those engaged in a trade or business, a schedule attached to the state return may be needed to reconcile the additional deductions allowed at the state level. At the state level, what is allowed as a deduction? It depends. Practitioners need to be versed in their state law. Practitioners also need to educate clients who may be engaged in cannabis activity, but the activity does not rise to a trade or business. This income is still reportable.
Practitioners also need to know the industry. There are so many different ways a client can be involved in the cannabis industry. Is your client a caregiver? If yes, for themself? For others? Are they operating a dispensary? Are they a grower? Are they a retailer? There may be different state rules and regulations placed upon a retailer versus a grower, for example, and practitioners need to know exactly what activity the client is engaged in.
Finally, you need to know your client. This most likely will be tough and will require open communication and dialogue. Knowing your client requires asking the appropriate questions. Federally, the decision-making tree is easy. From the state side, not so much. On the state side, will the activity be treated the same as the federal requirements (hobby) or does it rise to the level of a trade or business? To know how to treat the activity, practitioners will first need to know about the activity and then ask appropriate questions.
Finding out about the activity is the tough, but necessary, part of working with the client. Some may be offended by you asking, some may be open to talking. There is no way to know how a client will react; however, the topic must be addressed.
For example, if your client, Joe, is a caregiver and does not have a caregiver license, Rita, the practitioner, will not care if Joe has a medical license. On the other hand, if Joe says he has a caregiver license for himself but is selling to his neighbor, Bob, for recreational use, Joe will have income to report, but the income will not be subject to self-employment tax. If Joe does not sell to his neighbor, there would be no income to report.
Q: What about practitioner due diligence?
A: As we stated earlier, there is a requirement to report income generated by cannabis sales. The big task practitioners have is how do we ask these questions of our client without risking offending them or making them uncomfortable. A personal relationship is key.
Larry said this topic is harder to address than others, such as virtual currency. With virtual currency, there is a question on the tax return; there is no such disclosure for cannabis. Also, due to the changes brought about by COVID-19, many of us are not seeing clients in person. Larry suggested one way to address this topic is to discuss it in a client newsletter.
For those with additional questions, help is available. The IRS has FAQs on the cannabis industry, our research team is available or you can purchase the NATP Cannabis Businesses self-study.