Why Do Cannabis Companies Pay So Much Tax? Blame A Drug Dealer From The 70's

This is a story from Jeremy Berke's "Cultivated" newsletter. Subscribe now so you don't miss the next one.

Cannabis companies pay a heavy tax burden. If you run one, or are employed by one, you already know this.

But just how much extra tax do cannabis companies pay?

Well, according to a May report from Whitney Economics — that number is $1.8 billion. In other words, that’s an extra $1.8 billion compared to similar size non-cannabis companies.

It goes without saying, this is a hard industry to make money in. So, what’s the reason?

Blame a guy named Jeffrey Edmondson for trying to beat the system. And blame Congress for slapping him down.

But it’s really a story of how reactionary laws get made, and how they persist for decades despite being mostly nonsensical.

Stick with me, this is a groovy tale about the Seventies.

Edmondson, of Minneapolis, was “self-employed in the trade” of selling cocaine, meth, and weed, according to court documents and old newspapers I pored over to tell this story.

His trade wasn’t a small street corner operation.

In 1974, he was fronted 1,100,000 amphetamine tablets, 100 pounds of marijuana, and 13 ounces of cocaine by his supplier, Jerome Caby, according to the documents.

Like most drug dealers, Edmondson wasn’t keeping his books. That would be stupid. His trade, of course, was entirely illegal. The IRS caught on.

As part of a jeopardy assessment — the IRS’s way of determining if someone is concealing taxable income — he was asked to reconstruct his tax filing to include the money he earned from selling drugs.

So, he did what any other self-employed businessman would do. He tried to account for his expenses so he could deduct them from his now-expensive tax bill:

• He estimated his total cost-of-goods-sold (COGS), an accounting term for how much a business pays for the products it sells, at around $105,300.

• He drove 29,000 miles, of which he estimated two-thirds were for “work.” He took a business trip to San Diego, paid $250 for airfare and $200 for “food and entertainment.”

• He bought a $50 scale to weigh his merchandise, paid about $200 for packaging for the drugs, and another few hundred dollars for long-distance telephone calls.

• And finally, he paid $2,360 for his apartment — which he deemed his only place of doing business. (Whether or not it was is a hilarious part of the judge’s opinion).

He settled on trying to deduct about $30,000 worth of drugs, plus the other costs. The IRS hated that and barred him from doing so.

Edmondson wasn’t going to accept that. He took his fight to pay less taxes for selling drugs to the Tax Court.

The Tax Court, perhaps unpredictably, sided with Edmondson in the case. He was allowed to deduct the $30 grand.

You absolutely gotta hand it to him — Edmondson was a real straight shooter, at least post-jeopardy assessment. The judge liked the honesty.

Reads the decision in Edmondson v Commissioner:

The nature of petitioner's role in the drug market, together with his appearance and candor at trial, cause us to believe that he was honest, forthright, and candid in his reconstruction of the income and expenses from his illegal activities in the taxable year 1974.

It wasn’t a happy ending for Edmondson, though. He might’ve won his day at court, but he lost the battle.

In a later criminal trial, Edmondson was sentenced to four years in prison for possessing cocaine with the intent to distribute.

Let’s take a beat here and go back to the original question.

So again, why do cannabis companies pay so much extra tax, and what does it have to do with Edmondson v Commissioner?

You can blame a section of the federal tax code called 280E.

That code was passed by Congress in 1982 as a reaction to the Tax Court’s ruling in Edmondson’s case.

The rule forbids businesses that sell Schedule I or II controlled substances, like cannabis or cocaine, from deducting regular business expenses. These can be as simple as office supplies or payroll.

In more specific terms, 280E forces cannabis companies to pay federal tax on gross income, not the lower net income number after expenses have been deducted.

That means all income cannabis companies generate is taxable. It's perhaps the only quasi-legal industry in the world where that's the case.¹

That extra tax burden eats into already slim operating margins for cannabis companies, who are already competing with the untaxed illicit market and declining wholesale price of cannabis in many states.

Tax deductions exist as a matter of ‘legislative grace’. There’s no grace for cannabis, yet.

The Supreme Court ruled in 1992 that tax deductions for businesses are matters of "legislative grace," according to the Congressional Research Service.

Congress in 1982 evidently didn’t foresee today’s situation, where cannabis is legal in 23 states and in some of the US's most populous and economically powerful cities, like NYC, LA, Boston, and Chicago.

It’s now up to Congress to pass a rule to get rid of 280E if they want to help the cannabis industry stay afloat. While various bills have been proposed that would do so, none have managed to become law.

Let’s put another number on the 280E problem.

States have collected over $15 billion of legal cannabis tax revenue since 2014, according to a report from the nonprofit Marijuana Policy Project.

As far as I know, no one has calculated that number without 280E.² But it’s safe to say it would be a lot smaller than $15 billion. If you know a thing or two about incentives, well, there’s not much motivation to reform 280E.

As long as cannabis remains a Schedule I or II drug — and we know how difficult it is to get cannabis reform legislation passed — 280E will be in effect.

And as long as 280 is in effect, the federal government will still pull in far more taxes from the cannabis industry than other similar size industries.

So, one drug dealer's ploy to deduct his business expenses in the mid-1970s still hangs over the cannabis industry today.

Forgive me some sarcasm here, but I’m sure Congress will fix it.

This is a story from Jeremy Berke's "Cultivated" newsletter. Subscribe now so you don't miss the next one.

Image: Javier Hasse.