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February 6, 2023 Focus: Accounting

Effective tax rate on cannabis companies ‘can be fatal’; proposed bill would offer relief

PHOTOS | CONTRIBUTED A customer purchases cannabis at Fine Fettle’s Stamford dispensary. Cannabis retailers can pay an effective tax rate of up to 80% because they’re not allowed to deduct business expenses on their state or federal tax returns.
Fine Fettle’s Stamford dispensary.

After waiting years for the sale of recreational cannabis to become legal in Connecticut and crossing a plethora of regulatory hurdles, companies that sell the product face another challenge: taxes.

The state’s adult-use industry launched Jan. 10, with eight dispensaries now approved to sell marijuana to customers 21 and older. Two more dispensaries, in Torrington and Danbury, plan to debut soon.

Since opening to the general public, dispensaries have seen robust sales, recording $2 million in revenues in just the first eight days. But while adult-use sales open up a lucrative new market, a large proportion of companies’ revenues will go to the government.

Cannabis retailers’ effective tax rate can be as high as 80%, said Sarah Westby, co-chair of Hartford-based law firm Shipman & Goodwin’s cannabis industry practice. That’s largely because marijuana companies are unable to deduct their business expenses — such as rent and employee salaries — from their state and federal taxes due to cannabis still being illegal at the federal level.

Sarah Westby

“Their taxable revenue is much higher than it would be if they were able to deduct these expenses,” Westby said. “And so they end up paying an effective tax rate of up to 70%, or even 80%, which can be fatal to many businesses.”

In comparison, the federal corporate tax rate is much lower at 21%.

At least one state lawmaker is trying to aid the industry. House Majority Leader Jason Rojas (D-East Hartford) has proposed a bill (HB 5413) that would allow cannabis companies to deduct business expenses on their state taxes.

Deduction limits

Normally, companies can deduct “ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business,” under Section 162(a) of the Internal Revenue Code.

But companies engaged in the trafficking of “illegal” drugs are prohibited from deducting typical business expenses.

Cannabis remains classified as an illegal Schedule I controlled substance under the federal Comprehensive Drug Abuse Prevention and Control Act of 1970.

The only business expenses that cannabis companies may deduct are the costs of goods. For cannabis cultivators, that means they can deduct the costs of growing marijuana, such as fertilizer and the salaries of employees who cultivate the crops, said Robert Lickwar, a partner in national accounting firm UHY LLP’s Farmington office.

Robert Lickwar

“But if you are a retailer, your deduction is going to be limited only to what you pay for the item that you’re eventually going to resell, so your facility costs like your rent and the employees running the cash register and selling the product aren’t going to be deductible expenses,” Lickwar said.

Cannabis retailers are unable to deduct about 45% of the business expenses allowable under federal law, he said, because they are technically selling an illegal product.

But they may be able to reduce their effective tax rate by organizing as a C-corp entity, Lickwar said.

Leveling the playing field

While there has been talk of changing the legal status of cannabis at the federal level, a move that President Joe Biden has said he supports, there are not currently any proposals to do so.

Meanwhile, 37 states have enacted laws legalizing cannabis for medical use, and 19 allow recreational sales.

Some states have “decoupled” from the federal prohibition, allowing cannabis companies to deduct business expenses from their state taxes, Lickwar said. But Connecticut is not one of them, so the federal law applies.

House Majority Leader Rojas said his proposed legislation would level the playing field for cannabis companies so they can deduct their expenses the same way as other Connecticut companies.

Also, it remains difficult for cannabis companies to obtain financing, as many banks won’t lend to the industry unless the drug is legalized federally. That challenge, coupled with other barriers to entering the market, can put smaller cannabis companies at a disadvantage, Rojas said.

“Everyone I’ve met says it’s an incredibly challenging business to get into, particularly because of the capital costs that are needed, but also the regulatory environment is very complicated as well because you are dealing with a controlled substance that is still illegal at the federal level,” Rojas said. “... Anything that can be done to help reduce the cost of doing business, I think is to the benefit of the state, if we want to see this marketplace actually succeed.”

Westby said allowing cannabis companies to deduct their business expenses will help smaller players compete.

“I think it’s really hard for a business to survive without that ability,” Westby said. “And the businesses that can survive are mostly the large multistate operators. That type of tax scheme really squeezes out the small individual mom-and-pop businesses, the startup businesses and a lot of the social equity businesses that the state is trying to create.”

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