Up in smoke: WA pot firms say their profits are getting burned down by tax bills

A provision in the U.S. tax code that enables the IRS to tax marijuana-related businesses on excise taxes paid to the state is a chief concern.
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Medical marijuana grower Brendan Howley working with marijuana plants grown under current state medical marijuana prescriptions in Skagit County. New rules are being proposed for sales under a state law legalizing marijuana.

A provision in the U.S. tax code that enables the IRS to tax marijuana-related businesses on excise taxes paid to the state is a chief concern.

Cannabis City was the first recreational marijuana retailer to open in Seattle. The shop recorded just over $2.5 million in total sales between early July and the beginning of December, according to Washington State Liquor Control Board records.

While that might sound like a healthy amount of revenue for a new retail business with a single storefront location, the company's owner says that a potent mix of state and federal tax obligations is straining the shop's finances.

"We're just struggling to stay alive," says James Lathrop, the owner.

In order to cover all of his taxes, and other expenses, Lathrop said that he would need to more than triple the wholesale price of the marijuana he sells. "To actually make it work you have to put it on the shelf at $36 per gram," he said during a recent interview. Currently, most per gram prices at the shop are hovering between $20 and $23, according to an online menu.

For Lathrop and other players in Washington's budding recreational pot trade, this year is simply about hanging on and hoping to turn a profit in the future. "We're just taking a hit to pay those taxes and keeping the doors open," he said.

There is a single chief concern shared by many people currently involved in Washington's recreational marijuana industry: The 25 percent excise tax that the state levies on pot at each step in the supply chain — as it moves from growers, to processors, to retailers — cannot be written off when businesses file their federal taxes. This is because of a provision in the U.S. tax code, known as "280E," which prohibits businesses from claiming any tax deductions if they are trafficking drugs the federal government considers illegal.

"If you’re in this industry and you don’t know about 280E, you’re screwed," said Todd Arkley, an accountant, who owns Arkley Accounting Group, a Seattle-based firm that provides bookkeeping and financial management services for marijuana-related businesses. "If companies are not setting money aside for their federal tax bill right now, they are going to go bankrupt."

As of Dec. 4, Cannabis City owed $631,171, one quarter of the shop's $2,524,685 in total sales, to the state in the form of excise tax, according to state Liquor Control Board figures. Because of the 280E provision this excise tax expense cannot be written off. The Internal Revenue Service would view the $631,171 as income and tax it accordingly.

"I'm being taxed on the tax I'm paying the state of Washington," Lathrop said.

Dean Guske is an accountant who has about 150 clients in the cannabis industry. He sees the excise tax as a critical challenge for Washington's marijuana businesses.

"I would say that the biggest problem right now under 502 is the current structure of the excise tax," he said, referring to Initiative 502, the ballot measure that voters approved in 2012 legalizing recreational marijuana in Washington. "It’s making it extremely difficult for retailers in particular to really be profitable."

State lawmakers are taking note of the excise tax issue as they head toward the 2015 legislative session.

State Sen. Ann Rivers, R-La Center, said she believes the tax needs to be changed. "It’s a huge problem," she said last week. Referring to marijuana-related businesses, she added: "By having to pay enormous taxes to the feds there's no point to them being in business."

Rivers and state Sen. Brian Hatfield, D-Raymond, are working together on legislation that would change the excise tax to a business and occupation tax, which would allow marijuana businesses to write off the expense when they file their federal taxes.

Because of the way tax laws are written, if the excise tax were revised and collected differently, as a sales tax for instance, or as a business and occupation tax like the one Rivers is proposing, it would not be counted toward a business's income by the IRS. In the case of a 25 percent sales tax, a retailer would collect $25 from a customer on a $100 purchase. The IRS would recognize that the business is effectively holding that money so it can be transferred to the state's coffers. In contrast, with the excise tax model, the business builds the cost of the tax into the price of the product and it is seen as revenue by the IRS.

"If it were a state sales tax, it would never be a part of our revenue," said Sean Green, CEO of Kouchlock Productions, a marijuana producer in Spokane, which was the first company to receive a recreational grower's license from the state. "To have to pay income tax on that huge amount of money, that’s not even ours to begin with, is going to put people out of business."

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Total sales and excise tax figures for Washington's recreational marijuana businesses through Dec. 2. These totals are based on the most recent complete set of sales and tax figures the Liquor Control Board publicly released. Scrolling over each bar in the chart will show numbers for the corresponding business.

Green also serves as an advisor on marijuana issues for the City of Spokane. In late November, he presented officials there with a draft of proposed changes that he and others would like to see made to the state's marijuana laws. These included changing the excise tax to a sales tax.

Meanwhile, state Sen. Jeanne Kohl-Welles, D-Seattle, is in the very early stages assembling ideas for marijuana legislation. It would focus primarily on developing new guidelines for the state's loosely regulated medical marijuana growers and sellers.

But Kohl-Welles is also looking at changes to the current tax structure.

Like River's proposed legislation, the tax changes Kohl-Welles is considering would aim to eliminate the need for businesses to pay federal taxes on the state excise taxes. A Nov. 19 Senate staff memo prepared for Kohl-Welles suggests renaming the tax so it could be deducted. While she is uncertain about what the new tax could be called, Kohl-Welles said "sales tax" might be one option.

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A medical marijuana grower checking his crop (January 2013) Photo: Tom James

"It's evolving as I gain input," she said, referring to her plan for eventual legislation.

While he was not familiar with the details of how the excise tax relates to federal taxes, state Rep. Reuven Carlyle, D-Seattle, who chairs the House Committee on Finance, said there was likely room for improving the way Washington taxes marijuana. 

"The taxation in the initiative was a best first shot at designing a structure," he said in mid-November. "I think it's fair to say we learned a lot and I think it's fair to say there are some glitches." But, in his view, coming up with regulations for the state's medical marijuana sector is a bigger priority than tweaking the tax guidelines. Carlyle also emphasized the need for caution in making any adjustments to the recreational marijuana system. "We have a responsibility to be methodical and cautious and slow," he said.

Rivers sees the excise tax issue as urgent. "There’s no doubt if we don’t do this, it will be a severe detriment to the industry," she said of the changes she is backing.

Congress added the 280E provision to the federal tax code in 1982, about a decade after President Richard Nixon declared a "war on drugs." The law was passed in the wake of a situation that began unfolding in 1975, when a Minneapolis drug dealer, named Jeffrey Edmondson, deducted expenses on his tax return that were related to selling amphetamine, cocaine and marijuana. A U.S. Tax Court judge later ruled that Edmondson was entitled to some of the deductions, including one for a small scale, which was presumably used to weigh drugs, as well as other write-offs for phone bills and "packaging expenses."

Despite the rigidity of 280E, there is one workaround that allows marijuana businesses some leeway to reduce the amount of their revenue that is subject to federal taxation. As with other types of businesses, companies in the cannabis industry can subtract the "cost of goods sold" from their overall income. These costs are the total amount of money a business spends on materials and labor to produce a product. They are considered an "adjustment" rather than a deduction and therefore fall outside the purview of 280E.

For a marijuana producer, the cost of goods sold might include seeds, pots, employees involved in cultivation or harvesting, or the electricity needed to power grow lamps. For a retailer, the items that fall into this category are far more limited. While a retail shop can count the wholesale price of marijuana toward the cost of goods sold, items like counter staff, rent and utilities cannot be included.

Guske, the accountant, said that some retailers do include storage spaces, or safes used to hold marijuana, in their cost-of-goods-sold calculation, but he adds, "We’re kind of nibbling at the margin at the point."

Why not raise prices to cover the extra tax costs? Retailers say they can only jack up the price of marijuana so high before consumers turn to more affordable products in medical dispensaries or on the black market.

John Evich is a consultant who works with Top Shelf Cannabis, a Bellingham retailer. In July, the store made the state's first recreational marijuana sale. Evich said the shop is operating with razor thin profit margins selling many strains of marijuana for $20 to $28 per gram. Although there are retailers selling some types of pot for around $14 per gram, he said: "That’s the schwag."

"We’re not trying to make a fortune right now," Evich said. "We’re trying to get known as someone who has a good product at a fair price."

Top Shelf had logged $877,621 in total sales and owed $219,405 in excise taxes as of Dec. 4, according to the Liquor Control Board.

If nothing is done to change the tax structure, Evich said, the shop would have to sell grams at prices around $40 in order to turn a sustainable profit. Raise the price to that level and he thinks that many customers will choose other avenues to get pot.

"People know people who have weed up here," Evich said.

Whatcom County, where Bellingham is located, is a longtime epicenter for marijuana in Washington state, he added, likening it to Humboldt County in California.

"If we sell $38 grams, we’ll get laughed out of town," Evich continued, noting that the local black market price per gram was about $10. "That’s a big enough difference that it might be worth waiting a day and meeting up with whoever."

When the first marijuana retail stores opened in Washington earlier this year, there was initially a shortage of pot, which drove up prices. But those days seem to be largely over. "There’s too much," Evich said during the first week of December. "It hasn't even hit a low yet," he added. "Almost every producer I’ve talked to in the last week is sitting on product."

Cannabis City's Lathrop said that when his store first came online, the wholesale price for a gram of legal recreational marijuana in Washington was between $8 and $16, with most selling in the $10 to $12 range. Prices are currently trending between $6 and $8.

While the lower wholesale prices help retailers' finances, the tax issues remain a looming problem.

Evich sees the cost of paying federal taxes on the state excise tax as the difference between a workable business model and an unworkable one. "That right there would be the profit margin we could run at," he said. People involved in several businesses said they expected to pay a 35-40 percent federal tax rate on the money they will hand over to the state in excise taxes.

"The profit isn’t there for people who are saving their tax, or paying it," Evich added.

Even so, he said that Top Shelf was committed to staying in business and that he had no intention of walking away from the new industry.

"We’re just riding it out in the beginning," he said. "Hoping it all works out."


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