IRS says pot is illegal — but you still have to pay taxes

It's tax time at the Colorado Harvest Co., a marijuana business in Denver. In 2015 the company doubled its square footage, opened two new stores, hired 50 new employees, and christened a 10,000-square-foot production facility. Sales were good. "I think we'll cross the $10 million mark," said owner Tim Cullen.

Woman tending to her commercial cannabis crop in an indoor grow facility in Denver, Colorado.
Jon Paciaroni | Getty Images
Woman tending to her commercial cannabis crop in an indoor grow facility in Denver, Colorado.

Out of that $10 million, Cullen will pay special marijuana sales taxes, state income taxes and the IRS.

Pot is illegal on the federal level, but the IRS code states, "Marijuana businesses are required to file federal income tax returns." However, cannabis companies are significantly limited in taking deductions, because their business "consists of trafficking in controlled substances … which is prohibited by federal law or the law of any state in which such trade or business is conducted."

For Cullen, that means he cannot deduct the cost of rent, advertising and payroll, "all items that every other business in the country gets to deduct." Ironically, he can deduct the cost of growing marijuana, which the IRS does allow as a "cost of goods sold." Bottom line, the lack of normal business deductions will trim $1.5 million from Cullen's profits. "If we're licensed and legal in Colorado, that should be good enough for the IRS," he said. "They certainly cash our checks every month."

The IRS code in question is 280E, and it remains one of the greatest barriers to entry in the legal cannabis business. "The tax burden is significant," said Derek Peterson, CEO of Terra Tech. "Companies in our business are paying anywhere from 40, 50, 60, 70 percent."

Inside manhattan's first marijuana dispensary
Inside manhattan's first marijuana dispensary   

Peterson came from Wall Street to the cannabis industry in 2010 to start Terra Tech, a publicly traded holding company that owns a variety of pot-related businesses. Full-year revenue is estimated between $25 million and $30 million. It recently acquired the Blum Dispensary in Oakland, California, where medical marijuana is grown and sold legally to patients. But Terra Tech also owns subsidiaries that do not directly deal with marijuana — such as a company that makes growing equipment, and a firm called Edible Garden that sells regular produce to retailers such as Wal-Mart.

The company's tax team works to segregate the tax burden among subsidiaries, moving as many business costs as legally possible to areas where deductions are allowed, especially in growing. "A lot of people will embed a lot of the labor expense in the cost of the product," Peterson said, "which is actually one of the reasons why I think the product has maintained the wholesale value that it's at, because that's been a work-around."

Finding work-arounds has become a business in its own right. Flowhub has created a seed-to-sale mobile device that tracks and categorizes sales. "You've got multiple different businesses located in one retail space," said CEO Kyle Sherman. "It's about taking that stuff and parsing it out so that you're able as a business owner to see really clearly what your tax duty really is."

That could become more critical as legalization brings prices down and squeezes margins. Cullen in Colorado said that before legalization, an ounce of black market marijuana in Denver would cost $400 "for high-quality product." Today? "You could find it in Denver for $175."

Jeremy Carr owns the Exhale dispensary in West Hollywood and is also the CEO of BlazeNow, a website that provides information and reviews other outlets. "I've seen profit margins drop about 40 percent in the last five years," he said. Without normal business deductions, "You could end up with a tax bill far more than any potential profit you make."

No one has claimed that has happened yet. "Fortunately, the margins are there," said Terra Tech's Peterson, though he added that he believes some companies are operating with "one foot in the black market" to maintain profitability.

Finally, falling prices, lower margins and a higher-than-normal federal tax bill don't seem like the components of a successful business model, but Peterson sees an advantage. "There's a reason big tobacco, big alcohol aren't in this space right now, because if they were, they'd probably put us all out of the game," he said. Problems with the IRS actually keep competition at bay. "It gives us this opportunity to build our brands out."