- Jeff Garrison, CPA; Contributing Editor
Cannabis & Taxes: It’s (Dangerously) Complicated
A couple of years ago the California cannabis industry was prematurely counting the millions that would be generated from future licensed cannabis businesses. (If I hear the ‘B-word’with respect to a company’s valuation one more time, it will be too soon!) Not only the licensees, by the way… local and state government folks were leaping into imaginary piles of gold, as well.
As a CPA by training, and a professional in the California cannabis industry since 2014, I have watched the industry validate itself with the best intentions, from the taxing authorities at the local and state levels to the Operators desiring to comply. Notwithstanding their intentions, I question how well either side understands the true implications that various taxes will have on the sustainability of the legal cannabis industry.
There will be profitable cannabis businesses, despite the obstacles, but there will be many more that fail, just like any other fledgling industry. Here’s an example: from 1900 to 1910, 485 manufacturers entered the American automobile industry, and by 1929, 80% of automobiles sold were sold by the Big-Three, and only 44 manufacturers (most of which nobody has ever heard of) had to fight over the disappearing slice of the pie.
But taxes should never be the reason why businesses fail.
California Cannabis Business Types and Taxes
In California, there are five basic types of cannabis operating licenses:
Cultivation
Manufacturing
Distribution
Testing
Retail
Each license type has its own set of intricate rules and regulations including local and state taxes, and federal income taxes. Like any cost, these taxes get passed on up the chain to the ultimate consumer.
Facing the Customer: the Problem(s) with Sky-High Dispensary Taxes
For several reasons, Dispensaries are impacted the most by the various taxes. For the Operator, it becomes a particular challenge to build a profitable financial model when the tax implications are examined.
But the taxing authorities, whose major goal must always be to create a functional regulated system that generates revenues, must never lose sight of the fact that a dispensary is the ONLY method that a consumer can purchase cannabis legally. So, the retail model needs to work, and if it doesn’t, long live the black market, the regulated system has failed.
California dispensaries are typically saddled with three taxes for adult use before California and Federal income taxes, (in cannabis, Federal taxes on their own are a game-changer):
Excise tax,
Local cannabis tax,
State sales tax.[1]
To most Operators, it appears that the Excise tax and State sales tax will not affect the profit of a dispensary, as the dispensary is only an agent for collecting these taxes from a customer and paying them forward. And most dispensaries’ axiom is to just pass the local cannabis taxes on as well. I can tell you that it’s not as simple as passing on the taxes to the customers, as they will only pay so much. Econ 101!
Taxes alone are affecting a customer’s spending habits. The taxes must not be so large that Operators cannot provide product at a price the customer is willing to pay.
The bigger question is, have the local and state tax authorities fully evaluated the impact that the aggressive taxes have in driving the legal vs. illegal market, not to mention, driving retail customers to other more competitive cities. I hope many took note when the Berkeley City Council recently wisely voted to lower the city’s recreational marijuana tax from 10 to five percent. In addition, several cities have significantly reduced their cultivation tax based upon canopy square feet.
[1] State sales taxes are exempt if a consumer has a valid Medical Marijuana Identification Card (MMIC) issued by the California Department of Public Health and a valid government issued identification card (ID). State projections reflect the medical sales to approximate 10% of total cannabis sales.
Breaking Out California Excise, Local, and State Dispensary Taxes
Cannabis Excise tax
In California, the cannabis excise tax is 15% of the average market price of the retail sale. As of today, the market price is predetermined by the California Department of Tax and Fee Administration (CDTFA) at a 60% mark-up (mark-up rate) on cannabis products purchased in an arm’s length transaction by a dispensary. A non-arm’s length transaction is a different calculation (not discussed in this article), arriving at a market price as well. The arm’s length mark-up will be determined by the CDTFAon a biannual basis.
City or Local Cannabis Tax (Long Beach example)
Long Beach cannabis tax for adult use is 8% (effective August 2018).
California Sales Tax
The state sales tax is determined on a city-by-city basis, The City of Long Beach sales tax, for instance, is 10.25%.
In the Long Beach example, the CDTFA requires a dispensary to calculate and pay sales tax by adding on both the 15% excise tax and the eight percent local (Long Beach) cannabis tax to the retail sales price of cannabis product sold and multiplying that sum by 10.25%. Incidentally, this is a triple tax as taxing the product alone is not enough, as the dispensary is required to tax the 15% excise tax and the eight percent local tax at 10.25% as well.
But what is the impact to the customer if a product purchased by a dispensary before excise tax from a distributor for $50 is marked up 100% (50% gross margin)?
The customer will pay an additional $12 on the 15% excise tax mark-up at 60%, plus $12.30 for the California sales tax, plus $8.00 for the local Long Beach tax, aggregating a purchase price to the customer of $132.30. The effective tax rate for the California sales tax is 12.3% in Long Beach. Of the customer’s purchase price, $32.30 is for the various taxes.
That is a 32% tax passed on to the customer, not including taxes from other operations.
How Much is Too Much?
The customer will only pay so much for a product before they will look for alternatives. Due to the excessive excise and sales taxes, one alternative for the customer will be to seek the product at a cheaper price. Naturally retailers will start cutting their prices to accommodate their customer and to compete with other dispensaries in their market. Or the customer will purchase product from a dispensary in a more competitive city nearby. And of course, the black market is an option. When sales prices are cut, the gross margin is reduced, and a retailer can only cut their prices so much before they erode margins beyond their ability to cover fixed overhead.
The proof is in the pudding, as recently I noticed this Weedmaps customer review of a successful well-run dispensary in Los Angeles:
“Plenty of shops in the area with smoke just as good without the 33% tax mark up. I'm not paying taxes until I'm forced to so, until then my business is going elsewhere.”
The black market is apparently thriving still, and the customer even got the tax rate right!
Dispensary owners may try to lower their margins to create competitive pricing. Here's an example:
If the same product purchased from a distributor for $50 is now only marked up only 60% (37.5% gross margin) for sale, the sales price will be $80 before taxes and the customer will pay additional taxes of $28.49, for an out the door price, of $108.49.
Even though the taxes have been reduced in this example, the resulting excise and sales tax rates passed on to the consumer is now approximately 36%, which is greater than the 32% tax rate when marked up 100%. This is because, no matter what price a retailer sells the product for, the excise tax stays constant as it is calculated on a predetermined mark-up of the cannabis product purchased from the distributor.
And watch what happens when other discounts are applied:
Now, add general or loyalty discounts into the sales mix that many dispensaries offer to customers, and the gross margin is reduced even more.
If a 10% discount was added in the two examples above, the adjusted gross margin is reduced to 44% for the product marked up 100% before discounts and 30.6% for product marked up 60%, respectively.
How can a Dispensary Survive?
Since a Dispensary (or any business for that matter) can only lower their sales price so much before their business model is upside down, the analysis of the effect of the excise and sales taxes passed on to a customer needs to start when a dispensary purchases the product from the distributor.
For starters, a dispensary, like any other business, needs to understand what their breakeven point is to determine if their business model is viable.
Breakeven inputs include the following for a dispensary:
Sales price
Product purchase price
Variable costs
Fixed costs
Average ticket price per customer
Customers per day
To get the best insight into whether product costs are going to lead to profit, the Operator needs to have a template handy for when he or she is negotiating the purchase of product so that he / she can ascertain what the out-the-door sales price is to the consumer and evaluate it against the market price for that specific item. Using this tool and method, the dispensary will determine what the purchase price needs to be from the distributor to achieve a desired gross margin, and approve or decline the deal based on the actual the out-the-door price to the customer.
If a dispensary cannot reach a profitable gross margin on that item purchased, they need to pass on that purchase from the supplier and look for alternatives to sell at higher margins. This may appear obvious, but too many times in business, operators believe that sales alone, at lower margins, is a viable profitability model, and it is not.
Don’t Forget the Federal Tax: 26 U.S. Code § 280E
Most in the cannabis industry are familiar with Internal Revenue Code §280E (26 U.S. Code § 280E - Expenditures in Connection with the Illegal Sale of Drugs), which allows only for the adjustment to gross receipts (deduction) of cost of goods sold for calculating Federal income tax.
There are endless articles describing methods of maximizing deductions and minimizing the §280E impact. Some I agree with and some I don’t feel are best practices. One suggestion in particular is the CHAMP v. Commissioner case.
In 1982, Congress enacted §280E, which reversed prior case law, where §280E was precipitated by a 1981 seller of amphetamines, cocaine, and marijuana, who was allowed to deduct costs of goods sold, packing costs, phone, car and home office expenses, because the tax payer reported his illegal income. All allowed under tax law at the time. On the grounds of public policy, §280E was created, as the Federal government felt obligated to feign a resolution to the war on illicit drugs in the United States.
Section §280E reads as follows as it relates to deductions other than the costs of the controlled substances:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
(By the way, if the Feds in 1982 under §280E had their way, a business trafficking in controlled substances would NOThave been allowed to even deduct cost of goods sold either, except for under the Revenue Act of 1913 (1909 16th Amendment), cost of goods sold is considered an adjustment to gross receipts and not a deduction. To eliminate the deductionof cost of goods sold under §280E would have taken an act of Congress, and at the time, the authors of §280E were not ready to challenge the Constitution. Semantics to most, but if not for this, cannabis would only be a black-market industry today. It could have been worse.)
But how does 280E really affect a dispensary’s (and other licensed cannabis operator’s) breakeven, since Federal tax under §280E is not paid on pretax income, but is paid on a dispensary’s gross profit? It’s brutally simple, really. Unlike other businesses, a cannabis business can have a pretax profit and by the time Federal income taxes are assessed under §280E, the business may show a loss.
A dispensary’s breakeven calculation needs to include Federal income tax as a variable cost, as breakeven before the impact of §280E vs. after, usually is material. The additional customers required to breakeven after applying §280E is significant in most cases.
Treating Federal taxes as a variable cost is required in the breakeven analysis, because for every dollar of gross profit generated there is a tax cost at arriving at the Dispensary’s contribution margin.
Assuming for discussion purposes a 40% federal tax rate, at a 50% gross margin before taxes, federal taxes cost the company an additional 20 cents for every dollar generated (20%). To cover this added §280E tax cost, an increase in customers is required just to breakeven for Federal taxes (after tax). In a simple but typical business, the Federal income taxes will not affect breakeven, because the Federal tax does not exceed the pretax profit. But in the case of the cannabis industry, taxes can exceed the pretax profit because of the nature of §280E.
Putting It All Together – 280E in the Real World
An analysis I prepared for a California dispensary on the impact of breakeven before and after 280E resulted in the dispensary requiring an additional 73 customers per day at a 50% gross margin, to cover 280E vs. before. In this example, the 73-customer increase per day to cover §280E represented a 67% increase in customers per day over the breakeven customer calculation before §280E.
In order to move product, if the gross margin is reduced to a 37.5%, the additional customers required to breakeven increases to 97 per day in my client’s analysis.
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No single aspect of the cannabis industry can be taken for granted. Despite medical or adult cannabis laws in 46 states, cannabis is still illegal under federal law. Banking is at the forefront of the industry’s pitfalls. Licensing, compliance and reporting at the local and state levels are daunting. As the industry evolves, expect challenges to improve, and eventually, reform to take place. Via lobbying efforts and the like, licensees can effect change.
It is imperative to understand the impact that the regulations have on your business. It is on you if you do not.
Any one item touched upon in this article could dominate an entire class agenda at the UCLA Anderson School of Management. A good assessment at any point in time of the state of the cannabis industry is, “Is the line to get out of the industry longer then the line to get in.” Keep an eye on the exits, folks.
Only time will tell whether the taxing authorities recognize that, in their zeal to create revenues from the cannabis industry, they’ve killed their golden goose and taxed us right back into the black-market days.
About Jeff Garrison, CPA:
Jeff Garrison is a CPA, founder of Garrison + Company and an Advisor for BGP Advisors.
Jeff has 30 years’ experience in accounting and finance including eight years as President and Managing Partner of Los Angeles-based accounting firm Stonefield Josephson, a 200-person firm with six regional offices in California and Hong Kong (now merged with Marcum LLP); and most recently, as President of SIVA Enterprises, a leading cannabis consulting firm.
Jeff provides consulting services in California and other regulated states including financial modeling, business plans, operations management, investment, branding, real estate, representation with state and local authorities, license application preparation, submission, and approval. He has used his experience and expertise to architect financial and business strategies, source financing, establish best practices bookkeeping tied to regulatory compliance, and create exit strategies for firms in industries with changing regulations and requirements.