Reporting Collection CA Cannabis Taxes
Reporting collection CA cannabis taxes are highlighted in this post. The material that follows was prepared to illustrate the computation, collection and remittance of California’s cannabis excise taxes, and the computation of the gross profit for the parties to a cannabis business transaction, in the simplest of commercial cannabis transactions – the regulated commercial
movement of flower from the the cultivator to a dispensary. The sole difference between the two examples of the commercial movement the flower is the number of parties involved. In the first example, the flower is sold by a cultivator to a distributor that in turn sells the flower to a dispensary. In the second example, the cultivator sells to a distributor that sells to a second distributor that in turn sells to the dispensary. The total of the costs incurred in the movement of the flower is the same in both examples as is the total profit shared by the cultivator and the distributor or distributors.
These two examples do not address the truly difficult issues that arise in connection with business record-keeping and tax reporting for California’s regulated cannabis industry. The challenging record-keeping and tax reporting issues include:
(a) selection of appropriate record-keeping and reporting methodologies;
(b) accurate determination of responsibility for the collection, reporting and remittance of taxes;
(c) accurate assessment of the impact of record-keeping and reporting methodologies on tax efficiency;
(d) accurate assessment of the impact of consistency in record-keeping and reporting methodologies in connection with transactions among cannabis businesses; and
(e) the integration of the record-keeping and reporting relating to California’s cannabis excise taxes with the reporting and remittance of local cannabis taxes, sales and use taxes, and income taxes as well as the impact of such taxes on profitability.
Consideration of the application of Internal Revenue Code (“IRC”) §280E to commercial transactions among regulated cannabis businesses provides an excellent illustration of some of the many difficult questions that arise in connection with record-keeping and tax reporting for California’s regulated cannabis industry. IRC §280E is discussed in connection with the introductory portion of the first illustration because a cultivator that operates as a micro-business and distributes its own flower may be deemed to be subject to IRC §280E. A cultivator who incurs business expenses generally associated with trafficking in a controlled substance may be subject to the disallowance of the deduction of such expenses pursuant to IRC §280E by the IRS. Consideration of IRC §280E is beyond the scope of this presentation, but this provision of the Internal Revenue Code must not be ignored.
California Cultivator, which is licensed as a micro-business, sells 100 lbs. of flower in a bulk sale to a licensed Distributor for $852 per lb. California Cultivator and Distributor agree Distributor will assume Cultivator’s obligation to pay the Cannabis Cultivation Tax of $14,800 ($148 per pound) to the California Department of Tax and Fee Administration (“CDTFA”). In connection with this transaction California Cultivator pays an unrelated third-party $10,000 for preliminary testing and for packing and delivering the flower to Distributor. California Cultivator records the $10,000 expenditure as a business expense rather than as part of the cultivation costs. Assume California Cultivator’s costs for growing the 100 lbs., including depreciation, amortization, harvesting, drying and trimming, etc., are $500 per lb. not including the $10,000 paid to the third-party.
(A) Is California Cultivator a distributor for California’s Cannabis Excise Tax purposes as a consequence of its micro-business licensing and its payment of $10,000 to a third-party in connection with the testing and delivery of the flower? Should California Cultivator include the $10,000 paid to the third-party in COGS for reporting purposes in order to avoid classification as a distributor? If California Cultivator is treated as a distributor for regulatory purposes, is California Cultivator necessarily also subject to IRC §280E? Can California Cultivator be a distributor for California regulatory purposes and be solely a cultivator for income tax purposes? Can California Cultivator include the $10,000 paid to the third-party in its COGS both for regulatory purposes and for income tax purposes in order to avoid all of these issues? The answers to these questions involve substantial uncertainty. Multiple tax issues turn on whether California Cultivator is a distributor. Arguably California Cultivator could be a distributor for regulatory purposes, but not for federal and California income tax purposes.
If the costs paid to the third-party are classified as post-production distribution expenses, an argument could be readily made that California Cultivator is acting as a distributor and the sale to Distributor is the first in a series of sales leading to the retail sale of the flower to consumers. If California Cultivator is deemed to be a distributor for California regulatory purposes, California Cultivator should collect a Cannabis Excise Tax from Distributor. The Cannabis Excise Tax attributable to this sale will be $24,000 ($100,000 x 1.6 x 15% = $24,000). If the $10,000 of costs California Cultivator paid to the third-party are classified as post-production distribution expenses, the Internal Revenue Service (“IRS”) may well classify the $10,000 as a IRC §280E expense for federal income tax purposes. As is indicated by the preceding, subtle changes in the facts, i.e., licensing, timing, elections, classification of activities, relationships between taxpayers, etc., could have a significant impact on California Cultivator’s reporting of this simple transaction.
(B) If California Cultivator includes the $10,000 paid to the third-party in COGS, and does not claim to be the distributor, and no tax or regulatory agency disagrees with this treatment, what will be California Cultivator’s gross profit? What will be Distributor’s COGS? California Cultivator will have gross profit from this transaction of $25,200 (($100,000 – $14,800 = $85,200) – $60,000 ($50,000 + $10,000) = $25,200). Distributor’s COGS is $100,000 ($85,200 paid to California Cultivator plus $14,800 (Cannabis Cultivation Tax) due CDTFA).
(C) Distributor spends an additional $30,000 for testing, packaging and labeling the flower. Distributor sells the flower to Dispensary for $150,000 plus the Cannabis Excise Tax. What is Distributor’s gross profit from the sale to Dispensary? How much does Distributor owe to CDTFA for Cannabis Cultivation Tax and Cannabis Excise Tax? Distributor has $20,000 of gross profit from the sale to Dispensary ($150,000 – ($100,000 (purchase of flower) – $30,000 = $20,000). The value Distributor has added to the flower for the purposes of the Cannabis Excise Tax computation is $50,000. The Cannabis Excise Tax Distributor must collect from Dispensary is $36,000 ($150,000 x 1.6 x 15% = $36,000). Dispensary must pay Distributor $186,000 ($150,000 + $36,000 = $186,000). Distributor owes CDTFA $50,800 ($14,800 + $36,000 = $50,800). Notice that Distributor’s tax liability to CDTFA is 2 ½ times Distributor’s gross profit.
Please consider whether Distributor can include the $30,000 of expenses in its COGS or whether Distributor is engaged in a business which consists of trafficking in a controlled substance for the purposes of IRC §280E. In the event Distributor is deemed to be engaged in a business which consists of trafficking in a controlled substance, some or all of the $30,000 expenses will not deductible for federal income tax purposes pursuant to IRC §280E and cannot be included in Distributor’s COGS.
(D) How do the computations change if California Cultivator sells to First Distributor for $850 ($702 + $148), First Distributor assumes California Cultivator’s Cannabis Cultivation Tax liability of $14,800 to the CDTFA and pays the net amount of $702 to California Cultivator. In addition, assume First Distributor incurs the same $10,000 of costs that California Cultivator paid to the third-party, and further assume First Distributor adds $5,000 of profit for this first step in the movement of the flower into the commercial market. Further, assume First Distributor sells the flower to Distributor for $100,000 plus the Cannabis Excise Tax attributable to this first step. What is California Cultivator’s gross profit from the sale to First Distributor as a consequence of these changes to the illustration? What is First Distributor’s gross profit? How much does First Distributor owe to CDTFA? How much must First Distributor collect from Distributor?
What is Distributor’s COGS? California Cultivator’s gross profit will be reduced by $5,000 to $20,200 by this change in the arrangements for the commercial movement of the flower (($$85,000 – $14,800 = $70,200) – $50,000 = $20,200). First Distributor’s gross profit is $5,000 ($100,000 – $85,000 – $10,000 = $5,000). First Distributor has the $5,000 of gross profit that belonged California Cultivator in the first iteration. First Distributor owes CDTFA $38,800 ($14,800 Cannabis Cultivation Tax + $24, 000 ($100,000 x 1.6 x 15% = $24,000) = $38,800). First Distributor must collect $124,000 from Distributor ($100,000 + $24,000 = $124,000). Distributor’s COGS for the purchased flower is $100,000. In addition, Distributor will have a credit for $24,000 in connection with its collection and remittance of Cannabis Excise Tax to CDTFA on its subsequent sale of the flower to a Dispensary.
(E) Distributor spends the same additional $30,000 for testing, packaging and labeling the flower as is described above in the first illustration. The distributor sells the flower to Dispensary for $150,000 plus the Cannabis Excise Tax as is described in the first illustration. How much does Distributor owe to CDTFA for Cannabis Excise Tax? How much must Distributor collect from Dispensary? What is Distributor’s gross profit from the sale to Dispensary? The value Distributor has added to the flower for the purposes of the Cannabis Excise Tax computation is $50,000. The Cannabis Excise Tax Distributor must collect from Dispensary is $36,000 ($150,000 x 1.6 x 15% = $36,000). Distributor in this second illustration, however, has a credit for the $24,000 of Cannabis Excise Tax liability that Distributor paid to First Distributor. The distributor will be required to pay $12,000 in Cannabis Excise Tax to CDTFA in connection with its sale to Dispensary. Distributor’s gross profit from its sale to Dispensary in this second illustration is the same $20,000 ($150,000 – ($100,000 (purchase of flower) + $30,000 = $130,000) = $20,000) as in the first illustration.
The issues referenced above in the note between (C) and (D) relating the treatment of costs incurred by intermediary business functions in the movement of flower from cultivator to dispensary appear to be heightened when the flower moves from one distributor to a second distributor and then to a dispensary. In the second illustration increased cost and gross profit are generated between the cultivator and the dispensary. It seems likely increasing the number of transactions and the amount of money involved in the transactions between the cultivator and the dispensary increases the likelihood the IRS may seek to apply IRC §280E.
The preceding was prepared to illustrate the significance of record-keeping and tax reporting relating to the movement of regulated and taxed cannabis in California. In each of the two illustrations, $50,800 in cannabis excise tax is due CDTFA. The $50,800 due CDTFA consists of a Cannabis Cultivation Tax of $14,800 and a Cannabis Excise Tax of $36,000. In each of the two illustrations described above the total gross profit is $45,200. In the first illustration, California Cultivator’s gross profit is $25,200 and Distributor’s gross profit is $20,000. In the second illustration, California Cultivator’s gross profit is $20,200, First Distributor’s gross profit is $5,000, and Distributor’s gross profit is $20,000. The collection, reporting and remittance of the cannabis excise taxes in the two illustrations dramatically differ. The total cannabis taxes paid to CDTFA are the same in both illustrations.
The difficult complexities relating to record-keeping and tax reporting for California’s regulated cannabis industry flow from the issues of: timing; record-keeping and reporting methodologies; consistency relating to record-keeping and reporting among cannabis businesses; and the integration of collection, reporting and remittance of California cannabis taxes with local cannabis taxes, sales and use taxes and income taxes. The manner in which the record-keeping and reporting complexities relating to the taxes California has imposed on its regulated cannabis businesses are resolved is likely to be the single most significant factor in determining which businesses are profitable. Decisions relating to the collection, reporting, and remittance of California cannabis taxes are likely to the set of decisions that have the greatest impact on the long-term survival of a California cannabis business.
The IRS may be prepared to argue all of the costs of the distributor function in California’s regulated cannabis industry are non-deductible expenses for federal income tax purposes by virtue of IRC §280E. The two examples above will produce significantly different results to the parties when IRC §280E impacts the determination of the income tax consequences. Even the Cannabis Excise Tax may be deemed to be a non-deductible expense pursuant to IRC §280E under the IRS’ current position. A forceful argument can be made, however, that California’s Cannabis Excise Tax does not enter into the taxable income computation if this tax is separately stated in each buyer’s invoice and this tax is specifically identified as an item reimbursed to each seller by each buyer as cannabis moves through the chain of commerce.