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Don’t Fear the Reefer: Embracing the Nuances of Federal and State Taxation of Cannabis

Introduction

In the fall of 2014, Alaska, Oregon, and Washington, D.C., joined Colorado and Washington as jurisdictions where recreational marijuana use is legal. Notwithstanding the increase in the number of states permitting marijuana use, the federal government maintains its stance that marijuana is an illegal drug banned by the Controlled Substances Act. Although the Supremacy Clause

• f

the U.S. Constitution clearly dictates that federal law is the supreme law of the land, and in this case outlaws the manufacturing, distribution, or dispensing of marijuana anywhere in the United States, on August 29, 2013, the Department

• f Justice released a memorandum
• utlining a policy of leniency in

prosecuting marijuana crimes in those states where marijuana is legal under state law (the “Cole Memorandum”). The Cole Memorandum lists guideposts for the states in regulating the recreational and medicinal use of marijuana, but should not be mistaken for anything more than a temporary extension of administrative grace. Truly, the nascent recreational marijuana industry operates in a particularly uncertain space.

Federal Tax Considerations

Tax is one of the areas where the marijuana industry most acutely feels the dichotomy between federal and state

• law. Federal tax law prohibits certain

deductions to taxpayers engaged in the marijuana trade, among them state

• taxes. The tax burden at the state level is
• nerous enough, with cumulative rates

in Washington reaching 75% in 2014, but this creates an untenable position for marijuana businesses because they are subjected to federal income taxes on money that they already paid out to the

• states. Thus, the marijuana industry has

a significant phantom income problem.

Section 280E

Under federal law, taxpayers may deduct ordinary and necessary expenses arising from the conduct of their trades. Yet, to dissuade the illicit-drug trade, Congress passed IRC Section 280E, denying any deductions arising from the taxpayer’s “trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law.” As a result, taxpayers trafficking in controlled substances legitimately under state law or otherwise must report the entire proceeds from the trade to the federal government as taxable income. Softening the blow somewhat, case law establishes that such taxpayers may deduct the costs of goods sold from their taxable income. Thus, when determining federal tax consequences to a taxpayer dealing in marijuana, the taxpayer must answer three threshold questions. First, is the taxpayer engaged in trafficking of a controlled substance? Second, are the taxpayer’s expenses nondeductible because they arise from trafficking? Thirdly, if nondeductible, are the

inside this issue

2 For Related-Party Exchanges, Simple Is Better, and Other Lessons Learned From North Central Rental & Leasing 3 Successor Tax Liability: The Hidden Costs of Business Acquisitions in the Pacific Northwest 5 Washington Goes Fishing for Revenue Beyond Its Borders by David J. Brandon

david.brandon@millernash.com 503.205.2372

2 | miller nash graham & dunn llp | NW Tax Wire

For Related-Party Exchanges, Simple Is Better, and Other Lessons Learned From North Central Rental & Leasing

The words “simple” and “1031 exchange” are not often used in the same sentence, but in North Central Rental & Leasing, LLC v. United States, 779 F3d 738 (8th Cir 2015), the court held that North Central’s equipment exchanges (there were 398 of them) were fully taxable as impermissible related-party exchanges. The court’s reasoning was that the 1031 exchanges could have been completed with a much simpler structure and that the complex and inefficient structure appeared to be solely for the purpose of avoiding the related-party rules of Section 1031(f) of the Internal Revenue Code. Congress enacted IRC § 1031(f) to thwart the attempts of creative taxpay- ers to use related parties to circumvent the intent of IRC § 1031 by cashing out their investments, instead of reinvest- ing in like-kind property. Section 1031(f) prohibits tax-free exchange treatment if (1) related parties exchange property and either party disposes of the property it received in the exchange within two years after completing the exchange, or (2) the parties structure the transaction purposefully to avoid application of the related-party rules. In North Central, Butler Machinery Company was in the business of sell- ing and leasing heavy equipment. The family that owned Butler formed North Central, and within two months of its formation, North Central commenced a like-kind exchange program. Through a qualified intermediary (the “QI”), North Central sold its used equipment to third parties and the QI held the sales

• proceeds. Butler bought new equipment

for North Central, and the QI bought the equipment on North Central’s be- half and paid Butler for the equipment from the exchange proceeds. Butler did not mark up the cost of the equipment it sold to the QI, and Butler purchased the equipment with six months’ interest- free loans. When Butler received the exchange proceeds from the QI, instead

• f immediately paying off the equip-

ment loans, Butler used the exchange proceeds for general business purposes until the interest-free period expired. Although the exchanges don’t have the hallmark stench of a related- party “cash-out” exchange, the court nonetheless held that the exchanges were fully taxable. The court boiled down the exchanges into the following components: The day before Butler sold the equipment to the QI for the benefit

• f North Central, Butler had an invest-

ment in equipment. The day after the QI paid Butler for the equipment, Butler had cash. The court concluded that this meant that Butler had cashed out its investment in equipment. Oddly, at the beginning of the exchange Butler did not have cash or equipment, and within 180 days after selling the equipment to the QI for North Central’s benefit, Butler had neither cash nor equipment. The court also held that the QI and Butler were unnecessary parties to the exchange, and that their involvement made the exchange unnecessar- ily complex and inefficient. The court concluded that North Central or the QI could have purchased the equipment directly from the manufacturer (instead

• f purchasing the equipment from

Butler through the QI) and determined that Butler was involved only so that it could obtain the interest-free use of the exchange proceeds until the equipment loans were due. The court determined that Butler had likely received at least $210 million in interest-free loans over the course of the 398 exchanges and believed this benefit was too great to ignore. North Central is a good reminder that tax-free exchanges are allowed solely because of the generosity of Congress and that seeking to exploit the benefit of tax-free exchanges further than Congress intended can be risky. In evaluating any proposed 1031 exchange, the following general principles are important to remember. 1. Keep it simple (relatively speaking). Although some level

• f complexity must be tolerated

in 1031 exchanges, overly com- plex structures are less easily comprehended and often more

• pen to suspicion.

2. Have a business purpose (other than tax avoidance or interest-free use of exchange proceeds). A business purpose that is solid and can be clearly articulated should be the driving force behind any 1031 structure. 3. Keep your hands out of the cookie jar. Seeking to lever- age benefits from the exchange proceeds, in the form of profits, interest, or use of the exchange proceeds during the exchange period, stinks of constructive receipt of exchange funds or, at least, overreaching that the IRS doesn’t appreciate.

by Jeneé Hilliard

jenee.hilliard@millernash.com 503.205.2505

miller nash graham & dunn llp | NW Tax Wire | 3

Successor Tax Liability: The Hidden Costs of Business Acquisitions in the Pacific Northwest

(continued on page 4)

1 Only Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not.

While it is common knowledge that Washington State does not have a personal income tax, it would be a mistake to assume that the sale of a business has no tax consequences to past or future owners. This article will explore the tax consequences of buying

• r selling a business in Washington,

using the tax regime in the neighboring state of Oregon for contrast. To illustrate the tax considerations of business acquisitions in the Pacific Northwest, this article will follow the hypothetical sales of a Washington business to an Oregon resident and of an Oregon business to a Washington resident.

Income Tax Consequences

The vast majority of states in the United States impose a personal income tax on the income of all residents, as well as nonresidents earning income in the state.1 For example, Oregon imposes a personal income tax on all the income of full- and part-time Oregon residents, and on the Oregon-sourced income of nonresidents. The Oregon income tax regime uses a graduated tax rate, ranging from 5 percent to 9.9 percent. For Oregon income tax purposes, the amount of an Oregon resident’s taxable income is tied to the resident taxpayer’s federal taxable income, subject to modification for Oregon-specific deductions and credits. A nonresident taxpayer, on the other hand, has income subject to the Oregon income tax only to the extent that his

• r her income is derived from Oregon
• sources. Therefore, the proceeds from

the sale of a business in Washington would be taxable income for an Oregon resident, but not taxable income for a

• nonresident. Conversely, the proceeds

from the sale of a business in Oregon would be taxable income for both a resident and a nonresident. Many states, Oregon included, also impose a corporate income tax on the income of corporate business entities. In Oregon, corporations are subject to an excise tax for the privilege of conducting business in the state. The excise tax is measured as a percentage

• f the corporation’s income, and is

easily mistaken for an income tax. Yet Oregon also has a corporate income tax, imposed on all corporations doing business in the state and measured as a percentage of the corporation’s Oregon- sourced income. The income and excise taxes are mutually exclusive, so that the income of a corporation is subject to only

• ne or the other. Much like the personal

income tax, the corporate tax regimes purport to tax only a nonresident corporation’s income that is derived from or apportioned to Oregon. Thus, the proceeds of the sale of a business in Washington would be taxable income to an Oregon parent corporation, and the proceeds of a sale of an Oregon business would be taxable income to a nonresident parent corporation. It should come as no surprise to those familiar with the double taxation inherent in the corporate tax scheme generally that Oregon resident individuals would bear a heavy income tax burden if an Oregon corporation sold a subsidiary company and then dissolved, distributing the proceeds to its shareholders. Indeed, such a transaction would be subject to federal and Oregon corporate income tax on the sale of the subsidiary, followed by federal and Oregon personal income tax on the distribution of proceeds to the individual shareholders.

Sales and Use Tax Consequences

The silver lining for Oregon taxpayers is that no additional tax is imposed on the sale transaction itself. Indeed, apart from the presence of well- known shoe companies, Oregon may be best known among consumers for its abstention from a sales tax regime. Not so in Washington. Oregon’s neighbor to the north has nearly nothing in common with Oregon’s tax structure. Washington imposes a state-level tax on the sale of tangible personal property and authorizes the counties and cities in the state to impose sales taxes as

• well. Washington also imposes a use

tax to prevent consumers from taking advantage of the differences in state tax regimes by making purchases in Oregon, where there is no sales tax, or Idaho, where the sales tax is nearly half that of Washington. Under the use tax system, consumers are required to self- report a tax on the value of all tangible personal property acquired without paying sales tax but used in Washington. Thus, in the hypothetical sale situation, the purchase of a Washington business by an Oregon taxpayer would be subject to sales tax to the extent that the sale included tangible property, such as equipment or other tangible capital assets. In contrast, the sale of

by David J. Brandon

david.brandon@millernash.com 503.205.2372

4 | miller nash graham & dunn llp | NW Tax Wire the Oregon business to a Washington taxpayer would not be subject to sales tax, but could create a use tax obligation if the purchaser used the acquired business’s assets in Washington.

Business and Occupation Tax Consequences

In addition to the sales tax, Washington imposes a business and occupation (“B&O”) tax on the privilege of doing business in Washington. The B&O tax is a gross-receipts tax calculated as a percentage of the value of products or the gross income

• f a business at every level of
• production. B&O tax does not,

however, apply to sales outside the

• rdinary scope of the taxpayer’s

business (a “casual or isolated sale”). Because most taxpayers can’t properly be considered in the business of selling their business enterprises, the B&O tax does not generally apply to the sale of a

• business. Yet because the taxpayer

is in the business of selling inventories, the tax does apply to the inventory of the acquired business. As a result, the seller of a Washington business may be subject to B&O tax to the extent that the sale includes inventories. Naturally, the seller of an Oregon-based business does not worry about any additional tax

• n the business’s inventories.

Real Estate Excise Tax Consequences

Yet another tax consequence arises anytime real estate is sold in the state

• f Washington.2 The Washington real

estate excise tax is a percentage of the sales price of all real estate sold. Much like the B&O tax, the real estate excise tax will apply to any Washington real property transferred in the sale

• f a business. Therefore, the sale of

any Washington business requires a thorough analysis of the business’s assets and the attendant potential tax liabilities.

Successor Liability

Another, perhaps less well-known, difference between the states is who is responsible for payment. Generally, the person paying an income tax is the person who earned income. Thus, if an Oregon resident sold his or her Oregon business, the proceeds of the sale (less the basis in the seller’s ownership interest) would be included in taxable income for the year of sale. Yet in Washington, any tax due from the sale

• f a business automatically becomes

the responsibility of the purchaser if the seller doesn’t pay within ten days.3 Thus, if a Washington resident sold a Washington business, the buyer would foot the tax bill if the seller doesn’t pay

• up. The obvious application of this

state of affairs is that when an Oregon resident buys a Washington company, the buyer could be on the hook twice: primary liability for sales or use tax and successor liability for B&O and real estate excise tax upon purchase, and primary liability for income tax upon

• sale. To resolve this potential pitfall for

purchasers, Washington requires the purchaser to withhold the seller’s tax liability from the purchase price until the seller presents the purchaser with proof showing that the seller has paid its tax liability.

Who Is a Successor

Washington law defines a successor as any person receiving greater than 50 percent

• f

a taxpayer’s tangible or intangible assets in a transaction outside the scope

• f the taxpayer’s ordinary course
• f business. This definition also

includes any person acting as a surety or guarantor under a contract. So for successor liability to apply, there need

• nly occur an exchange of greater than

half the value of the company’s tangible

• r intangible assets. Yet Washington

courts have interpreted this definition broadly, even extending successor status to a lessor who reclaimed equipment from a defunct lessee and, to ensure that the equipment was productively employed, used the equipment in an

• perating business. Tri-Fin. Corp. v.

Dep’t of Revenue, 6 Wash App 637, 495 P2d 690 (1972). The Washington Department of Revenue clarifies that acquisition of

2 Real estate excise taxes also apply in certain counties in Oregon, such as Washington County. Because such treatment is rare in Oregon as a whole, however, the Oregon real estate excise tax is not discussed here. 3 RCW 82.32.140(2).

Successor Tax Liability . . . | Continued from page 3

(continued on page 9)

miller nash graham & dunn llp | NW Tax Wire | 5

Washington Goes Fishing for Revenue Beyond Its Borders

by Ryan R. Nisle

ryan.nisle@millernash.com 503.205.2521

On July 1, 2015, Washington Governor Jay Inslee signed into law Substitute Senate Bill 6138 (the “Law”). The Law expands the reach of Washington’s business and occupation tax (“B&O tax”) to wholesalers making sales to Washington customers, as well as to certain out-of-state retailers with referral sources in Washington. The B&O tax is applied against the taxpayer’s gross receipts attributable to various

• activities. Before the Law’s enactment,

the B&O tax applied only to out-of-state taxpayers with “substantial nexus” with the state and apportionable income, that is, income from providing services, from royalties, and from a variety of particular industries (such as certain insurance and health care activities). In contrast, wholesalers were subject to the B&O tax only if they were physically present in the state. The concept of “substantial nexus” has garnered a great deal

• f

airtime with the United States circuit courts and Supreme Court, and is in some senses a moving target. The term “nexus” refers to the minimum connection between an out-of-state taxpayer and a state necessary to support the state’s imposition of a tax

• n the taxpayer. The nexus requirement

derives from the Due Process and Commerce Clauses of the United States Constitution; this constitutional flavor has been the subject of significant scholarship and jurisprudence and continues to evolve. At the forefront of this evolution is the subset of nexus known as “economic nexus”: the establishment of a connection between the taxpayer and the state simply by virtue of the taxpayer’s participation in the state’s markets. Another offshoot of nexus is the concept of “affiliate nexus”: that a taxpayer can establish a taxable connection with a state by virtue of its affiliate’s activities. Each theory has found its place in Washington.

Economic Nexus and the Taxation of Out-of-State Wholesalers

Starting September 1, 2015, Washington began to apply its economic-nexus standard to both out-

• f-state retailers and wholesalers for

B&O tax purposes. Again, this marks a clear shift in Washington tax policy, as the state looks outward to drive B&O tax revenues. By statute, Washington dictates that a taxpayer has economic nexus with the state if certain operational thresholds are met. Under the statute, a taxpayer has nexus with the state if in the immediately preceding tax year the taxpayer earns more than $267,000

• f gross income in Washington, if the

taxpayer has more than $53,000 of its payroll or property in Washington, or if more than a quarter of its total property, payroll, or income is attributable to

• Washington. RCW 82.04.067.

Because wholesalers with payroll and property in the state are likely already deemed to be present in Washington, and therefore subject to B&O tax, the economic-nexus standard really affects

• nly
• ut-of-state

wholesalers with greater than $267,000 in gross income attributed to Washington. “Gross income,” in this instance, refers both to apportionable income (service income, royalty income, etc.) and to wholesale sales of goods delivered into Washington. The Washington Administrative Code dictates that tangible personal property will be included in gross income for the purpose of establishing economic nexus, if the property is actually delivered to a customer in Washington, whether by common carrier or otherwise and without regard to commercial delivery terms contained in the Uniform Commercial Code. See WAC 458-20- 193(b). So wholesalers with significant levels of income from services, royalties,

• r sales to customers in Washington

must be on alert. Additionally, under its so-called trailing-nexus statute, wholesalers subject to B&O tax in the prior year will be subject to B&O tax in the following year even if they have no Washington income. RCW 82.04.220(2). For example, a Nebraska wholesaler of chinchilla collars sells $300,000 worth of its product to a single retailer in Washington on January 1, 2016. The sale floods the Washington market, and because of a precipitous decline in demand, the wholesaler is unable to sell a single chinchilla collar in Washington ever again. In 2017, the wholesaler will be deemed to have nexus with Washington and will be subject to B&O

• tax. Further, because the wholesaler was

deemed to have nexus in 2017, it will be subject to B&O tax in 2018 as well.

(continued on page 6)

“The concept of ‘substantial nexus’ has garnered a great deal of airtime with the United States circuit courts and Supreme Court, and is in some senses a moving target.”

6 | miller nash graham & dunn llp | NW Tax Wire Washington Goes Fishing for Revenue . . . | Continued from page 5 It’s not all bad news for our hypothetical Nebraskan chinchilla- collar wholesaler, however. The B&O tax is levied against only the taxpayer’s gross income in Washington. Thus, in the example above, the out-of-state wholesaler would not have any tax liability in 2017 and 2018 because it would have no gross income in Wash-

• ington. If instead the wholesaler’s

Washington sales decreased from $300,000 in 2016 to $100,000 in each subsequent year, then the wholesaler would have B&O tax liability in 2016, 2017, and 2018—each of the years in which the wholesaler has nexus. In each

• f the following years, the wholesaler

would not have B&O tax nexus because its Washington gross income would not exceed the $267,000 threshold amount.

Affiliate Nexus and the Taxation of Out-of-State Retailers

In addition to the economic-nexus standard for B&O tax discussed above, retailers are subject to an affiliate-nexus standard for sales and use taxes. This standard, also effective as of September 1, 2015, provides that retailers have substantial nexus with Washington, and must collect and remit sales tax, if they have entered into an agreement with a Washington resident, whereupon the retailer pays a commission to the resident for customer referrals, and the revenue associated with Washington customers exceeds $10,000 in the preceding calendar year. The “traditional” conception of sales-and-use-tax nexus, as formulated by the United States Supreme Court, is a bright-line test based on physical presence. Therefore, under the traditional view of sales-and-use-tax nexus, any taxpayer physically present in Washington is subject to sales or use tax, while any taxpayer not physically present in the state would generally expect to not be subject to Washington’s sales or use tax. By adopting the Law, Washington has used its affiliate-nexus rule to refine the physical-presence requirements adopted by the United States Supreme Court. In recognition

• f its slight departure from the

accepted interpretation of Commerce Clause jurisprudence, Section 201 of the Law recites the physical-presence requirements and explains the legislature’s intent to interpret the physical-presence nexus standard in a manner more befitting the era

• f e-commerce. In fact, the types of

referral agreements contemplated by the Law specifically include links on websites, making the nexus standard adopted by the Washington legislature not entirely different from the so-called click-through nexus standards adopted in New York, Colorado, and elsewhere in response to the widespread practice

• f an out-of-state retailer’s not collecting

and remitting sales tax in jurisdictions in which the retailer has no physical presence. The Law contains an exception for an out-of-state retailer whose referral agreement prevents the retailer’s referral sources from soliciting sales

• n behalf of the retailer, and that can

establish that the referral sources have not engaged in solicitation. It is unclear what such an exempt referral agreement would look like, insofar as a passive link on a website alone and without any solicitous language is sufficient to create nexus under the

• Law. Fortunately, the Law also grants

the Department of Revenue discretion to accept proof of nonsolicitation by

• ther means, although relying on

departmental discretion is at best a hollow victory.

Preventive Maintenance: Compliance and Recordkeeping

The Law presents new challenges to out-of-state wholesalers and retailers. To prevent these challenges from becoming expensive headaches, wholesalers and retailers should review their records for the immediately preceding tax year to determine whether they have substantial nexus with Washington. If they are subject to Washington’s B&O or sales tax regime, such wholesalers and retailers must ensure that they establish adequate recordkeeping policies to capture revenue-sourcing information on sales contracts, invoices, or bills of lading. Maintaining adequate records and actively performing nexus studies in Washington will avoid any unwelcome surprises from the Washington Department of Revenue.

NW Tax Wire | miller nash graham & dunn llp | 7 expenses attributable to the taxpayer’s cost of goods sold? Trafficking The prohibition

• n

deducting expenses under Section 280E is dependent on the taxpayer’s trafficking in controlled substances. Marijuana is classified as a Schedule I controlled substance under the Controlled Substances Act. Thus, the scope of the activity related to marijuana must fall within the scope of “trafficking” before Section 280E has any operative

• effect. The Tax Court, relying
• n the common definition of the

term, interpreted “trafficking” to refer to “engag[ing] in commercial activity: buy[ing] and sell[ing] regularly.” Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 TC 14 (2007) (“CHAMP”). This somewhat narrow definition has prompted some speculation that Section 280E will deny business-expense deductions only to those engaged in the retail sale of marijuana. A more robust definition is provided in the Controlled Substances

• Act. Prohibited trafficking activities

under the Controlled Substances Act include manufacturing, distribution, dispensing, or possession with the intent to do any of the foregoing. The act of manufacturing includes “production, preparation, propagation, compounding, or processing,” as well as such ancillary activities as packaging and labeling. This broad concept of manufacturing under the Controlled Substances Act encompasses almost any fathomable activity performed by a marijuana grower or processor, as well as some of the activities of retailers. For example, “production” includes “planting, cultivation, growing,

• r

harvesting.” There may be some wiggle room, however, because the definition

• f “manufacture” specifically exempts

“preparation, compounding, packaging,

• r labeling of a drug or other substance

in conformity with applicable State or local law by a practitioner as incident to his administration or dispensing of such drug or substance in the course of his professional practice.”1 “Practitioner,” in turn, is defined to include “other person[s] licensed, registered,

• r
• therwise permitted, by the United

States or the jurisdiction in which he practices or does research, to distribute, dispense, conduct research with respect to, administer, or use in teaching or chemical analysis, a controlled substance in the course of professional practice

• r research.”2 But note that in every

instance of legal distribution of medical marijuana presented to the Tax Court, the court has found such distribution to be trafficking, undermining the validity of arguments for exempting state-regulated manufacture. The term “distribute” means simply to “deliver” under the Controlled Substances Act. “Dispensing,” in contrast, is delivery by a practitioner (as discussed above). The basic activity

• f

marijuana retailers—selling marijuana—fits squarely into the category of distribution or dispensing. Thus, nearly every activity undertaken with respect to marijuana, even if legal under state law, constitutes trafficking in controlled substances. Furthermore, any activity that doesn’t fit directly into the category, such as storing inventory, is swept up in the catchall of “possession with intent” to perform a trafficking activity. Trafficking, as generally understood under federal law, appears to be an expansive concept spanning every phase of marijuana production, processing, and retailing. Additionally, the Tax Court’s interpretation of the term focused on whether the taxpayer’s distribution of medical marijuana was encompassed in the term “trafficking,” and did not go so far as to say that activities incident to the purchase and sale of marijuana— growing, harvesting, processing, packaging, and so on—were somehow beyond the scope of “commercial activity” included in the concept of

• trafficking. While it is theoretically

possible that “trafficking” holds a different connotation in the Internal Revenue Code from “trafficking” in the Controlled Substances Act, it seems unlikely. Thus, there is little weight to the argument that some of the marijuana industry’s expenses fall

• utside the ambit of “trafficking” as

used in IRC § 280E. Don’t Fear the Reefer: Embracing the Nuances . . . | Continued from page 1

(continued on page 8)

1 21 USC § 802(22) (emphasis added). 2 21 USC § 802(21) (emphasis added).

miller nash graham & dunn llp | NW Tax Wire | 8 Attributable to Trafficking Although marijuana businesses generally fall within the scope of trafficking, not all hope is lost. A taxpayer is not denied the benefit of all business deductions simply because one

• f the taxpayer’s activities is trafficking

in controlled substances. If the taxpayer is engaged in additional lines of business, the taxpayer may deduct expenses properly attributed to those activities. It is well established that taxpayers may have more than one trade or business, but the existence of different trades or businesses is a question of fact. The characterization of trade or business as distinct from a taxpayer’s trafficking in marijuana is predominantly dependent

• n the “organizational and economic

interrelationship” between the lines

• f business, the business purposes of

each, and the similarity of the trades to each other. Assuming that the taxpayer’s characterization of each trade

• r business is supported by the facts, the

Internal Revenue Service will accept it as presented. Note, however, that the level of substantiation is not insignificant, and requires more than the mere assertion that a dispensary provides

• ther

services. Olive v. Commissioner, 139 TC 19 (2012). The deciding factor in determining which expenses are disallowed as incident to trafficking and which are attributable to legal trades seems to be the taxpayer’s ability to distinguish between trades in an accurate and consistent manner that is based in some

• bjective expectation of achieving a

business goal. For example, in CHAMP, the taxpayer was able to deduct expenses relating to caregiving services despite simultaneously dispensing medical

• marijuana. In contrast, the taxpayer in

Olive was denied any deductions because any “caregiving” at the taxpayer’s dispensary was merely incidental to the taxpayer’s business objective of dispensing medical marijuana. Cost of Goods Sold It is well settled that taxpayers that are otherwise denied the deduction

• f expenses arising from illegal

trafficking in controlled substances are nonetheless permitted to deduct the cost of goods sold from their taxable

• income. What constitutes the cost
• f goods sold, in turn, is extensively

covered in the uniform capitalization rules of IRC Section 263A. Yet because Section 263A prohibits capitalization

• f any cost that cannot be taken into

account when calculating taxable in- come, the IRS Office of Chief Counsel issued a memorandum on December 10, 2014, determining that taxpayers trafficking in marijuana must instead calculate cost of goods sold under the inventory-costing regulations in existence in 1982, before Section 280E was enacted. The inventory-costing regulations provide for different methods of calculating the taxpayer’s cost of goods sold depending on the taxpayer’s activities. For example, a retailer uses different inventory methods from a manufacturer or producer, and certain other classes— notably farmers—are permitted to use different methods still. Furthermore, the inventory-costing regulations provide for capitalization of fewer items than do the uniform capitaliza- tion rules in Section 263A. As a result, taxpayers engaged in the marijuana industry should carefully analyze their inventory cost methodology to ensure compliance with the 1982 regulations. Conclusion In summary, a taxpayer engaged in trafficking marijuana should expect a significant tax burden. This can be alleviated to some extent by deliberate planning: differentiating between lines of business, establishing accurate accounting methodology, providing a system for documenting compliance with applicable state and federal law, and perhaps structuring an integrated marijuana business so that costs of goods sold are focused in the business’s profit centers.

Washington and Oregon Tax Considerations

Washington’s excise tax is levied against the marijuana producer, processor, and retailer, respectively, at each point of sale—the sale from producer to processor, the sale from processor to retailer, and the sale from retailer to consumer. In contrast, Oregon’s tax is structured as a tax on the privilege of doing business as a marijuana producer, is triggered upon any sale of marijuana from a producer, and is a flat amount per ounce, adjusted for inflation. Two main issues consistently arise relating to the state marijuana taxes. First, Washington’s excise tax is prohibitively high, and may incentivize the shifting of marijuana to lower-tax jurisdictions or to the black

• market. Second, state-level taxes are

Don’t Fear the Reefer: Embracing the Nuances . . . | Continued from page 7

“In summary, a taxpayer engaged in trafficking marijuana should expect a significant tax burden.”

(continued on page 9)

9 | miller nash graham & dunn llp | NW Tax Wire Don’t Fear the Reefer: Embracing the Nuances . . . | Continued from page 8

4 Det. No. 90-377, 10 WTD 173 (1990). 5 Det. No. 14-0043, 33 WTD 394 (2014).

not deductible for federal tax purposes under the analysis discussed under Section 280E above; thus, state-level taxes, if not carefully tailored, can cause phantom income problems for marijuana businesses. Washington’s tri-level tax structure has two significant implications. First, the rate differential between Washington and Oregon is substantial. This creates an incentive for Washington and Oregon marijuana processors and retailers to funnel Washington- grown marijuana to Oregon for sale, to avoid the upstream tax burden in Washington. Yet insofar as the Department of Justice, and indeed both states, strictly prohibits the interstate transportation

• f

marijuana, any interstate marijuana transactions would jeopardize the status of the entire legal marijuana industry in the Northwest. satisfied outstanding IRS liens with his own funds, and later contributed those assets to a new company.5 In so distinguishing, the Appeals Division noted that title to the assets acquired in the latter case was not transferred from the dissolving corporation to the acquiring officer and the officer failed to prove that the IRS liens were actually

• discharged. It is unclear whether the

Appeals Division would have followed the precedent set by Determination

• No. 90-377 if the taxpayer had followed

the formalities of discharging the lien. In either case, it is certainly advisable to discharge all IRS liens and to obtain certificates of discharge, but it is not clear whether this remains sufficient to avoid successor liability in Washington. Successor Tax Liability . . . | Continued from page 4 a company’s assets by “regular legal proceedings” doesn’t trigger the successor rules. This includes enforcing a lien, security interest, or judgment. But what constitutes a “regular legal proceeding” may not be entirely clear. For instance, the Appeals Division

• f the Washington Department of

Revenue held that a corporation acquiring assets subject to an IRS lien was not a successor within the meaning

• f the statute because the assets were

acquired by “regular legal proceeding to enforce a lien” when the corporation paid the lien and received a certificate

• f discharge from the IRS.4 Yet the

Appeals Division recently distinguished this precedent from a similar case in which an officer of a dissolved company acquired the company’s assets,

Conclusion

If an acquiring party is deemed to be a successor, the tax liability to which he or she succeeds is dependent on the nature of the underlying business. Because Washington does not have an income tax, the tax consequences of the transfer must be analyzed under the sales, use, B&O, and real estate excise tax structures. These often present unfamiliar and confusing tax consequences for Oregon purchasers. Further, although Washington requires that purchasers set off the seller’s tax liability from the purchase price, successor liability presents a trap for the purchaser who is unaware of this requirement. If, however, the federal government were to legalize marijuana use, the tax savings of shifting marijuana south to Oregon would instantly become more appealing, and may cause Washington to rethink its multilayer tax scheme. Second, the high rates in Washington also incentivize black-market sales. Although there is no direct, readily available measure of the cost difference between the legal and black markets in Washington, it is clear that sales outside the regulated market pose huge issues for the recreational marijuana market, just as interstate sales do. The second major issue related to state marijuana taxes—phantom income—is a legislative creation that has a legislative solution. The problem is that, for federal purposes, Section 280E disallows the deduction of state taxes. Thus, marijuana businesses pay taxes to the state and then pay federal taxes on the amount of state taxes paid, thereby paying federal taxes on “income” they don’t actually have in their pockets. This issue, however, is potentially fixable by creating a state scheme of taxation that permits inclusion of the state-level taxes into the cost of goods sold or excludes the state taxes from income altogether by passing the tax on to the end consumer. Indeed, proposals are already before the Washington legislature either to amend the tax structure to a single tax or to

• therwise adjust the tax to eliminate the

phantom income problem. Notwithstanding the plethora of

• pinions on the numerous challenges

facing the marijuana industry, the question remains: where do we go from here? Only time will tell.

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