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Mid-Terms In Sight

On October 6, 2022, the President announced three changes in the Federal government’s policy toward cannabis:

  1. He pardoned all prior Federal offenses of simple possession of marijuana;[i]
  2. He urged governors to do the same with regard to state offenses;[ii] and
  3. He asked the Secretary of Health and Human Services (“HHS”) and the Attorney General to reconsider how marijuana is scheduled under Federal law.[iii]

The announcement came on the heels of increasing pressure from fellow Democrats who ran on a pro-marijuana platform in 2020 and who are facing mid-term elections next month with nothing to show for their efforts:

“Democrats are beginning to pressure President Biden to take on marijuana reform as Congress struggles to find a path forward on decriminalization and as the party contemplates what’s possible before the midterms.”[iv]

Indeed, in an earlier letter, dated July 6, 2022, several Senators urged the Administration to “use its existing authority to (i) deschedule cannabis and (ii) issue pardons to all individuals convicted of non-violent cannabis-related offenses.”[v]

In Congress

Speaking of Congress, on April 1, 2022, the House passed the Marijuana Opportunity Reinvestment and Expungement Act (the MORE Act), which would remove marijuana from the list of scheduled substances under the Controlled Substances Act and eliminate criminal penalties for an individual who manufactures, distributes, or possesses marijuana.[vi]

In June, however, a bill that would have provided banks a legal safe harbor to work with legal cannabis businesses was removed from the legislative package that would ultimately be enacted in August of this year as the Chips and Science Act.[vii]

Shortly thereafter, in July of this year, Senator Booker and others introduced the Cannabis Administration and Opportunity Act, which has been referred to the Senate’s Committee on Finance.[viii] This bill would decriminalize cannabis by removing it from the Controlled Substances Act, thereby ensuring that businesses in the cannabis industry “will no longer be denied bank accounts or financial services simply because of their ties to cannabis.”[ix]

The Election Campaigns

Based on the foregoing, you’d think that the status of cannabis would be among the leading topics being addressed by candidates on the mid-term campaign trail.

Turns out it isn’t, at least according to one study that was recently published by a well-regarded non-profit think tank, the Brookings Institution,[x] which found that “86.4% of candidates either made no mention, staked out an unclear position, or explicitly opposed cannabis reform.” After reviewing the data, the report concluded:

“In sum, cannabis as a political issue has risen in importance over the past 25 years. As state legislatures and voters via referenda have enacted changes to cannabis laws, the issue has become more popular even in the halls of Congress. However, cannabis reform advocates’ frequent stupefaction at the lack of progress at the federal level bumps up against a stark reality. Most candidates for federal office do not see cannabis as an issue prominent enough to discuss, and deep partisan differences still remain among elected officials, even as support for cannabis in the general public has exploded in recent years. And the true motivator for a member of Congress to take or change a position—whether voters hold their feet to the fire over an issue—has not yet become a reality in the vast majority of Congressional races across the United States.”

The States – Well, CA, Really

Speaking of the states, 37 of them, plus the District of Columbia, allow the medical use of cannabis products; 19 states, plus the District, allow the recreational use of cannabis products by adults.[xi]

Notwithstanding the expansion of legal markets reflected in these figures, the mother[xii] of all cannabis markets – California, which is the single largest cannabis market in the world[xiii] and which collected almost $580 million in taxes on legal sales in excess of $2.4 billion in the first half of this year alone[xiv] – finds itself fighting unlicensed and unregulated growers and distributors to whom the legal cannabis industry is losing revenue while the state loses the related tax dollars.

In fact, according to one report, the vast majority of sales are still “illegal;[xv] another source states that “only one-third of cannabis sold in California currently comes from the legal market.”[xvi]

Among the reasons most often cited for this lopsided fight are the following: legal businesses pay the costs of compliance with state regulation,[xvii] including high state sales and excise taxes;[xviii] and legal businesses pay Federal[xix] income taxes that are determined without the benefit of deductions for the ordinary and necessary costs of doing business.[xx]

In other words, illegal growers and distributors provide the consumer a tax-free, and thus less expensive, product that is presumably as efficacious and safe as its legal version.[xxi]

That translates into stiff competition for licensed businesses.

In response to recent pleas for tax relief from such businesses, California has eliminated the state cultivation tax, capped the excise tax on sales (at the current 15% rate) for three years, and provided certain tax credits.[xxii]

Will this be enough to preserve or sustain the legal cannabis market (at least in California) in the absence of changes to the other most frequently cited reason for the economic challenges faced by the industry: the Federal government’s regulation and taxation of cannabis?

The Code

But is it fair to say that the Code is the reason, or a principal reason, cannabis businesses are struggling, at least in California, and perhaps elsewhere in the country?

The humorist Will Rogers once said: “We don’t seem to be able to stop crime, so why not legalize it and put a heavy tax on it.  We have taxed other industries out of business; it might work here.”[xxiii]

Is that what we have here?

In computing their taxable income, a taxpayer is allowed to deduct their ordinary and necessary expenses paid or incurred in carrying on a trade or business subject, however, to certain stated exceptions.[xxiv]

What about a taxpayer engaged in an unlawful business which generates income, and with respect to which the taxpayer pays certain expenses?

Under federal law, cannabis is a “Schedule I” controlled substance; thus, the manufacture, distribution, dispensation, or possession of marijuana is unlawful as a matter of federal law.[xxv]

Illegal Activity

The following phrase is sometimes attributed to mobster Al Capone: “They can’t collect legal taxes from illegal money.”

Of course, in 1931 Capone was convicted of tax evasion, just four years after the Supreme Court’s decision in U.S. v. Sullivan that “[g]ains from illicit traffic in liquor are subject to the income tax.”[xxvi]

Writing for the Court in Sullivan, Justice Holmes pointed out that the definition of “gross income” under the tax statute then in effect did not distinguish between a lawful and an unlawful business; rather, it sought to tax income “derived from any source whatever.”

“As the defendant’s income was taxed,” Holmes continued, he was required to file a tax return.

Similarly, the Code allows a defendant who operates an illegal business to deduct, for purposes of determining its taxable income, all of “the ordinary and necessary expenses paid or incurred during the taxable year in carrying on” such business,[xxvii] provided the specific activity for which the expenses were incurred is not itself illegal,[xxviii] and subject further to certain statutory exceptions.[xxix]

Sec. 280E

One of these exceptions resides in Section 280E of the Code, which denies a “deduction” for any amount paid or incurred during the taxable year in carrying on any trade or business that consists of trafficking in certain “controlled substances”[xxx]  which is prohibited by federal law or by the law of any state in which such trade or business is conducted.[xxxi]

Cannabis is a Schedule I controlled substance,[xxxii] and dispensing it constitutes “trafficking” within the meaning of Section 280E.

Therefore, the Code prohibits a taxpayer that is engaged in the business of “trafficking” in cannabis from deducting their related expenses.

Cost of Goods Sold

However, the fact that a taxpayer engaged in the business of trafficking in controlled substances cannot deduct its business expenses does not mean the taxpayer owes tax on the gross receipts generated by the business.

All taxpayers – including “drug traffickers” – determine their “gross income,” from which ordinary and necessary business expenses would normally be deducted[xxxiii] to arrive at the taxable income from a business, by reducing their gross receipts (total sales) by their cost of goods sold (“COGS”).[xxxiv]

Although Section 280E of the Code prohibits deductions, it says nothing about a taxpayer’s COGS. Thus, a cannabis business may reduce its gross receipts by its COGS in determining its gross income.

Deduction v. COGS?

The main difference between deductions and COGS is one of timing; specifically, when does the taxpayer who incurs the cost in question benefit from the resulting reduction in their taxable income?

In general, a taxpayer can claim a deductible expense (and thereby reduce their taxable income) for the year in which the expense was incurred. However, when accounting for COGS, the taxpayer has to capitalize the cost for the item in the year of acquisition or production of the item; then the taxpayer generally waits until the year in which the item is sold to make the corresponding adjustment (i.e., reduction) to their gross income.

Recognizing that a taxpayer may be tempted to include an otherwise non-deductible expense in their COGS, the Code provides that “Any cost which . . . could not be taken into account in computing taxable income for any taxable year shall not be treated as” an adjustment to COGS.[xxxv]

In this context, “cost” means expenses that would otherwise be deductible;[xxxvi] thus, a cannabis business cannot circumvent the prohibition under Section 280E of the Code against claiming a deduction for a particular expense by including the expense in their COGS.

Elimination of 280E

If the Administration decides to stop treating cannabis as a “Schedule I” controlled substance, then a cannabis business will be allowed to claim a tax deduction for a number of expenses that are ordinarily paid or incurred by a business including, for example, compensation, rents, taxes, license fees, repairs, bad debts, interest on indebtedness, depreciation, amortization, the cost of Section 179 property, advertising, employee benefit plans, retirement plans, start-up costs, insurance premiums, professional fees, utilities, and other expenses, which currently are not deductible by a cannabis business for tax purposes.

This laundry list[xxxvii] of deductions should reduce the Federal income tax liability of a legal cannabis business.

But will a reduced federal income tax liability be enough to offset the economic advantage enjoyed by the illegal, non-taxpaying competition?

Which Policy?

What if the change in the Code is coupled with an increase in state and local enforcement activity directed at unlicensed growers and distributors, similar to California’s Campaign Against Marijuana Planting (“CAMP”) program, as a result of which authorities this year have seized nearly one million illegally cultivated cannabis plants and over 200,000 pounds of illegally processed cannabis in the state?[xxxviii]

However, query how effective and expensive such enforcement activities can be. Will the additional expenditures by the states dampen their enthusiasm for promoting the development of cannabis markets within their borders? Or will they accept it as cost of implementing an important policy?

I suppose that depends upon how one defines the “policy” in question.

For example, let’s look back at then-Governor Cuomo’s reasoning for legalizing cannabis in New York. During one interview, the governor explained that “cash-strapped New York” was “ripe” for the picking when it came to legalizing marijuana for public sale and distribution.[xxxix] When asked about New Jersey’s successful referendum permitting the sale and recreational use of cannabis — the third state adjacent to New York to do so – he responded that “the question becomes about the money and the distribution and the power.” He added, “I think this year (2021) it is ripe, because the state is going to be desperate for funding.”[xl]  He then stated that “the pressure is going to be on” the legislature in Albany to legalize cannabis and to reap the financial benefits of doing so through state taxes and license fees.

Sounds like a play for generating more tax revenue – just another so-called sin tax, like the ones on alcoholic beverages[xli] and tobacco products.[xlii] Such taxes are not imposed for the purpose of dissuading self-destructive behavior or activities that are harmful to society.[xliii] Instead, government imposes such taxes to profit from such behavior and activities.[xliv]

Ah, New York and taxes: the mention of one invariably evokes thoughts of the other. New York imposes a 7 percent excise tax on medical cannabis. It imposes a “potency” excise tax[xlv] on distributors of cannabis products at a rate that varies depending on the product sold: cannabis flower, concentrate, and consumables. This potency tax will be collected by distributors from retailers. A retailer that sells to consumers will be required to collect a 13 percent excise tax on non-medical (“recreational” dude) cannabis products. Regular sales tax must be collected from consumers on the sale of ancillary products, including lighters, rolling paper and pipes, among other items.[xlvi]

Let’s compare New York’s approach to online sports gambling; it may shed some light on the state’s approach toward cannabis.[xlvii]

The State legalized mobile sports betting in April 2021 and, in November 2021, the State Gaming Commission recommended approving 10-year licenses for two groups of gambling companies.

“The recommendation comes after years of delays as New York’s neighbors have raked in buckets on their legalized gambling operations. And New York has missed out on that revenue in more ways than one: it’s estimated that 20% of New Jersey’s sports gamblers are New Yorkers hopping the Hudson River.”

Notwithstanding a whopping 51 percent “sin” tax on gross gambling revenues,[xlviii] New York has turned into the mother of all bookmaking markets.[xlix] In fact, the state’s online gambling program has been so successful that now there is talk of installing betting kiosks in stadiums – undoubtedly adjacent to the vending machines for edible cannabis products[l] – and expanding brick-and-mortar casinos, perhaps even into New York City.[li]

In the end, how will we determine whether the decision to decriminalize, license, and tax the cannabis industry was the right call? Will its success depend upon how much tax revenue is generated, or will it be a function of the number of cannabis businesses that survive in a regulated and taxable environment in the face of competition from an established, fairly sophisticated, and less expensive illegal market?

Stay tuned.[lii]

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Basically, “Neither do I condemn thee: go ahead and do it again.”

Compare, “Neither do I condemn thee: go, and sin no more.” John 8:11.

[ii] New York enacted legislation in March 2021 that expunged convictions of anyone possessing an amount of marijuana that is less than the new legal limit set by such legislation.

Specifically, New Yorkers are now allowed to possess 3 ounces of marijuana, and to grow up to three mature pot plants at home, with a limit of six per household.

Query whether your grandmother’s tomatoes will be supplanted by the new every man’s every person’s plant.



No doubt, the Democrats hope to attract younger voters and voters of color.

At the same time, and notwithstanding the President’s statement in September that the pandemic emergency was over, HHS last week extended the COVID “emergency” for another three months, no doubt to dissuade older voters from going out in public . . . like polling places. Let’s not be disingenuous here – sadly, we’re way beyond that.


[vi] H.R. 3617. See also the Judiciary Committee’s report: H. Rept. 117-276.

The bill would also make other changes, including the following:

  • replaces statutory references to marijuana and marihuana with cannabis,
  • requires the Bureau of Labor Statistics to regularly publish demographic data on cannabis business owners and employees,
  • establishes a trust fund to support various programs and services for individuals and businesses in communities impacted by the war on drugs,
  • imposes an excise tax on cannabis products produced in or imported into the United States and an occupational tax on cannabis production facilities and export warehouses,
  • makes Small Business Administration loans and services available to entities that are cannabis-related legitimate businesses or service providers,
  • prohibits the denial of federal public benefits to a person on the basis of certain cannabis-related conduct or convictions,
  • prohibits the denial of benefits and protections under immigration laws on the basis of a cannabis-related event (e.g., conduct or a conviction),
  • establishes a process to expunge convictions and conduct sentencing review hearings related to federal cannabis offenses,
  • directs the Government Accountability Office to study the societal impact of state legalization of recreational cannabis,
  • directs the National Highway Traffic Safety Administration to study methods for determining whether a driver is impaired by marijuana,
  • directs the National Institute for Occupational Safety and Health to study the impact of state legalization of recreational cannabis on the workplace, and
  • directs the Department of Education to study the impact of state legalization of recreational cannabis on schools and school-aged children.


[viii] S.4591.

[ix] An additional benefit: access to investors via the public markets.



[xii] Remember Saddam Hussein’s statement about the “mother of all battles” on the eve of the first Gulf War?

[xiii] California legalized medical use in 1996 and recreational use in 2016: the Compassionate Use Act and the Adult Use of Marijuana Act, respectively.



“Local government opposition, high taxes and competition from unlicensed businesses are complicating California’s push to build a thriving legal market. Many of those factors are baked into California law, including rules allowing city leaders to shut out licensed cannabis enterprises. Meanwhile, the state has relaxed penalties against illegal operations in the name of racial justice.”

The report continues:

“California has just 823 licensed brick-and-mortar cannabis shops, but close to 3,000 retailers and delivery services operate in the state without a permit.”



[xviii] provides a guide to CA’s taxation of cannabis.

[xix] Some states allow the deduction of such expenses. New York, for example. See here:

See also California:

[xx] IRC Sec. 280E.

[xxi] Or enough not to make a difference to the consumer.


[xxiii] Daily Telegram, #1453, March 20, 1931.

[xxiv] IRC Sec. 161 and Sec. 162.

[xxv] See Controlled Substances Act, P.L. 91-513, Sec. 202.

[xxvi] 274 U.S. 259 (1927).

[xxvii] For example, rent or compensation.

[xxviii] For example, bribery, or an illegal kickback.

In response to the defendant’s argument in Sullivan, that “if a return were made, the defendant would be entitled to deduct illegal expenses, such as bribery,” Holmes responded, “This by no means follows, but it will be time enough to consider the question when a taxpayer has the temerity to raise it.”

[xxix] IRC Sec. 161 and Sec. 162.

[xxx] Within the meaning of schedule I and II of the Controlled Substances Act.

[xxxi] The section in its entirety reads as follows:

“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.”

[xxxii] .

[xxxiii] IRC Sec. 63(a).

[xxxiv] Reg. Sec. 1.61-3(a); Reg. Sec. 1.162-1(a). Basically, the cost of acquiring inventory, either through purchase or production.

[xxxv] IRC Sec. 263A(a)(2).

[xxxvi] Reg. Sec. 1.263A-1(c)(2).




[xl] Because of COVID.



[xliii] Ostensibly, they are, but a smoker or an alcoholic will not quit because of the tax – rather, they’ll switch to a less expensive brand.

I recall a lawsuit more than 10 years ago in which New York City sued several Native American smoke shops on Long Island, N.Y., accusing them of selling cigarettes to bootleggers who then resold the cigarettes in the City. The City claimed it lost millions of dollars in tax revenues.

[xliv] What’s more, they tend to be regressive taxes, having a disproportionately greater impact upon more economically challenged folks.

[xlv] Based on the THC content.

[xlvi] On average across the state: approximately 8.25%.


[xlviii] Bets received minus winnings paid.

[xlix] One quarter of all mobile sports bets on the Super Bowl.

[l] Sarcasm.

[li] Which may not bode well for the Native American casinos that operate in the state, though the impact will likely be softened thanks to the tax-exempt status of the revenue generated by these tribal-owned casinos. (If the profits are distributed among members of the tribe, then they must be reported as income by the individual recipients.)

[lii] As the Godfather, Don Corleone, said to Sollozzo:

“I said that I would see you because I had heard that you were a serious man, to be treated with respect. But I must say no to you and let me give you my reasons. It’s true I have a lot of friends in politics, but they wouldn’t be so friendly if they knew my business was drugs instead of gambling which they consider a harmless vice. But drugs, that’s a dirty business.”