What is AB 37’s practical effect on the Cannabis Industry?
On October 15th, the pro-Cannabis community celebrated as California Governor Gavin Newsom signed Assembly Bill 37 into law. This legislation grants Cannabis businesses owners the ability to use business deductions for their California state taxes. But as with most technical initiatives, the devil is in the details. And so what does this practically mean?
Pre-AB 37 California Tax Regime
A look at federal law
California, like many states, mirror and adopt much of the federal Internal Revenue Code, and so it’s important to understand the historical and federal context of this legislation.
This issue is born out of 26 U.S. Code § 162(a), which allows individuals to deduct all “orindary and necessary” business expenses from their personal income taxes. This provision of the tax code is a bedrock of American industry, and also one of the most litigated sections of the code.
In 1974, Jeffrey Edmonson used § 162(a) on his annual taxes, except his business was trafficking cocaine, amphetamines, and Cannabis. The IRS served Edmonson with a deficiency letter on his tax liability and Edmonson decided to litigate. The court held that although his record-keeping was not sufficient to support all his claims, he could use § 162(a) to deduct expenses related to this illegal enterprise. Edmonson v. Commissioner, 42 T.C.M. 1533 (1981).
The very next year after Edmonson, 280(e) was enacted to reverse it and bar anyone trafficking in Schedule 1 or 2 controlled substances from taking advantage of a § 162 deduction:
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. 26 U.S. Code § 280(e).
California’s approach pre-AB 37
California largely adopted the 280(e) prohibition on deductions, with the exception of businesses filing a corporate franchise tax return. In addition, many operators organize their businesses with multiple LLC’s, which are taxed as S-corporations, and so they carefully silo all plant-touching elements of their businesses in a separate LLC, so some of their LLC’s can use the 162 deduction.
Effectively, partnerships and sole proprietors running legal, plant-touching Cannabis businesses were the only operators in California that could not get some type of benefit from 162 deductions.
What AB 37 Does
AB 37 lets those legally operating Cannabis businesses as sole proprietors or partnerships use 162 deductions for their person California tax returns. These individuals still cannot deduct their expenses from their federal taxes so long as Cannabis is a schedule one controlled substance and thus subject to the 280(e) prohibition.
How this affects Cannabis companies
Ultimately, AB 37 is about leveling the playing field. Typically early stage, less sophisticated, or “on a budget” Cannabis entrepreneurs are the ones most likely to run their business as a sole proprietor or as a partnership. They will now be able to take advantage of a state deduction that LLC’s and corporations have already leveraged to help grow their businesses.
It is estimated that fewer than 10% of the industry in California is structure as a sole proprietorship or partnership, so the impact will be seemingly minimal en mass. However, this will give help to those early stage operators at a critical early stage to determine their success or failure.
Recommendations going forward
With AB 37, the State of California putting its money where its mouth is when it says Cannabis is a legitimate business. California cannot remove the federal roadblocks from integrating Cannabis into the community of legitimate industries, but it can ameliorate others. For example, California's adoption of METRC has dissuaded many existing industries and service providers from joining Cannabis, and has created significant regulatory costs to operators. California should take a look at the reporting standards METRC requires and how that affects the industry’s safe and responsible growth.
The state also needs to act on cities that are refusing to issue licenses to operators or have been exceedingly slow in issuing licenses.
The pro-Cannabis community should be encouraged by what AB 37 represents and continue to stay active in building success from success. The fact that Governor Newsom has been a friend and ally on the issue shouldn’t be taken for granted. It should show its gratitude to him, and champions in the legislature, to continue building meaningful legislation to help the industry prosper.
