At the federal level, cannabis businesses that “touch the leaf” are taxed on the sum of revenue less cost of goods sold, according to IRC section 280E. Businesses that do not touch the leaf—meaning those that indirectly benefit from cannabis activity, such as suppliers and landlords—can also claim other deductions. But if there is a loss on your investment or loan, will the loss be deductible? Although the investment might appear rosy right now, storm clouds could one day come to this industry. 

The U.S. Department of Justice (DOJ) may be signaling to the IRS on how it should interpret investment and lending activity for tax treatment, and we should pay attention. Granted, the DOJ is not the IRS—but what they say is chilling. In a December 2017 article, the DOJ tried clarifying issues involving the bankruptcy of businesses engaged in cannabis. Authors Clifford White III, director of the DOJ’s Executive Office for U.S. Trustees, and John Sheahan, a trial attorney for the agency, restated the DOJ’s earlier position regarding federal bankruptcy: They stated that courts are not permitted to discharge any debts tied to cannabis activities, whether indirectly or directly, because the DOJ views any activity involving the attempted profiting from cannabis as an illegal activity related to drug trafficking. The DOJ does not distinguish plant touchers from non-plant touchers. 

Everyone in the business of cannabis is the same in the eyes of the U.S. government with respect to drug trafficking. In simple terms, if you are attempting to profit from an illegal act of drug trafficking, the only loss you get is the deduction for the cost of goods sold against your revenue. That’s it, plain and simple. 

Imagine the T.V. character Walter White from “Breaking Bad” investing a million dollars for a meth lab (which he operates or someone else operates). If the lab blows up or is confiscated by the feds, poor Walter can’t take a tax loss for that. Whether capital or debt was used to pay for the lab—or whether the vehicle holding the debt or equity was an individual, corporation or a partnership—the substance of the illegal activity appears to be the same. If state law follows federal law, then the loss of tax deductions would likely occur at the state level as well, unless the state has made a noted exception.

So what does this mean for pricing the quality of debt or capital connected to a cannabis operation? We need to consider that without creditors being able to rely on the U.S. bankruptcy courts for recovery, only the state courts offer possible venues. Coupled with the possibility of not being able to take a tax loss, the cost to lend or invest capital would appear to justify a premium, unless the lender or investor is a tax-exempt institution or retirement plan.

Perhaps a request for a private letter ruling would be able to clarify the following:

• whether or not investing in a cannabis operation is a capital asset and thereby eligible for step up in basis at death
• whether or not capital losses are allowable for investments in cannabis
• whether or not loan losses qualify as ordinary losses and bond losses qualify as capital losses.

Peter Metz, CPA,  is a principal in the tax practice of Grassi & Co. and brings more than 20 years of accounting experience to the firm. He can be reached at pmetz@grassicpas.com.

John Pellitteri, CPA,  is a partner and healthcare practice leader of Grassi & Co. and brings over two decades of experience in accounting, auditing, tax planning, and business consulting. He can be reached at jpellitteri@grassicpas.com.