At a presentation by the Accountants Club of America on Dec. 5, Eric Altstadter and Thomas Cardinale, partners at EisnerAmper, discussed the evolving landscape of New York state's cannabis business. The talk was entitled “High Times in New York: Navigating the Cannabis Industry Emergence."

Altstadter, an audit partner and chair of the firm’s cannabis and hemp practice, and Cardinale, whom Altstadter called the leading tax person in that practice, started with an overview of cannabis legalization in the country, showing a map of the states that have decriminalized or legalized cannabis. Only three states—Idaho, Nebraska and Kansas—have no public programs at all, according to the National Conference of State Legislatures.

Altstadter reported on a settlement agreement in principle that the New York State Cannabis Control Board approved in November in two recent court cases that challenged the the state’s conditional adult-use retail dispensary (CAURD) program. If a judge approves of the agreement, it could resolve the two lawsuits and lift a court order that has blocked the state from processing or issuing retail cannabis licenses since August, ending a three-month-long freeze on recreational dispensary openings across the state.

One lawsuit was filed by four military veterans, and the other was filed by a coalition that included large medical cannabis companies. They both challenged state rules that allowed people with drug convictions to open the first dispensaries.

The Cannabis Control Board said that if the judge approves the settlement, more than 400 provisional retail licensees will be able to move forward with their dispensaries. Regulators have also opened up a general application window to grow, process, distribute or sell cannabis, expecting to issue more than 1,000 new licenses as a way to revitalize the market, The Associated Press reported at the time.

This proposed settlement would provide for “anyone to apply for a cannabis license, not just those with prior convictions,” as was set out in the 2021 law that legalized cannabis in New York, Altstadter said. At that time, “the criteria for industry access were established to benefit individuals affected by cannabis prohibition policies through the CAURD,” he said. He noted that there has been a proliferation of thousands of illicit businesses across the state. “The state has struggled to address and crack down on these businesses so far, not too effectively,” he said, adding that “lawsuits and delays and implementation processes further hindered the issuance of licenses for retail dispensaries." He observed, "As of today, I believe there are roughly 26 legal retail dispensaries operational in the state.”

To illustrate his point, Altstadter said, "If you walk down Seventh Avenue south of Madison Square Garden, it feels as if there is a cannabis dispensary on every block but there are only a few that are legal, so how do those stores remain open? Are these dispensaries legal? The answer is: No, they are not.”

Just because cannabis may be legal and decriminalized according to state laws, it does not mean that anyone can sell without a license, Altstadter said. Purchasing from illegal sources means that the product has not gone through the official steps to ensure that it is free of contaminants such as harmful pesticides, E. coli, heavy metals and salmonella. He cited a 2020 study by the New York Medicinal Cannabis Industry Association that found that 40 percent of unregulated products in New York state contain such contaminants. The study also found that many products contain different amounts of THC than advertised on the label, including one product that had twice the amount of THC that was listed on the label.

In contrast with neighboring New Jersey, New York has established eight types of business licenses: plant nurseries, cultivators, processors, operatives, distributors, dispensaries, delivery services and micro businesses, Altstadter said. They are split between two broad categories, supply and retail, with rules forbidding most businesses from owning stakes in both categories, in order to prevent market domination. New Jersey has, or will have, six types of licenses, he said: cultivation, manufacture, retail, delivery, distribution and wholesale.

Because of New York's CAURD program, New Jersey has reaped more revenue: Sales of recreational cannabis topped $24 million in the states first month of sales in 2021. “The state gets a cut, with a 6.65 percent sales tax, and their additional state and local tax," Altstadter said. "So while sales of cannabis for federal purposes remain illegal, as you can tell, it's a big business, and as far as I'm concerned, this is an issue between federal and state." That led to a discussion about IRC Section 280E, which denies tax deductions and credits for amounts paid or incurred in carrying on the trade or business of trafficking controlled substances, including cannabis, as it currently is still under Schedule I of the Controlled Substances Act.

Cardinale gave a brief history of Section 280E, saying that it was the result of a landmark 1981 case in which drug dealer Jeffrey Edmonson reported to the IRS all of the 1974 revenue he made in drug dealing. He filled out a tax return, reported all the income, paid the tax, and took deductions such as travel and freight, according to Cardinale. “He even deducted the scales he was using … to measure his product,” he said.

Despite Edmonson’s payment of his taxes, the IRS attempted to deny the “ordinary and necessary” expenses, as detailed in the Code, chapter one of which states that “everything is taxable by default, meaning illegal activities are taxable,” Cardinale said. “So ... if it's legal from a tax perspective only, then you should be allowed ordinary and necessary deductions. So, the IRS lost that case and then they went crying right to Congress. This commingled with President Reagan's war on drugs, and hence 280E was born.”

“So 280E in its statutory form means all deductions from gross income are disallowed," Cardinale said. "When you drill down on what does gross income mean, it will tell you it is revenues less cost of goods sold. It's as simple as that.”

But change may be in the offing, the pair pointed out. Cardinale said that “there is more traction in Congress on descheduling cannabis as a Schedule I drug [by] either taking it off entirely or putting it to Schedule III,” as the U.S. Department of Health and Human Services (HHS) recommended in August.

The acceptance of this recommendation to reclassify cannabis—which would allow it to join drugs such as ketamine, anabolic steroids and testosterone as Schedule III substances— would be “seismic,” according to Altstadter.

“If they move it from Schedule I to … Schedule III, 280E doesn't apply anymore, and cannabis owners would be allowed to take all their tax deductions,” said Cardinale. In the meantime, however, states such as New York and New Jersey have decoupled from federal law, meaning that cannabis businesses can claim state deductions on their cannabis businesses.

During the presentation, the pair said that entrepreneurs and other individuals who want to start a cannabis operation often ask them what kind of entity should they be. “I give the same answer to that question for everybody,” said Cardinale. “It depends. There's no slam dunk answer. It really depends on what you plan to do with the business.”