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ACKRELL
CAPITAL
Cannabis Investment Report | December 2017

filed a petition for involuntary bankruptcy. The bankruptcy court dismissed the petition, stating it
would not assign a trustee “to administer drug tainted assets for the benefit of creditors who assumed
the risk of doing business with an enterprise engaged in violations of federal law.” Federal courts in
California, Oregon, Colorado and Michigan have applied the same rationale to dismiss bankruptcy
proceedings involving illegal cannabis-related assets.

State law alternatives to federal bankruptcy that may be available to cannabis businesses and their
creditors include an assignment for the benefit of creditors (ABC) and receivership. An ABC is a state-
law process for the orderly and controlled liquidation of a debtor’s assets through a neutral, third party
administrator. Receivership is a remedy whereby a court appoints a receiver to take possession of and
protect property for the benefit of all concerned parties. In the state of Washington, for example, at
least one medical cannabis business is reported to have successfully concluded a receivership process.

Internal Revenue Code

The Internal Revenue Code (IRC) defines gross income to include “all income from whatever source
derived”; this definition has been interpreted by the Internal Revenue Service (IRS) and the U.S.
Supreme Court to include income derived from unlawful activities. Consequently, cannabis businesses
that violate the CSA and other federal laws related to cannabis nonetheless must file federal income tax
returns and pay federal income tax.

A business generally computes its taxable income in two steps. First, the business computes its gross
income by subtracting from its gross receipts the cost of goods sold (COGS), which includes the cost of
acquiring, constructing or extracting a physical product that is to be sold. The subtraction of COGS to
compute gross income is premised on constitutional grounds and cannot be changed by federal statutes
or IRS regulations. Second, the IRC “allows” a business to deduct from gross income all ordinary and
necessary business expenses, which generally include all business expenses other than COGS, such as
employee salaries, payments to contractors, marketing costs, insurance premiums, and the cost of rent
and utilities. But there are exceptions to this “allowed” deduction. One such exception is provided by
IRC section 280E (Section 280E).

Section 280E disallows any deduction or credit for any amount paid or incurred in carrying on
a “trade or business” that consists of unlawful “trafficking” in a Schedule I or Schedule II controlled
substance. Although Section 280E does not prevent a cannabis business from subtracting COGS to
compute gross income, it may prevent the deduction of all other business expenses for purposes of
computing taxable income. As a result of Section 280E, businesses in the cannabis industry may have
effective tax rates significantly higher than other businesses subject to federal income tax.

The scope of Section 280E, as it applies to U.S. cannabis businesses, is the subject of recent and
ongoing federal court cases. The U.S. Tax Court has adopted the view (a view endorsed by the U.S.
Supreme Court) that a “trade or business” is any activity entered into with the dominant hope and
intent of realizing a profit, and it has indicated in multiple rulings that dispensing or buying and selling
marijuana involves unlawful “trafficking” in a Schedule I controlled substance.

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© 2017 Ackrell Capital, LLC | Member FINRA / SIPC

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