Do Cannabis Stocks Need Tax Reform More Than Legalization?

The patchwork, state-by-state legalization of marijuana in the U.S. has created a market for cannabis companies that is less than ideal, leaving many people hoping the federal government will finally decriminalize pot, as Canada has.

Yet the rollout of legal weed north of the border has also been marked by bureaucratic bungling that has inhibited cannabis stocks from realizing their full potential. Legalizing marijuana at the federal level in the U.S. might create a regulatory burden that's even more prohibitive than what legal pot companies already experience from the individual states.

What the marijuana industry might need more than legalization is tax reform, because the current code is at odds with how legal cannabis businesses operate -- and with common sense.

Image source: Getty Images.

Carrying a heavy burden

To prevent drug traffickers from profiting off their illegal activity, the federal government naturally prohibits them from taking tax deductions. 

While you wouldn't think that was necessary since what traffickers are doing is against the law, the tax court in the 1970s actually allowed a cocaine and amphetamines trafficker to deduct his "business expenses," and Congress ended up enacting a law to prevent traffickers from doing that again. 

People don't consider their local marijuana dispensary owner to be anything like the guy hauling kilos of cocaine across the ocean in a cigarette boat and evading the Coast Guard. But because cannabis remains a Class I controlled dangerous substance, the Internal Revenue Service doesn't make any such distinctions. 

So legal cannabis companies like Trulieve (TCNNF -3.22%) and Cresco Labs (CRLBF -4.11%) are not permitted to deduct legitimate business expenses like marketing and advertising, health insurance premiums, interest, rent, or even employee salaries.

Those deductions could be the difference between being profitable and running ruinous losses -- or for companies that do manage to turn a profit, from having additional resources to invest in their business.

Image source: Getty Images.

Double jeopardy

The offending section of the tax code is Section 280e, which allows a cannabis business to deduct only the expenses directly related to sales of product, and not those associated with carrying on the actual business. So they're able to deduct the cost of goods sold, but not expenses related to selling, general, and administrative efforts.

All this means a marijuana company is being taxed on its gross profits rather than operating income, which could make its effective tax rate well more than double a similarly structured business not in the cannabis industry. In short, marijuana companies might be taxed on more income than they actually make.

Tim Winkler, controller at Fello Cannabis, a Michigan-based cultivator of pot for medical and adult use, says the problem is more acute for dispensaries than for grow operations, but "this is cash, so EBITDA [earnings before interest, taxes, depreciation, and amortization] takes the hit as well."

EBITDA is a metric many investors use to compare businesses, as it largely focuses on how a company is operating, its profitability, and its cash flow. While not perfect, it serves as shorthand for investors evaluating a business -- and since marijuana companies are not able to deduct any of the listed expenses, they are put at a disadvantage. And obviously, the bigger the business, the bigger the hit it takes in taxes.

The high cost of success

All this is why many marijuana companies don't operate in the U.S. Canopy Growth, HEXO, Tilray, and others remain firmly ensconced in Canada so that they're not subject to Section 280e oversight.

Meanwhile, some companies -- such as multistate dispensary operators like Curaleaf Holdings (CURLF -2.69%), Green Thumb Industries (GTBIF -1.37%), Trulieve, and Harvest Health & Recreation (HRVSF) (which Trulieve is acquiring) -- actually have it worse. 

Even though they're Canadian companies subject to Canadian taxes, because they operate state-level legal cannabis businesses in the U.S., they are taxed a second time as U.S. corporations. And in states that align their local tax codes with the IRS code, they can't deduct normal business expenses locally, either.

The results are evident in their financial statements: As their business grows, their tax liability often increases exponentially.

Data source: Company websites. 

Paying their fair share

Federal legalization of marijuana would obviously eliminate the undue burden cannabis companies face when calculating their taxes, but as noted previously, it could unleash a regulatory burden that might be just as bad as the current system.

There's a reason the black market in marijuana still proliferates even where states have legalized it: The government has made the cost of doing business too expensive, which shows up in prices. It's often just cheaper to buy illegal weed.

It's a testament to their businesses that Cresco and Trulieve have been able to grow sales faster than their taxes, but if cannabis companies had their druthers, they might just prefer the government to enact tax reform over marijuana legalization.