Cannabliss or Cannabust? What’s Really Halting the Cannabis Market

It seems like every single year in the United States, another state moves closer to passing a piece of legislation that supports further legalization of cannabis. 

New York is one of several states that have recently gone legal. New Mexico, New Jersey, and Virginia have all signed and approved adult-use marijuana laws this year alone. Based on the latest information from the Marijuana Policy Project, there are 18 states that have now legalized recreational cannabis, with a total of 36 states allowing citizens to use the drug for medicinal purposes. 

While marijuana proponents across the United States are singing the praises of tax surpluses and their ability to directly benefit from a multitude of state-based initiatives (specifically state public school funds), there remains several federal laws and tax codes spurring chatter amongst cannabis companies – most notably the IRC 280e.

What is IRC 280e and how does it impact the cannabis market?

The IRC 280e is a piece of tax code that forbids any business connected with Schedule 1 and Schedule 2 drugs from deducting business expenses. Since cannabis is still classified as a Schedule 1 substance at the Federal level due to the Controlled Substance Act, state-licensed and legal cannabis businesses cannot claim typical business deductions like payroll, marketing expenses, or rent. 

Without the ability to deduct these items, cannabis businesses are repeatedly at a financial disadvantage compared to non-cannabis businesses.

The temptation to increase taxes

It’s tempting for newly legal states to hike up cannabis taxes, especially as these local governments look for ways to prop up their long-term finances after the pandemic. The initial tax revenue projections might certainly be generous enough to get conservative politicians and voters behind a legalization push, but is there longevity in the industry? 

High taxes alone can cripple the legal market. According to industry adviser MPG Consulting, two-thirds of marijuana purchases still happen with black market drug dealers, who easily outcompete higher-cost licensed players. 

The New York cannabis market is already worth around $4.6 billion, MPG added. Herding all of that ripe business into a formal legalized economy will present challenges, especially if the laws and taxes cripple consumers with overpriced products.

But how important and consequential is IRC 280e and is the persistent black market a reason for any financial setbacks on the side of legitimate cannabis companies?

We looked at some companies that had interesting insights on the presence of an illicit marijuana market and the IRC 280e. In our research within the AlphaSense platform, we found a 61% increase across company docs and research mentioning “cannabis black market” over the last 7 days (AlphaSense users, click here for a saved search link for the platform.), highlighting an elevated focus on the topic.

Key event transcript statements on consumers turning to the illegal marijuana market

Northern Lights Acquisition Corp. | S-1 Form, Prospectus | AlphaSense Transcript

Due to the nascent nature of the market, it could be difficult for the potential target to forecast demand. In particular, it could be difficult to forecast the rate of the illicit cannabis market crossing over to the legal market. If the market does not develop as the potential target business expects, it could have a material adverse effect on its business, results of operations, and financial condition. 

Lowell Farms Inc. | Prospectus | AlphaSense Transcript

Also, we expect to face continued competition from the illicit or “black-market” commercial activities that still operate within the state. Despite state-level legalization of cannabis in the United States, such operations remain abundant and present substantial competition to Lowell Farms. In particular, illicit operations, because they are largely clandestine, are not required to comply with the extensive regulations with which we must comply in order to conduct business, and accordingly may have significantly lower costs of operation. It is estimated that the current illicit cannabis market in California exceeds $8.5 billion.

Hexo Corp | Annual Report| AlphaSense Transcript

In addition to distribution, we believe being a number one market share leader requires competing directly against the illicit market. The Canadian black market for cannabis continues to account for approximately half of the total market. HEXO was among the first to disrupt the illicit market through the creation of Original Stash and its value formats. 

Key event transcript statements on IRC 280e 

Jushi Holdings Inc. and Subsidiaries | MD&A | AlphaSense Transcript

Section 280E of the Code prohibits businesses trafficking in Schedule I or II controlled substances, including cannabis, even if legal under state law, from claiming tax deductions beyond costs of goods sold. Accordingly, Section 280E generally causes such businesses to pay higher effective U.S. federal tax rates than businesses in other industries. Management expects the Company and certain of its subsidiaries to be subject to Code Section 280E. The application of Code Section 280E to the Company may adversely affect the Company’s profitability and, in fact, may cause the Company to operate at a post-tax loss.

The Harborside Group | MD&A | AlphaSense Transcript

As discussed earlier in this document, Section 280E of the U.S. Tax Code has a significant impact on the Company’s retail sale of cannabis. A result of Section 280E is that an otherwise profitable business may, in fact, operate at a loss, after taking into account its U.S. income tax expenses.

FlowerOne Holdings | Annual Report 2020 | AlphaSense Transcript

Section 280E, therefore, has a significant impact on the retail side of cannabis, but a lesser impact on cultivation, processing, production, and packaging operations. A result of Section 280E is that an otherwise profitable business may, in fact, operate at a loss, after taking into account its United States income tax expenses. 

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Nico Bryan
Nico Bryan

A brand storyteller and word-wrangler, Nico Bryan is the Senior Content Marketing Manager at AlphaSense. Previously, she has developed and managed content for creative agencies, tech startups, and traditional in-house marketing departments.

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