Over the last several years, there has been a movement towards legalizing marijuana in various states. In those states where it is legal, recreational marijuana has created countless businesses and jobs. It’s also lead to billions of dollars in tax revenue for those states. Without a doubt, there is a tremendous amount of growth and opportunity in the industry which is why New Jersey is one of the latest states to explore legalization. Keep in mind, however, that the drug is still illegal at the federal level.
So how does a business that sells state legalized marijuana pay federal taxes? Is there a higher tax burden for companies within this industry? Let’s take a look.
Regardless of what a business does to make money, it will pay tax on its net income. Net income is basically total sales less cost of sales less any operating expenses. When it comes to businesses selling a controlled substance, however, federal tax law limits the amount of deductions permitted on a tax return. Specifically, the law does not allow most operating expenses of these types of business. This means that the number a marijuana based business pays tax on is typically much higher than net income. If we look at a simple example, you’ll see how significant the taxes could be.
Let’s assume there are two identical business, except that one of them sells computer equipment and the other sells marijuana. Gross sales are $10 million, the cost of sales is $3.5 million, and operating expenses are $4.5 million. How much of a difference is the tax between these two industries?
| Typical Business | Marijuana Business | |
|---|---|---|
| Gross Sales | $ 10,000,000 | $ 10,000,000 |
| Costs of Sales | 3,500,000 | 3,500,000 |
| Operating Expenses | 4,500,000 | 4,500,000 |
| Net Income | 2,000,000 | 2,000,000 |
| Net Income for Tax Purposes | 2,000,00 | 6,500,000 |
| C Corporation Tax rate | 21% | 21% |
| Tax Amount | $ 420,000 | $ 1,365,000 |
As you can see, there is a pretty large difference here. Essentially, that is because the marijuana business has to pay tax on the $4.5 million of operating expenses. The effective tax rate for this company is about 68% compared to the 21% rate paid by the other company. When you take the federal tax into account, the net income for each of the companies is $1.58 million versus $635,000 for the marijuana business. As you can see, the marijuana business has significantly less cash flow when taxes are considered.
There are options available that allow a business to work within the marijuana industry while avoiding these high tax rates. Consider operating a business that is ancillary to a marijuana grower or dispensary. If you don’t touch the plant, you won’t be subject to the restrictive tax laws. For example, the tourism industry has seen an influx of businesses promoting different dispensaries. These business aren’t considered as selling marijuana so they are not subject to the restrictive tax laws of those same dispensaries. There is also nothing that prohibits you from providing goods and services to the marijuana industry. So, if you currently manufacture containers for use in the agriculture industry there is nothing prohibiting you from selling your products to a marijuana grower or dispenser. You can do so without fear of having to pay additional taxes on these transactions.
While the recreational use of marijuana is still illegal in most states throughout the nation, the trends seem to be moving towards legalization. Should New Jersey legalize it, there will be new opportunities for business throughout the state.
If you’re considering starting a business within this industry, it’s important to speak with an accountant and advisor at Alloy Silverstein so we can help navigate you through the pitfalls of starting a new business in this industry.
Associate Partner
Ren III provides tax, accounting, and advisory services to a broad range of clients, with a specialty for manufacturers, title insurance companies, and professional service providers.
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