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Tax Accounting and Investing for the Legal Marijuana Industry

The excitement over the legal marijuana industry is building all over the U.S., as states continue to follow Colorado and California in legalizing both medical and recreational marijuana. Much like the predictive rise in users, this new pattern of legalization is also bringing with it a whole new crop of investors into the cannabis market. Whether it be in the dispensary business or in the stock market, taxpayers are eager to enter this highly profitable industry. However, investors must understand there are significant issues in investing in the legal marijuana industry, as it still remains illegal under Federal law.

From an accounting prospective, professionals need to be aware of the consequences that Internal Revenue Code § 280E will impose on their marijuana clients who wish to own dispensaries and so-called “head shops”. I.R.C. § 280E states that no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if the trade or business consists of trafficking in controlled substances, regardless if it is legal to distribute under state law. Since marijuana is listed as a Schedule I controlled substance at the Federal level, even legal marijuana businesses are not permitted to take tax deductions and credits that would normally be usual by ordinary business operations. Conversely, in accordance with I.R.C. § 61, all revenue generated by operations in the marijuana industry is to be included in their taxable income, whether illegal or otherwise.

Likewise, investors need to be aware of the consequences of investing in marijuana stocks as the volatile industry carries with it a very high level of risk. Until recently, most big banks refused to shoulder the political and legal risks of having their brands associated with a cannabis fund. Possible risks arising from the holding of stocks involved in the cannabis trade and the receipt of money from underlying investments include running afoul of federal banking laws, the loss of insurability under the FDIC or the possible suspension of banking licenses. Marijuana exchange-traded funds (“ETFs”), for instance, are extremely difficult to create and manage because custodians, the independent third parties (usually banks) whose sole task is to hold securities for the fund are very reluctant to administer to marijuana ETFs. Though they often go unseen and unnoticed, custodians play a critical role in the launch and operation of any fund. Without custodians, there can be no ETFs, and when it comes to marijuana ETFs, custodians will likely continue to remain hesitant of the industry.

Investing directly in a marijuana stock is also an extremely risky and difficult endeavor due to the speculative nature of the crop and the unpredictable legal challenges. At present, most publicly traded marijuana companies are penny stocks, meaning they trade in the thinly-regulated and highly speculative over-the-counter markets. Combine the patchwork regulation with the uphill legal climb the marijuana business still faces we are looking at potentially volatile stock price action which will affect the entire market as the pot stocks have shown to move in unison. Marijuana stocks are also highly susceptible to pump and dump schemes; a situation which individual investors would be wise to avoid.

On the local level, states have become increasingly liberal with regards to marijuana legalization, and New Jersey state law in particular is more open to legalizing both medical and recreational marijuana. New Jersey will likely become the ninth state to legal marijuana in 2018 if the newly elected governor is successful in pushing his agenda. Still, the Federal tax code remains conservative in their beliefs of taxing businesses that sell marijuana which creates significant roadblocks for those wanting to enter the legal marijuana market. Only time will tell where the industry will eventually end up, but investors would be wise to remain educated when funding an investment in this arena. For tips on how best to stay on top of the industry, please contact a member of our Financial Services Group by filling out the form below.

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