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Legalizing marijuana was sold to the public as a cash cow for governments, which were going to reap billions of dollars by taxing weed.

Turns out a majority of the businesses have been bilking Uncle Sam to the tune of hundreds of millions of dollars from illegal deductions or hidden income, the IRS inspector general said in a report released Thursday.

But the feds are at least partly to blame, the audit said. With a national ban on marijuana still in place, pot-based businesses face a complicated set of rules that forces many to operate cash-only, making it tough for the IRS to track operations.

The Treasury’s inspector general for tax administration sampled tax filings from 140 marijuana businesses in the West Coast states of California, Oregon and Washington, where use of the drug is broadly legal.

It found 78% of the businesses in California, 40% in Oregon and 59% in Washington claimed deductions for business expenses that probably should have been rejected because of the federal rules.



Investigators took a deeper dive into the Washington data and found 26% of pot businesses underreported their income or didn’t file returns at all.

The report was released amid scrutiny on the marijuana industry during the coronavirus crisis. Many governors have declared pot dispensaries to be essential businesses, allowing them to remain open, though a reported early surge in sales appears not to have been sustained.

Marijuana Business Daily reported this week that while California is running ahead, sales in Washington and Colorado are below their levels at this time last year. Pot sales in Colorado were off nearly 50% over the weekend.

The inspector general said legal marijuana is a growing industry, with nearly $11 billion in sales in 2018, projected to rise to $13 billion last year and $25 billion by 2025. Use is legal in some form in 33 states and the District of Columbia.

Tax problems begin with the Internal Revenue Code’s Section 250(e), which bans businesses from taking tax deductions for expenses incurred while trafficking in controlled substances.

Since the federal government still classifies marijuana as a Schedule I controlled substance, pot businesses are covered by that provision.

“Consequently, businesses that sell marijuana can reduce gross receipts by the cost of goods sold but cannot deduct other business expenses,” the inspector general said.

That means they can subtract their costs for the supply of pot they sell from their gross income — the seeds, the labor to grow and process plants, and rent — but can’t subtract other business expenses such as advertising, distribution or interest expenses.

A hypothetical regular business with gross income of $500,000 and expenses of $250,000 for inventory sold and another $150,000 in business expenses would show a net taxable income of $100,000.

If it was a pot business, then $150,000 in expenses would be disallowed and the business would show a net taxable income of $250,000, the audit said.

Looking at the three states it sampled, the inspector general calculated pot businesses underpaid $48.5 million in taxes in 2016, or nearly $250 million projected out over a five-year span. The inspector general’s office said the total is likely to be much higher if the other 30 states are included.

The inspector general said the IRS doesn’t give good guidance to the pot industry or to tax preparers, so they may not be aware that their expenses are treated differently.

The audit says pot businesses face other unique problems, chiefly a lack of access to banking because federal rules discourage banks from doing business with establishments that violate the letter of federal law.

Pot businesses end up doing most of their transactions in cash and have to schedule times to arrange to pay their tax bills — again, with large sums of cash.

That can lead to a 10% penalty, which applies to all businesses that don’t make tax payments by electronic transfer. While a waiver is available to businesses that show they were prevented from opening bank accounts, most taxpayers are unaware of that option, the inspector general said.

“Taxpayers including marijuana businesses should not be penalized because they cannot satisfy their respective employment tax obligations via the required electronic transmission process,” the audit said.

Relying on cash also makes it tough for the IRS because there is no bank account it can levy if it needs to and transactions can be shielded more easily, the audit said.

In a deep dive into the tax returns of Washington businesses, the inspector general found that 26% of companies didn’t properly report their income. Eight underreported, and 15 others didn’t file at all.

Projected over the whole state for a five-year window, that came to $19.3 million in additional taxes that the IRS should be assessing Washington pot businesses, said the inspector general’s office, calling the pot business high-risk for underpaying taxes and urging the IRS to focus on the issue.

Morgan Fox, media director at the National Cannabis Industry Association, said the inspector general was right to highlight the tricky situation the federal government creates for pot businesses when it comes to banking.

“Given that the cannabis industry is increasingly recognized as a vital part of health care and the economy, it is simply unconscionable that financial institutions are still discouraged from working with these heavily regulated and essential businesses, or that these businesses are forced to pay 3-5 times the effective federal tax rate as other industries,” he said.

Indeed, while the inspector general said the federal government may be missing out on some taxes, state governments are raking in revenue.

Washington imposes a 37% excise tax on sales above the state’s 6.5% retail sales tax. Oregon’s is lower, at 17%, and there is no state retail sales tax.

Mr. Fox said he was skeptical of the audit’s finding that businesses are taking federal deductions they shouldn’t be.

But he said whatever the situation, Congress should give cannabis establishments the same deductions as other businesses.

The IRS said it would like to Congress to step in and make the process easier for the tax collectors and the businesses.

Still, Eric C. Hylton, the IRS commissioner for the small business division, bristled at some of the audit’s findings. He said they disagree with the inspector general’s outcome measures and that pursuing cases against pot businesses may not be as cost-effective as the audit suggests.

Mr. Hylton blamed budget cuts last decade for sapping enforcement money and said they have other priorities, such as figuring out how to enforce the massive tax overhaul President Trump signed into law in 2017.

“Whether we pursue taxpayers in the marijuana industry or any other industry depends upon IRS priorities and availability of resources,” he wrote in the agency’s official response, though he said the IRS will look at the state data available to see how easy it is to spot underpayments from marijuana establishments.

Mr. Fox at the National Cannabis Industry Association said an ongoing court case could settle at least part of the issue.

Harborside Inc., a California-based cannabis retailer, is fighting its tax assessment based on Section 280(e), the provision that makes many pot business expenses nondeductible.

The company argues that business expenses are deductible for all sorts of illicit activity and the marijuana industry is unfairly penalized by Section 280(e).

Harborside lost in tax court but has appealed to the 9th U.S. Circuit Court of Appeals.

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