CAPITAL Cannabis Investment Report | December 2017

ACKRELL CAPITAL Cannabis Investment Report | December 2017 filed a petition for involuntary bankruptcy. The bankruptcy court dismissed the petition, stating it would not assign a trustee “to administer drug tainted assets for the benefit of creditors who assumed the risk of doing business with an enterprise engaged in violations of federal law.” Federal courts in California, Oregon, Colorado and Michigan have applied the same rationale to dismiss bankruptcy proceedings involving illegal cannabis-related assets. State law alternatives to federal bankruptcy that may be available to cannabis businesses and their creditors include an assignment for the benefit of creditors (ABC) and receivership. An ABC is a state- law process for the orderly and controlled liquidation of a debtor’s assets through a neutral, third party administrator. Receivership is a remedy whereby a court appoints a receiver to take possession of and protect property for the benefit of all concerned parties. In the state of Washington, for example, at least one medical cannabis business is reported to have successfully concluded a receivership process. Internal Revenue Code The Internal Revenue Code (IRC) defines gross income to include “all income from whatever source derived”; this definition has been interpreted by the Internal Revenue Service (IRS) and the U.S. Supreme Court to include income derived from unlawful activities. Consequently, cannabis businesses that violate the CSA and other federal laws related to cannabis nonetheless must file federal income tax returns and pay federal income tax. A business generally computes its taxable income in two steps. First, the business computes its gross income by subtracting from its gross receipts the cost of goods sold (COGS), which includes the cost of acquiring, constructing or extracting a physical product that is to be sold. The subtraction of COGS to compute gross income is premised on constitutional grounds and cannot be changed by federal statutes or IRS regulations. Second, the IRC “allows” a business to deduct from gross income all ordinary and necessary business expenses, which generally include all business expenses other than COGS, such as employee salaries, payments to contractors, marketing costs, insurance premiums, and the cost of rent and utilities. But there are exceptions to this “allowed” deduction. One such exception is provided by IRC section 280E (Section 280E). Section 280E disallows any deduction or credit for any amount paid or incurred in carrying on a “trade or business” that consists of unlawful “trafficking” in a Schedule I or Schedule II controlled substance. Although Section 280E does not prevent a cannabis business from subtracting COGS to compute gross income, it may prevent the deduction of all other business expenses for purposes of computing taxable income. As a result of Section 280E, businesses in the cannabis industry may have effective tax rates significantly higher than other businesses subject to federal income tax. The scope of Section 280E, as it applies to U.S. cannabis businesses, is the subject of recent and ongoing federal court cases. The U.S. Tax Court has adopted the view (a view endorsed by the U.S. Supreme Court) that a “trade or business” is any activity entered into with the dominant hope and intent of realizing a profit, and it has indicated in multiple rulings that dispensing or buying and selling marijuana involves unlawful “trafficking” in a Schedule I controlled substance. 82 © 2017 Ackrell Capital, LLC | Member FINRA/SIPC HOUSE_OVERSIGHT_024718