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George F. Bearup, J.D. Senior Legal Trust Advisor

15-Feb-22

Cannabis Business Assets- Unanswered Questions

Take-Away: As time passes, more and more individuals and their estates may hold investments in cannabis-related businesses. Interesting estate planning questions arise at the federal level if a decedent’s estate holds an investment in cannabis license or a cannabis-related business.

Background: Over 40 states and the District of Columbia have legalized cannabis sales in some form. A reasonable expectation is that more states will join the march to permit the legalized sale of cannabis products within their borders. In 2020, sales of legal cannabis exceeded $17.5 billion. In Michigan those revenues from cannabis sales for 2020 were $9.7 million. That national number is projected to grow to over $41 billion by 2026, which is why the other states may soon want to ‘get in’ on the tax revenues to be derived from cannabis product sales. These states have vastly different rules with regard to the issuance of licenses to sell cannabis-related products, and whether those issued licenses can even be transferred by a licensee. As a couple of examples, in California a license to sell cannabis products is issued to the individual or business entity to whom it is issued, but that license is not transferrable. In New York, a license or permit to sell cannabis is described by the New York statute as not a property or vested right. So, while there seems to be fairly extensive regulation at the state level, it is hard to predict how those regulations will impact the value of a cannabis-related business, and in addition the challenges associated with the transfer of a cannabis-licensed business.

Federal Government: At the federal level, it is an entirely different story. The federal Controlled Substances Act continues to prohibit the cultivation, distribution and possession of cannabis for anything other than research purposes. [21 U.S.C. 812(c), which defines marihuana as a Schedule I controlled substance.] Consequently, cannabis plant ‘touching’ businesses, i.e. buyers and sellers come into contact with cannabis, are treated as trafficking in controlled substances for purposes of federal criminal laws. The resulting impact of this classification is that: (i) there is a clear prohibition on income tax deductions that are associated with a cannabis-related business [IRC 280E]; and (ii)  a cannabis plant-‘touching’ type of business is extremely limited when it comes to bank processing services, including opening bank accounts, depositing business proceeds, or handling credit card transactions.

  • Digression: Marihuana is defined as a Schedule I controlled substance. [ U.S.C. 812(c).] A Schedule I substance is defined as a ‘drug having high potential for abuse and no currently accepted medical use treatment in the United States.’ [ 21 U.S.C 812(b)(1).] In 2020 the House of Representatives passed legislation to remove cannabis from its classification under the Controlled Substances Act, but the bill did not get anywhere in the U.S. Senate. See the Marijuana Opportunity Reinvestment and Expungement Act of 2019, H.R. 3884.

Open Questions: It is no surprise then that the federal estate and gift tax rules do not even address the impact of ‘illegal’ assets which are the subject of lifetime or death-time transfers. Accordingly,  while a cannabis-related business or license may be legal at the state level for purposes of determining property rights, federal gift and estate tax purposes should apply [IRC 2501 and IRC 2031] to the transfer of a cannabis-related business. However,  there is nothing at the federal level that provides any helpful direction as to the impact of the cannabis’ ‘illegality’ when it comes to federal income, gift or estate tax laws. A few rhetorical questions come to mind:

  • No Deductible Business Expenses: Estate administration expenses generally are deductible either on the estate’s annual income tax return or used to reduce any federal estate tax liability. Since IRC 280E limits IRC 162 business deductions related to cannabis businesses, does that mean that the income tax deductions under IRC 212 will be unavailable to a decedent’s estate, the wealth of which derives, in part, from a cannabis-related business?
  • No Deductible Estate Administration Expenses: Will the IRS disallow, on public policy grounds, a federal estate tax deduction under 2053 for estate administration expenses that are associated with those expenses attributable to the decedent’s cannabis-related business? The IRS may disallow estate tax deductions where otherwise permitting those deductions would “frustrate sharply defined national or state policies proscribing particular types of conduct.”  [Commissioner v Heininger, 320 U.S. 468 (1943.]
  • Valuation Complications: How will the transfer of a cannabis-related business be valued for federal estate or gift transfer tax purposes? The business interests will be valued for federal wealth transfer tax purposes, but the business is technically illegal from a federal perspective. There is limited legal authority in the Tax Court that suggests ‘street value’ is an appropriate standard to use  to value illegal drugs, at least where the taxpayer did not maintain adequate books and records. [Jones v. Commissioner, T.C. Memo, 1991-28, which held that unreported income from the importation and distribution of illegal cannabis to be computed at ‘street value.’ See also Kent v. Commissioner, T.C. Memo, 1986-324.]] This same ‘street value’ approach to the valuation of cannabis was used where the decedent piloted an airplane that crashed that carried large bales of cannabis. The pilot died. The IRS included the value of the cannabis in the deceased pilot’s gross estate at the ‘retail street value.’  [Technical Advice Memorandum 9207004, October 21, 1991.] It is conceivable that the IRS might assert that because cannabis is illegal under federal law, it should have broad discretion when it assigns a value to the transferred cannabis-related business.
  • Loss of Estate Tax Deductions: Citing public policy grounds, could the IRS deny the federal marital deduction for lifetime gifts to a spouse [IRC 2523] or the federal estate tax marital deduction [IRC 2056]  for the transfer of a cannabis license or cannabis-related business to a surviving spouse? The same concerns arise with regard to the transfer of a cannabis-related business to a charity where a charitable income tax deduction is claimed. [IRC 2522.]
  • No Estate Tax Installments: Will a decedent’s estate that holds a cannabis-related business be eligible for the extension of time in which to pay federal estate taxes related to that business if all other statutory requirements are met? [IRC 6166.]

Conclusion: Counting the number of cannabis-related businesses that I see every day on my drive to work, its readily apparent that cannabis sales in Michigan are booming and the number of cannabis-related businesses is rapidly growing. Yet we have federal criminal laws and public policy concerns at the federal level associated with cannabis that create many questions with regard to how the IRS will treat a cannabis related business, or license, when it is transferred. Suffice it to say that routine estate planning concepts may not a apply when an individual owns a cannabis license or a cannabis-related business.