Cannabis Culture On 4/20—A Look At Efforts To Legalize And Tax America’s Most Controversial Crop

Today is 4/20, a counterculture holiday based on the celebration of cannabis. A few years ago, the day would have confounded some. Now, 4/20 is so mainstream that it trends on social media. Cannabis simply doesn’t have the same taboo as it once did, largely due to legalization efforts.

History Of 4/20

While there are dozens of theories about how the date came to have such significance, the most widely accepted explanation can be traced to a group of teenagers from San Rafael, California. The group, nicknamed the Waldos for their favorite hangout spot (a wall outside of school), used to meet after school to smoke pot. The timing of their meeting, 4:20 pm, became a kind of greeting in the hallway, and the rest, as they say, is stoner history.

Legalization Of Cannabis

Nearly 50 years later, the use of cannabis has spread from high school-age kids taking illegal drags behind walls to a front-and-center movement. While still prohibited by federal law—possession can lead to fines and jail time—most states and the District of Columbia have legalized cannabis for medical or recreational use (or both). Just four states have laws that treat cannabis as wholly illegal— Idaho, Kansas, South Carolina, and Wisconsin.

That largely tracks with opinions about cannabis. According to a 2022 Pew poll, an overwhelming share of U.S. adults (88%) say either that cannabis should be legal for medical and recreational (59%) or medical use only (30%). These views have been virtually unchanged since April 2021.

A Federal Crime

Despite the trend, possession of cannabis remains a federal crime. Under federal law, it’s classed as a Schedule I drug—on par with heroin and LSD—which means that it is not legal in any form. It is against federal law to grow, sell, or use cannabis for any purpose, including medical reasons.

And while it’s the case that cannabis sellers must report their income—even from illegal means—the uneven treatment of the drug means that the revenue from its growth or sale is not always taxed. Interestingly, it was the taxation of cannabis in the 1930s which led to criminalization in the first place. In the early part of the 20th century, during Prohibition, booze was illegal, but cannabis was not.

Under the 1937 Marihuana Tax Act (yes, with an “h”), cannabis was legal—and taxed. There was a two-part tax on sales, one which functioned like a sales tax and another more akin to an occupational tax for licensed dealers. Failing to comply resulted in severe consequences.

In 1969, Timothy Leary challenged his arrest for possession of cannabis under the Act. Leary v. United States made it to the Supreme Court, where part of the 1937 Act was invalidated as a violation of the Fifth Amendment against self-incrimination. The result was a new law, the Controlled Substances Act, passed in 1970, which criminalized the possession or sale of cannabis for federal purposes—it has remained so to this day.

The IRS Weighs In

The IRS was fairly quiet about the taxation of cannabis until 2011 when it made clear that it would disallow expenses for medical dispensaries. The justification? Section 280E of the Tax Code which states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

In 2015, the IRS indicated it might be softening. As the popularity of cannabis increased, IRS Memorandum 201504011 took another look at the tax deduction question. The memo didn’t reverse course on the issue of the deductions but it did suggest that, by looking at section 263, careful consideration as to the characterization of certain activities might result in legitimate reductions in tax.

Today, for the most part only the cost of goods sold is deductible for cannabis businesses for federal tax purposes. In most cases, traditional business costs, like employee payroll and marketing, remain non-deductible. The result can be an effective tax rate of between 40% and 70% for cannabis-based businesses.

A New Day At IRS?

In 2021, the IRS took steps to resolve confusion—and lost tax dollars—by addressing tax implications for the cannabis industry. Today, the IRS maintains a cannabis industry page on its website with a focus on section 280E, income reporting, and cash payment options. The latter is a serious concern for the industry since banking regulations can make it challenging to be an unbanked industry—remember, cannabis is still illegal for federal purposes, which typically limit banking options.

State Cannabis Taxes

While the feds continue to grapple with the challenges related to an industry that is not legal, state coffers have benefited from legalization. According to the Urban Institute, eleven states collected cannabis tax revenue in all 12 months of fiscal year 2022. Those revenues totaled nearly $3 billion, ranging from $28.9 million in Alaska to $774.4 million in California—not including local or general sales taxes.

As of February 2023, 19 states have levied a recreational cannabis tax. Maryland and Virginia will join the list soon—those states have legalized recreational marijuana but have not yet begun taxing sales.

As more states make recreational cannabis legal—in some states, it’s only legal for medical purposes—expect to see more questions about taxes. As with sales taxes, there is no unified tax treatment across states—each state designs its own system. It’s not only what gets taxed, and at what rate, but the “how” that can vary. Some states, like New York and Connecticut, use a potency-based tax per milligram. Other states tax based on weight. Still others may impose an ad valorem—meaning based on value—tax on the retail sales price.

When it comes to creating a cannabis tax, there are several issues to consider—including whether the tax is sustainable. As more states open markets, prices can swing wildly, resulting in varied revenue streams. Governments prefer the opposite—dependable revenue streams—because they make budgeting easier.

Change Is Certain

There’s no question that the industry will continue to change—and state and local tax laws are bound to follow suit. What’s more unclear is how the federal government will respond—both in terms of regulations and taxation.