miller nash graham & dunn llp | Winter 2015 brought to you by the tax law practice team NW Tax Wire ™ Don’t Fear the Reefer: Embracing the Nuances of Federal and State Taxation of Cannabis more than a temporary extension of trafficking in controlled substances administrative grace. Truly, the nascent legitimately under state law or otherwise recreational marijuana industry operates must report the entire proceeds from by David J. Brandon in a particularly uncertain space. the trade to the federal government david.brandon@millernash.com as taxable income. Softening the blow 503.205.2372 Federal Tax Considerations somewhat, case law establishes that such taxpayers may deduct the costs of Tax is one of the areas where the Introduction goods sold from their taxable income. marijuana industry most acutely feels In the fall of 2014, Alaska, Oregon, Thus, when determining federal tax the dichotomy between federal and state and Washington, D.C., joined Colorado consequences to a taxpayer dealing in law. Federal tax law prohibits certain and Washington as jurisdictions where marijuana, the taxpayer must answer deductions to taxpayers engaged in the recreational marijuana use is legal. three threshold questions. First, is the marijuana trade, among them state Notwithstanding the increase in the taxpayer engaged in trafficking of a taxes. The tax burden at the state level is number of states permitting marijuana controlled substance? Second, are the onerous enough, with cumulative rates use, the federal government maintains taxpayer’s expenses nondeductible in Washington reaching 75% in 2014, its stance that marijuana is an illegal because they arise from trafficking? but this creates an untenable position drug banned by the Controlled Thirdly, if nondeductible, are the for marijuana businesses because they Substances Act. Although the are subjected to federal income taxes on (continued on page 7) Supremacy Clause of the U.S. money that they already paid out to the Constitution clearly dictates that federal states. Thus, the marijuana industry has law is the supreme law of the land, and a significant phantom income problem. inside this issue in this case outlaws the manufacturing, distribution, or dispensing of marijuana Section 280E 2 For Related-Party Exchanges, anywhere in the United States, on Simple Is Better, and Other Under federal law, taxpayers may Lessons Learned From North August 29, 2013, the Department deduct ordinary and necessary expenses Central Rental & Leasing of Justice released a memorandum arising from the conduct of their trades. outlining a policy of leniency in 3 Successor Tax Liability: The Yet, to dissuade the illicit-drug trade, Hidden Costs of Business prosecuting marijuana crimes in those Congress passed IRC Section 280E, Acquisitions in the Pacific states where marijuana is legal under Northwest denying any deductions arising from state law (the “Cole Memorandum”). The the taxpayer’s “trafficking in controlled 5 Washington Goes Fishing for Cole Memorandum lists guideposts for Revenue Beyond Its Borders substances (within the meaning of the states in regulating the recreational schedule I and II of the Controlled and medicinal use of marijuana, but Substances Act) which is prohibited should not be mistaken for anything by Federal law.” As a result, taxpayers millernash.com
For Related-Party Exchanges, Simple Is Better, and Other Lessons Learned From North Central Rental & Leasing for North Central, and the QI bought $210 million in interest-free loans over the equipment on North Central’s be- the course of the 398 exchanges and half and paid Butler for the equipment believed this benefit was too great to by Jeneé Hilliard from the exchange proceeds. Butler did ignore. jenee.hilliard@millernash.com not mark up the cost of the equipment it 503.205.2505 North Central is a good reminder sold to the QI, and Butler purchased the that tax-free exchanges are allowed The words “simple” and “1031 equipment with six months’ interest- solely because of the generosity of exchange” are not often used in the free loans. When Butler received the Congress and that seeking to exploit the same sentence, but in North Central exchange proceeds from the QI, instead benefit of tax-free exchanges further Rental & Leasing, LLC v. United States , of immediately paying off the equip- than Congress intended can be risky. In 779 F3d 738 (8th Cir 2015), the court ment loans, Butler used the exchange evaluating any proposed 1031 exchange, held that North Central’s equipment proceeds for general business purposes the following general principles are exchanges (there were 398 of them) until the interest-free period expired. important to remember. were fully taxable as impermissible Although the exchanges don’t 1. Keep it simple (relatively related-party exchanges. The court’s have the hallmark stench of a related- speaking). Although some level reasoning was that the 1031 exchanges party “cash-out” exchange, the court of complexity must be tolerated could have been completed with a much nonetheless held that the exchanges in 1031 exchanges, overly com- simpler structure and that the complex were fully taxable. The court boiled plex structures are less easily and inefficient structure appeared to be down the exchanges into the following comprehended and often more solely for the purpose of avoiding the components: The day before Butler sold open to suspicion. related-party rules of Section 1031(f) of the equipment to the QI for the benefit the Internal Revenue Code. 2. Have a business purpose of North Central, Butler had an invest- (other than tax avoidance or Congress enacted IRC § 1031(f) to ment in equipment. The day after the interest-free use of exchange thwart the attempts of creative taxpay- QI paid Butler for the equipment, Butler proceeds). A business purpose ers to use related parties to circumvent had cash. The court concluded that this that is solid and can be clearly the intent of IRC § 1031 by cashing out meant that Butler had cashed out its articulated should be the driving their investments, instead of reinvest- investment in equipment. Oddly, at the force behind any 1031 structure. ing in like-kind property. Section 1031(f) beginning of the exchange Butler did prohibits tax-free exchange treatment if not have cash or equipment, and within 3. Keep your hands out of (1) related parties exchange property and 180 days after selling the equipment the cookie jar. Seeking to lever- either party disposes of the property it to the QI for North Central’s benefit, age benefits from the exchange received in the exchange within two Butler had neither cash nor equipment. proceeds, in the form of profits, years after completing the exchange, or interest, or use of the exchange The court also held that the QI and (2) the parties structure the transaction proceeds during the exchange Butler were unnecessary parties to the purposefully to avoid application of the period, stinks of constructive exchange, and that their involvement related-party rules. receipt of exchange funds or, at made the exchange unnecessar- least, overreaching that the IRS In North Central , Butler Machinery ily complex and inefficient. The court doesn’t appreciate. Company was in the business of sell- concluded that North Central or the QI ing and leasing heavy equipment. The could have purchased the equipment family that owned Butler formed North directly from the manufacturer (instead Central, and within two months of its of purchasing the equipment from formation, North Central commenced Butler through the QI) and determined a like-kind exchange program. Through that Butler was involved only so that it a qualified intermediary (the “QI”), could obtain the interest-free use of the North Central sold its used equipment exchange proceeds until the equipment to third parties and the QI held the sales loans were due. The court determined proceeds. Butler bought new equipment that Butler had likely received at least 2 | miller nash graham & dunn llp | NW Tax Wire
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