While the legalization of adult use of marijuana is currently off the table in New Jersey, New Jersey and other states will have to contemplate taxation in anticipation of future legalization. Determining a “right” sales tax that balances revenue receipts as it serves to eliminate a black market is not an easy task.  The following article sheds light on various marijuana taxation methodologies. (For purposes of this article, local taxes are not being considered.) There are two primary ways states tax the sale of adult use marijuana products: as a percentage of the selling price, similar to sales tax, or by weight. Taxing based on sales is easier to calculate. However, prices will likely decline once the market matures (see FIGURE 1), so tax revenue will decrease as well. As well, vertically integrated businesses could manipulate markups to reduce the tax burden. The Colorado Department of Revenue’s Marijuana Enforcement Division reported pounds of flower and bud sold in 2018 as of the date of the writing of this article. They had not reported revenue.  The Average Market Rate per pound of has been reported and, as shown in FIGURE  1, decreased significantly in 2018, then started to rebound in 2019.  
Weight-based taxes are more complicated in that it requires determining the amount of the tax and when the tax is assessed.  For example, a weight-based tax could be assessed at the cultivator, processing or retail level.  At the retail level, taxes would need to be set at different rates for different types of products: flower, concentrates, edibles. When taxing edibles, how would the non-cannabis ingredients be accounted for?  When taxing tinctures, would the potency and quantity be considered? There are significantly more factors to consider when ‘weighing’ the options of a weight-based tax. History indicates that prices tend to be higher immediately following legalization; lower tax rates can encourage the legal purchase of cannabis.  When prices decline, tax rates could be increased, keeping out-of-pocket costs to consumers the same or almost the same.  If taxes are too high, whether weight-based or assessed as a percent of sales, many customers will continue to purchase through the black market.  States must also consider that when the United States de-schedules or legalizes marijuana, it is highly likely a federal excise tax will be placed on sales of the product.  This will replace the burden of Internal Revenue Code Section 280E currently burdening business taxpayers. What is the effect in dollars of taxing based on a percent of sales versus weight? To illustrate, we analyzed Colorado’s reported sales and the wholesale weight of flowers/buds sold from January 1, 2014, to December 31, 2018.  As Colorado has not yet reported weight data for 2018 yet, we used the 2017 monthly data adjusted for the year-over-year sales increase. These computations are for illustrative purposes only and are subject to the following assumptions:

• includes only the weight of sales of flowers/buds;
• assumes no markup no profit made by the cultivator, distributor, or retailer; and
• ignores local taxes.

FIGURE 2 reflects a computation of tax revenue (medical and adult use) for the first four years of legal adult use in a state with a population of 8.908 million (specifically New Jersey).  
Based on this analysis, total sales tax collected for the five years was $52.8 million greater using a weight-based tax structure of $42 per ounce compared to the 12% percent of sales tax.  Obviously, the 25% tax rate would generate more revenue – but it would likely be a less effective means of eliminating the black market.   Examples of Sales Tax on Marijuana  
As FIGURE 3 shows, the process of taxing marijuana can range from simple to complex and the amounts of tax collected can vary significantly.   Nine states (and Washington DC) do not impose their general sales tax on medical marijuana while four states (Alaska, Delaware, Minnesota, and New Hampshire) do not levy sales taxes. FIGURE 4 illustrates a sample transaction ($250 per ounce based on no markup of product and all taxes being passed through to the consumer) in both medical and adult use markets and the different amounts that would be charged to the ultimate consumer and the taxes collected.  On the medical side, the purchase of an ounce of marijuana results in a purchase price ranging from $250 to $342.50, depending on the state.  For adult use, the price paid would range from $282.50 to $360.75.  
Under the weight-based tax structure ($42 per oz), the consumer’s cost for medical marijuana would be $266.63 (the fourth lowest, with two states levying no taxes).  For adult use, the $42 per ounce tax would result in being at the halfway point compared to other states.  It is very important to realize that the price will not be the same in all states and that this example is presented for comparison purposes only. Sources: Colorado Marijuana Enforcement Division’s Market Size and State Demand for Marijuana in 2017 – Market Update (Aug. 2018) https://www.colorado.gov/pacific/sites/default/files/MED%20Demand%20and%20Market%20%20Study%20%20082018.pdf Colorado Marijuana Enforcement Division: 2016 Annual Report https://www.colorado.gov/pacific/sites/default/files/2016%20MED%20Annual%20Report_Final.pdf Colorado Marijuana Enforcement Division’s Market Demand and Size Study, July 2014 https://www.colorado.gov/pacific/sites/default/files/Market%20Size%20and%20Demand%20Study%2C%20July%209%2C%202014%5B1%5D_3.pdf https://www.colorado.gov/pacific/revenue/colorado-marijuana-tax-data https://www.colorado.gov/pacific/revenue/colorado-marijuana-sales-reports https://www.colorado.gov/Tax/marijuana-taxes-file Economic Impact of Tourism in New Jersey, 2017 – January 2018) https://www.visitnj.org/sites/default/files/2017-nj-economic-impact.pdf

The Internal Revenue Service has just released its first installment of the much anticipated proposed rules relating to Qualified Opportunity Zones (QOZ) that will help investors use a new tax incentive created by 2017 Tax Cuts and Jobs Act. QOZs are underdeveloped areas that have been certified by the federal government allowing for special tax breaks to promote investment in these nearly 9,000 U.S. regions. These proposed rules would govern investments made in QOZs to provide various tax advantages to investors in two ways. First, capital gains placed in certified opportunities zone funds will be deferred and not be taxed through the 2026 tax year, or until the time in which the investment is sold, whichever occurs first. Second, gains from these QOZ investments are “permanently” shielded from income taxes if such investments are held for at least 10 years. Otherwise, gains from the initial investments in qualified opportunity funds will be discounted by up to 15% if held for 7 years and 10% for 5 years. The proposed rules state that any type of capital gains including from marketable securities are eligible for this preferential tax deferral. Additionally, the opportunity to invest in these qualified opportunity funds is available to individual taxpayers, business entities, REITs and estates and trusts. The proposed rules also clarify how to calculate substantial improvements in the property. and The rules state that taxpayers do not need to include the value of the land for the purpose of calculating how much the law requires they spend on qualifying renovations, or refurbishments of the property. For example, if a taxpayer paid $10 million for a warehouse and land, with the building being valued at $500,000, the fund must spend at least what the building is valued, or $500,000 as opposed to the total $10 million purchase price, in renovations. This exclusion of land value for the purposes of determining substantial improvements made within a QOZ applies to both tangible property, such as equipment, and realty. This will create an increased importance as to the qualified valuations performed on property located in within the boundaries of a QOZ. Additionally, investors will have 180 days from the sale of stock or businesses to place the proceeds from those sales in opportunity funds to qualify for these tax breaks. The Internal Revenue Service (IRS) also stated in these proposed rules that funds have 30 months from when the money is placed in them to perform the required renovations. The Treasury also created a 70-30 rule that measures whether a given business counts as having “substantially all” of its assets in an opportunity zone. Under that rule, as long as 70% of a business’s tangible property is in a zone, the business doesn’t lose its ability to qualify for the tax break. In the proposed regulations, Treasury does ask for input on a couple of technical questions, such as what happens if a business abandons property in an opportunity zone and how to treat movable property, such as vehicles, that may possibly spend part of their time outside the QOZ. While these rules have provided some of the answers to questions on the minds of taxpayers, some additional items still remain unanswered.

• Will grace periods will be permitted related to the proceeds of large scale asset sales?
• Will the emerging cannabis and gambling industries will be permitted benefit from these tax advantages?
• What benefits will be able to be yielded by lessees of QOZ properties?
• Will partnerships and partners need to invest as a singular unit or if partners are permitted to invest their portions of asset sales individually into their own qualified opportunity zones?

The Treasury is expected to announce additional guidance on opportunities zones before the end of the year and are currently under review by the IRS. In the meantime, taxpayers can rely on the proposed regulations while the IRS solicits comments and considers changes in the final version. Since this is a developing area, HBK will continue to provide updates on the QOZ issue as it becomes available. Committing capital to a QOF is an option with many variables and it is a decision investors/taxpayers should weigh carefully. If there are any questions on this, please contact your local HBK team representative to discuss further. For more details or other related questions, please contact a member of the HBK Tax Advisory Group.

The IRS has recently issued proposed regulations here which clarify that the IRS is utilizing a substance over form approach for all states that are attempting to circumvent the $10,000 state and local deduction cap under the Tax Cuts and Jobs Act (TCJA) through charitable giving strategies.

Under the TCJA taxpayers are limited in their Schedule A deductions for all state and local income, sales, and property taxes such that these cannot exceed $10,000 ($5,000 for married filing separately). Prior to the TCJA there was no limitation on the amount of state and local taxes you could claim.

New York, New Jersey, Maryland and Connecticut in an attempt to fight the new $10,000 cap on state and local tax deductions, have legislation in place in an attempt to bypass this limitation. The suggested workaround for many of these states involved variations on a state and local charitable fund that taxpayers could make payments to in satisfaction of their state and local liabilities. These payments would then be re-characterized as a fully deductible charitable contribution completely bypassing the $10,000 cap on state and local deductions under the TCJA.

The IRS has now issued new rules that will block states’ attempts at circumventing this deduction cap. The IRS warned taxpayers back in May that they would be looking into state-approved maneuvers to avoid these new federal limits, especially those that involved charitable organizations and charitable giving. The proposed regulations state that whenever a charitable gift is given, if the taxpayer receives anything in return the Fair Market Value (FMV) of what you receive must not be included in your total charitable deduction. This is a well-established principal that the IRS is now applying in the context of state work around charitable funds. When a taxpayer makes a contribution to one of these workaround charitable funds, they are expecting a benefit in return, the state or local tax credit in return for their contribution. The IRS will now be looking at the receipt of these benefits as quid pro quo, and taxpayers will not be permitted to claim the full value of the deduction. The proposed regulations state that the amount that would otherwise be a deductible charitable contribution must be reduced by the amount of state or local tax credit received or expected.

For example:

If a taxpayer contributes $20,000 to a state charitable fund in lieu of paying their state property taxes, and receives a $13,000 state credit for that donation, for federal income tax purposes that taxpayer would only be permitted to deduct $7,000 as a charitable deduction. The remaining quid pro quo $13,000 is disregarded.

Additionally, if you were to receive or expect to receive a state or local tax deduction that exceeds the amount of your FMV contribution, your charitable contribution deduction must be reduced. The proposed regulations also include a de minimis provision that allows a taxpayer to disregard the value of their state or local tax credit if that credit does not exceed 15% of their payment or 15% of the FMV of the transferred property.

The IRS has also proposed that these regulations apply to all contributions made after August 27, 2018. This means the IRS may challenge contributions made before today.

If there are any questions on this or any other tax matters please contact a member of TAG.

An overview of three provisions of IRS §199A Proposed Regulations

Last week the IRS issued much anticipated proposed regulations regarding the new 20 percent qualified business income (QBI) deduction, part of the sweeping tax reform bill (the Tax Cuts and Jobs Act) passed into law in late 2017. While the deduction creates a potentially significant benefit for business owners, the language of the law left numerous questions as to its application. The proposed regulations address many of these questions, including the following three:

How will the 50% W-2/25% W-2 plus 2.5% of qualified property limitation apply to related entities?

For taxpayers with income over certain thresholds – $157,500 for single taxpayers, $315,000 for joint filers – the QBI deduction is limited to the greater of 50 percent of the owner’s allocable share of the business’s W-2 wages, and 25 percent of their share of wages plus 2.5 percent of their share of the cost of qualified property used in the business. The language of the law calls for this limitation to apply on a business-by-business basis. This was a cause of significant concern for owners of multiple businesses where wages and assets might live in one entity, and business income in another.

Business owners commonly use a related management company to pay their employees. If their operating entity has business income but no wages, will the IRS allow the related businesses to be counted together? Fortunately, the proposed regulations allow for aggregation of commonly controlled businesses. The aggregation provisions do not follow §469, but create a new method for aggregating commonly owned entities. Aggregation is accomplished through an irrevocable election made at the partner or shareholder level, not the entity level, and requires, among other things, that the same person or group of persons, directly or indirectly, own 50 percent or more of each business.

What is a qualified “trade or business” for purposes of the deduction?

To be eligible for the QBI deduction, the activity must be a qualified “trade or business.” Until the regulations were passed, it was uncertain how to define trade or business income for purposes of the deduction. For example, is rental income business income?

The proposed regulations require a business to rise to the level of a Section 162 trade or business to be eligible for the deduction. This makes it difficult for rental activities to qualify and the aggregation rules discussed above do not help. The determination must be made for each individual rental activity and will be based on the facts and circumstances, including the owner’s involvement in the day-to-day operations, type of rental activity and number of rented properties. The regulations do allow self-rental income to be included in qualified business income eligible for the deduction.

What are specified service trades or businesses (SSTB) not eligible for the deduction for taxpayers with income over the threshold amounts?

The QBI deduction is not available for SSTBs, unless the taxpayer’s income is below certain thresholds. The law pointed to Section 1202 for the definition of SSTBs, which includes the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment management, trading, and dealing in securities. While not all situations are addressed, the regulations provide a more detailed definition of what is meant by the performance of services for each of those practices.

The code also includes a potential catch-all provision for any “trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” However, the proposed regulations limit the application of this provision, stating it will only apply to trades or businesses where a person is paid for endorsing a product, or for the use of their personal likeness.

Note: This article is intended as a high-level discussion of three important provisions contained in the proposed regulations. Please contact HBK with questions regarding your specific tax situation.

As taxpayers have struggled to understand the effect that the Tax Cuts & Jobs Act of 2017 (TCJA) will have on their 2018 taxes, Congress and the Treasury Department have been busy working behind the scenes to draft the framework for a new tax cut package and proposed regulations that will hopefully provide some clarity to an increasingly complex tax system.

Framework for a New Tax Cut Package

On July 24th, the House Ways and Means Committee Chairman, Kevin Brady (R-Texas) released the framework of a new tax cut package – labeled Tax Reform 2.0 – that gives some insight into additional tax law changes that may be coming in the near future. The following is addressed in the framework:

Making the TCJA Tax Cuts Permanent

In order to pass tax legislation at the end of 2017, the Republican-lead House and Senate had to rely on a special legislative process known as budget reconciliation. Legislation passed through this process is not subject to filibuster (meaning that the minority party cannot block the legislation), and it only requires a simple majority vote to pass. The trade-off to using this process is that any legislation passed under budget reconciliation cannot increase the deficit after 10 years. This means that most of the provisions of the TCJA are set to expire after 2025.

The Republicans used budget reconciliation to pass tax reform quickly, and now they are on a continuous campaign to try to make the changes permanent. The framework argues that permanency will provide “certainty for our families, workers, and Main Street small businesses while unleashing even more economic growth in America for the long run.” This seems rather unlikely since the Democrats, in general, do not appear to support making the cuts permanent.

Promoting Family Savings

Problems with the social security system have lead to an increased focus on other methods of promoting savings across the country. The framework focuses on the following savings accounts:

1. Retirement savings – the framework indicates that Tax Reform 2.0 will help small businesses provide retirement plans for their workers, and will help employees participate in those plans. In addition, the framework indicates that changes will be made to allow families to use their retirement accounts to pay for the costs of welcoming a new child – whether by birth or adoption – into the family.

2. Universal Savings Account (USA) – the framework introduces a new savings account that it claims will be a “fully flexible savings tool for families.”

3. 529 Education Accounts – the framework indicates that these types of accounts will be expanded to pay for apprenticeship fees to learn a trade, homeschooling costs, and to help pay off student debt.

Spurring New Business Innovation

With the United States no longer in Bloomberg’s list of top 10 most innovative countries in the world, Congress is looking for ways to increase innovation across the country. The framework indicates that Tax Reform 2.0 will introduce expanded benefits to help new businesses write off more of their initial start-up costs, and to remove barriers that may inhibit growth.

Brady hopes to move forward with a committee vote on draft legislation this coming September, though the actual legislation may change significantly as members of Congress continue to lobby for their own ideas. The November midterm elections may also have an impact on the final legislation that is put up for a vote.

Proposed Regulations

As Congress continues to focus on new legislation, the Treasury Department has been focused on providing guidance for various provisions of the TCJA. One area of the new tax law that needs clarification is the new 20% pass-through deduction. Proposed Regulations were originally slated to be released in June, but that date has been pushed back.

On July 25th, a draft of the proposed regulations were delivered to the Office of Management and Budget’s Office of Information and Regulatory Affairs. Since the regulations are listed as “economically significant,” they qualify for an expedited 10-day review. Hopefully this means that we will see the proposed regulations soon.

At HBK, we strive to keep you informed of major developments and changes to the tax code. These changes may have a significant impact on current business operations and year-end planning. We encourage you to reach out to your CPA to see what impact these developments may have on your tax situation.