Cannabis Industry Tax Implications: Federal v. State Tax Law

State Conformity to Federal Provisions

 

In general, most states' income tax treatment conform to the federal income tax code regarding transactions or specific items. Advantages of state conformity to federal tax laws include simplicity of a “single” starting point and reduction of compliance costs.

 

However, certain states may apply different approaching to whether to conform entirely (or piecemeal). For example, some states may define “state taxable income” as federal taxable income plus or minus certain items, or adopt certain define terms (i.e. income, deductions) as being the same as the federal internal revenue code (IRC). Other states  may adopt a “rolling” conformity date (automatically conform to the latest version of the IRC), use a "fixed" (or static) IRC conformity date (calculate state taxable income as of a certain date), or even follow a selective approach to federal conformity by adopting only certain provisions as of certain dates.

In either case, most states acknowledge the persuasiveness of the federal pronouncements, rules and regulations, including case law interpretation, in applying state tax regarding of it being non-binding for state purposes.

When addressing issues of federal conformity, the first step is to identify the general type of conformity: (1) rolling, (2) fixed (aka "static"), or (3) selective. If it is fixed conformity, the next step is to determine whether the federal treatment being relying upon is a result of recent legislation, and whether that specific state has adopted the recent update. If selective conformity applies, the taxpayer must generally determined whether the state conforms to the applicable federal code provision.

Because there are a variety of ways to define each method of federal tax conformity, some states may fit into more than one category.

Generally, when applicable states conform to the IRC, either (1) the state tax calculation starts with federal taxable income, or (2) the state will conform to the definitions provided in the federal IRC. For example, certain state conformity issues may depend on which whether the starting point is federal taxable income before NOLs and special deductions, or federal taxable income after NOLs and special deductions.

For additional background on federal to state tax conformity, see Tax Foundation, Fiscal Fact, No.631 (Jan.2019), Toward a State of Conformity: State Tax Codes a Year After Federal Tax Reform. 

Three General Categories of State Conformity:

  • (1) Rolling Conformity:

    • Automatically adopt provisions of the IRC as enacted (i.e., on a continual basis). 

      • 21 states have rolling conformity:

        • Alabama, Alaska, Colorado, Connecticut, Delaware, District of Columbia, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Rhode Island, Tennessee, and Utah

  • (2) Fixed date (aka "static") Conformity 

    • Follow the IRC as of a certain, fixed date with additional legislative action required to update the state income tax laws to conform to the IRC.

      • 21 states with fixed date conformity:

        • Arizona, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Michigan, Minnesota, New Hampshire, North Carolina, Ohio, Oregon, South Carolina, Texas, Vermont, Virginia, West Virginia,
          and Wisconsin

  • (3) Selective Conformity: Adopt only certain IRC provisions (or as of a specific date), or make certain changes to noteworthy IRC sections.

    • 5 states have selective conformity:

      • Arkansas, California (note 1/1/2015 date of conformity), Mississippi, New Jersey, and Pennsylvania

Note, certain states do not impose corporate or personal income taxes, and as such, updates to the IRC may have no impact on state income taxation:

  • States that do not impose corporate income taxes:

    • Nevada, South Dakota (except for financial services companies), Washington and Wyoming.

  • States that do not impose personal income taxes:

    • Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington and Wyoming.

Once the type of state conformity is identified, it is often necessary to confirm what modifications to the federal base the state may require to derive state taxable income. These modifications often require [federal] tax adjustments (e.g. state income taxes paid, depreciation, dividends received, net operating losses). Regarding state tax credit implications on federal tax reporting, below outlines some key background information summarizing its impact.

Taxability Of State Credits

Refundable State Credits: Included as Income

In general for federal tax purposes, IRC § 61 defines “gross income” as including “all income from whatever source derived.” Treas. Reg.  § 1.61-1(a) provides that gross income includes income realized in any form, whether in money, property, or services. 

U.S. tax courts have affirmed this broad definition of “gross income” by noting payments that are “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” constitute taxable income unless an exception applies. See Maines v. Comm’r, 144 T.C. No. 8, 77 (Mar. 11, 2015) (quoting Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955)).

In Maines, the tax court conceded that tax credits that merely reduce taxes owed do not constitute gross income. See Maines v. Comm’r, 144 T.C. No. 8, 78. The dispute in this case was solely about the excess refundable credits available to a taxpayer once the taxpayer has already zeroed out his or her taxable income in a given year. Here, the taxpayers paid no state income taxes in 2005, 2006 or 2007 and had access to large refund payments in each of those years.

In Maines, the tax court noted that the excess refundable tax credits would have been deemed “constructively received” by the taxpayers regardless of whether the taxpayers claimed the credits in the year they were earned or carried them forward to be applied against future tax liabilities. The tax court in Maines relied on the IRC § 451 concept that a taxpayer must recognize income when the taxpayer has an unqualified right to receive immediate payment. Id. at 79 (citing Treas. Reg. § 1.451-2 and Martin v. Comm’r, 96 T.C. 814, 823 (1991)).

With respect to refundable state tax credits that are not need-based, taxpayers may exclude the value of such credits for federal income tax purposes only to the extent they offset current year taxable gain.

Tax Benefit Rule / Non-Refundable State Credits: Excluded as Income

Under the "tax benefit rule," partially codified in IRC § 111(a) provides, in part, that gross income does not include income attributable to the recovery during the taxable year of a prior tax, to the extent of the amount of the recovery exclusion with respect to the tax. IRC § 111(b)(2) provides that the term “prior tax” means a tax for which a deduction was allowed for a prior year. IRC § 111(b)(4) provides, in part, that the term “recovery exclusion” means the amount of the deduction allowed on account of the prior tax that did not result in a reduction of the taxpayer's income tax

IRC § 164(a) generally allows as a deduction certain types of taxes, listed in § 164(a)(1)-(5), that are paid or accrued within the tax year. See also Treas. Reg. § 1.164-1(a). Specifically, § 164(a)(3) provides for the deduction of state and local income taxes paid or accrued within the tax year. Additionally, § 164(a) provides for the deduction of state and local taxes not described in IRC § 164(a)(1)-(5) that are paid or accrued within the tax year in carrying on a trade or business or an activity described in § 212 (relating to expenses for production of income). 

Generally, a state tax credit, to the extent that it can only be applied against the recipient's current or future state tax liability, is treated for federal income tax purposes as a reduction or potential reduction in the taxpayer's state tax liability. The amount of the credit is not included in the taxpayer's federal gross income, or otherwise treated as
a payment from the state, and is not deductible as a payment of state tax under  See IRC § 164; Revenue Ruling 79-315, 1979-2 C.B. 27, Holding (3) (the amount of a state tax rebate credited against tax is neither included in income nor allowable as a deduction under Section 164); Snyder v. Commissioner, 894 F.2d 1337 (6th Cir. 1990). Similarly, an accrual-basis taxpayer is not required to take the value of such future tax credits into income; the credits will simply reduce the taxpayer's otherwise-deductible tax liabilities as, and if, they accrue. See Snyder v. United States, 894 F.2d 1337, 1990 U.S. App. LEXIS 1603 (6th Cir. 1990).

Whether to Include a State Credit in Income
If a state directly provides a cash payment to an individual for engaging in a specific activity, the payment generally represents income for federal income tax purposes. However, a nonrefundable state tax credit resembles a restricted cash saving from the state, which may only be applied against the state tax. And the state nonrefundable credit compensates the taxpayer by reducing state tax liability, but the taxpayer generally does not include it in income for federal tax purposes.

One reason for this application for nonrefundable state credits is that paying state tax would generally give rise to a federal deduction, so that the income from receiving the credit and the deduction from paying the tax would simply net out.

However, this may not apply in all situations. Netting may not occur if the taxpayer does not claim a deduction for state income tax purposes. Thus, a taxpayer who receives cash instead of a credit and uses it to pay the state income tax would not benefit from a federal deduction if the taxpayer claims the standard deduction, elects to deduct
sales tax instead of income tax, or is subject to the alternative minimum tax. Nevertheless, both the IRS and the courts have excluded from income the receipt of nonrefundable credits that reduce state income tax liability. The exclusion reduces potential administrative complexity.

Treatment of a Purchaser of a State Tax Credit
For the purchaser of the state tax credit, the credit should generally qualify as a property right, and its adjusted basis
equaling the purchase price. When a purchaser applies the credit to satisfy state tax liability, a transfer of the property occurs, representing a realization event. As with any transfer of property in satisfaction of a liability, the purchaser realizes gain or loss in the amount of the liability satisfied, less the allocable portion of the adjusted basis. The use of appreciated property to satisfy an indebtedness results in gain recognition, and the character of the property as a state tax credit should not alter that result.

 

State income tax credits ordinarily affect the federal income tax of the recipient by reducing the state tax liability and any corresponding federal deduction. They enter directly into the federal income tax calculation only when the taxpayer receives something more, in the form of a right to a refund from the state or the proceeds of a sale of the credit.

Cannabis / Hemp Industry: State Tax Incentive Implications

Although there is still significant federal restrictions limitations of the cannabis industry, many states have also enacted separate laws overseeing the legal grow, manufacture and use of medicinal and recreational cannabis and commercial application of hemp and its derivatives. As such, thoroughly investigating state to federal tax conformity and its impacts (e.g. § 280E limitations) is critical to reasonably determining whether your activities may be eligible for state specific tax incentives. And once determined, properly allocating its benefit for federal income tax return reporting is the next step that should be carefully considered, as mentioned above.

Cannabis companies, and affiliated operating businesses, in legal states should carefully tax plan regarding its eligibility for federal and/or state tax incentives, its implications, and around how to properly identify and document these incentives.

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