In mid-May, Treasury Secretary Mnuchin told the Subcommittee on Financial Services and General Government of the Senate Appropriations Committee that cannabis businesses would not be eligible for Opportunity Zone (“OZ”) tax benefits. According to news reports of his testimony, Secretary Mnuchin said that the business of growing and dispensing cannabis is misaligned with the intent of the OZ program, which he appears to believe is designed to directly uplift low-income residents of distressed communities through OZ investment dollars. Secretary Mnuchin apparently believes that the business of growing and dispensing cannabis has less tangible impact on the residents of distressed communities than the building of new upscale rental units or luxury hotels.
Secretary Mnuchin’s desire to tie OZ tax benefits to investments that directly benefit low-income residents of the targeted communities is at odds both with the law itself and economic reality.
IRC Section 1400Z-2(d)(3)(A) defines the term “qualified opportunity zone business” to mean a trade or business that, among other things, is not a “private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal purpose of which is the sale of alcoholic beverages for consumption off premises.” If Congress had intended to include the growing and dispensing of cannabis in its pre-existing list of “sin businesses,” it had every opportunity to do so when the OZ provisions were enacted. Moreover, if Secretary Mnuchin believes Congress had such an intent, he could have so stated in either the October 2018 or April 2019 guidance issued by his Treasury Department. Yet, both Congress and Mnuchin chose not to make clear to investors their belief that the state-authorized growing and dispensing of cannabis is a “sin business”.
More curious is what Secretary Mnuchin did not say during his testimony before the subcommittee. Specifically, he did not mention that Congress has already expressed its belief that the state-authorized growing and dispensing of cannabis qualifies for OZ tax benefits, as long as such activities are performed by a qualified opportunity fund directly rather than indirectly through a subsidiary or lower-tier partnership.
Whether intended or not, the exclusion of sin businesses from OZ tax benefits is restricted to the activities of a qualified OZ business. A similar restriction is not applicable to business activities conducted by a qualified opportunity fund itself. In other words, investors can build a world-class golf course, race track or gambling facility in an OZ and qualify for tax benefits as long as the qualified opportunity fund undertakes the business activities directly. What legitimate social purpose could be served by providing that investors can do directly that which they cannot do indirectly?
It also is interesting that Secretary Mnuchin and others appear deeply concerned about tying OZ tax benefits to investments that directly benefit low-income individuals living in the targeted communities. Yet, when the OZ legislation was enacted, and again when Treasury was considering guidance, comments suggesting that eligible OZ investments be expressly linked to a demonstrable community benefit were ignored. There is no requirement that any OZ investment provide any tangible community benefit. The application of the OZ rules are purely mechanical without any qualitative assessment of community impact.
Finally, there are some who contend that the growing and dispensing of cannabis should be disqualified from the OZ program because cannabis continues to be illegal for federal purposes. Yet, that view willfully ignores the fact that partners in a state-authorized cannabis business continue to benefit from other preferential federal income tax provisions, including a preferential capital gains rate on the sale of an investment in a partnership growing and/or dispensing cannabis in states where it is legal to do so. Likewise, even though IRC Section 280E precludes a state-authorized cannabis business from deducting its usual and ordinary business expenses when calculating federal taxable income, there is no corresponding provision precluding a partner in such a business from reporting his or her distributive share of the gross income tied to previously disallowed business expenses as a capital loss upon the disposition of his or her interest. In fact, in cases where the partnership has no debt, a partner may even be able to report the full value of his or her positive capital account as an ordinary deduction upon abandonment of the interest.
When it comes to state-authorized growing and dispensing of cannabis, the IRC is filled with inconsistencies. Rather than off-the-cuff remarks that serve only to confuse investors and further delay investment, what is needed is a fair and comprehensive evaluation of the federal income tax consequences of growing and dispensing cannabis where it is state approved, which even Congress appears to believe is no longer a “sin."
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