Sonoma County cannabis taxes on ballot could heighten competition

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On March 7, Sonoma County voters decide whether to hit local cannabis businesses in unincorporated pockets of the county with annual tax up to 10 percent of revenue. Santa Rosa plans a similar tax, slated for vote in June.

Cannabis growers and other operators who morph from illegal to legal operations and absorb tax burdens at local, state and federal levels will potentially see other operators who stay in black-market shadows gaining competitive advantages. Will they turn in competitors who shirk taxes?

That sticky business conundrum looms over the fast-growing cannabis industry now that statewide voters pushed it out of prohibition into legitimacy and created a taxation target for government.

 Federal tax law allows whistleblowers to reap financial rewards for turning someone in (see sidebar below). There is no provision like that in cannabis tax plans proposed by Sonoma County or Santa Rosa. But businesses that pay the new cannabis taxes will have a strong incentive to rat out competitors who don’t pay and thereby gain unfair market advantage. Legitimate cannabis operators may report those that remain illegal.

“Absolutely,” said David Guhin, Santa Rosa’s director of planning and economic development, who is finalizing the city’s draft cannabis tax. “It’s already happening,” Guhin said. “I’m pretty blunt about it. I’ve spoken to the Sonoma County Grower’s Alliance — big rooms of people. Our best source of information will be people who are doing it right. It’s not fair. They know the industry better than I do. It’s happening already,” he said of local whistleblowers.

“I want to have a policy in place that people can go to,” Guhin said. “I need to provide a pathway first. Let people into that pathway that want to be part of our business in Santa Rosa. Those that choose not to do that, then we’ll act. Going after people left and right while we’re still in this mode, it’s too early. We’re aware of it,” he said of operators who may want to shirk the tax.

“We’re trying to do everything we can to encourage people to come in through this process,” he said. “We don’t want to push people into the black market. If we did that, we may as well just ban it (cannabis) — the approach some cities take (such as Rohnert Park and Petaluma).”

When cities place a ban on cannabis, “all that does is encourage that black market,” Guhin said.

“It’s not easy running a legitimate business,” Guhin said. “If a person makes amazing cookies in their kitchen, to go from that to creating a store downtown to sell them is a big jump. It takes capital, business acumen, employees and payroll. You have a whole different role you are entering into. That’s what we need” in the cannabis industry. “If we are serious about providing this type of medicine and this product to our community, we want to make sure it’s done in a legitimate, fair and safe way.”

The city’s new cannabis tax will target cultivation, manufacturing, distribution and dispensaries, but not testing and transportation services.

Sonoma County’s Measure A provides draconian penalties for a cannabis operator who “fails or refuses to pay any commercial cannabis business tax required to be paid,” with a penalty of 25 percent of the tax due, plus the tax and interest at 1.5 percent for the first month. If the tax remains unpaid more than a month past its due date, Measure A adds an additional 25 percent penalty then continuing interest at 1.5 percent per month (18 percent a year). For instance, a $100,000 unpaid cannabis tax two months overdue would incur a $50,000 penalty plus the tax due and $3,000 interest for a total of $153,000. Such penalties could cripple a non-compliant cannabis operator.

Any local taxes are added to state taxes imposed by Proposition 64, passed in November, at $9 per ounce for cannabis flowers and $3.25 an ounce for trim. Then there’s the federal tax burden under IRS code Section 280e, which prohibits normal deductions or credits for businesses that traffic in controlled substances, such as cannabis. “The aggregate (tax) cost along with the other costs of compliance is very steep,” said Julie Mercer-Ingram, attorney in CannaLegal practice in Santa Rosa.

“When you have a large number of operators in rural-residential zones,” Mercer-Ingram said, “not even able to come out, add that to the cost of taxation, the cost of compliance, some people will elect not to come into the regulated marketplace. However, there are a good number of people who want to have a business that’s above-board.”

Local operators must comply with city or county ordinances, including paying taxes, in order to obtain state permits for cannabis businesses, according to Jolene Strange, board member of Sonoma County Growers Alliance and paralegal with CannaLegal. “People who want state licenses are going to go through the process. If they can find investors and property, and the means to go through the process, they will.”

Smaller operators have a harder time attracting investors. “Those people are going to have a tougher time getting into the marketplace,” Strange said.

She expects few small operators who run legitimate businesses to turn in other small operators who stay in the shadows, instead leaving that enforcement to government. “People who are trying to do it right are going to pay for enforcement against people who aren’t,” Strange said.

“It boils down to culture,” Mercer-Ingram said. “People who have been part of the culture of cannabis would rather bury themselves than turn someone in. That’s not how they operate. However, I don’t know that we can say the same for people who are looking at it purely as an industry, purely as profit margins. That is steep competition. People who are in it just for the money — I can’t say that they might not turn people in.”

Even taxpaying businesses with licenses will not be able to sell cannabis in black markets. “They will have to play by the rules and not send their product into an illicit marketplace,” Mercer-Ingram said. “You might have shades of gray that will continue for years. Pointing the finger — I can’t imagine a culture that has been so protection-minded” would generate whistleblowers.

But legal cultivators, even small operators, who see illegal growers inflict environmental damage might report that damage and trigger tax and other penalties, Strange said. “Cannabis operators are going to lean more toward turning in bad operators” where their activities put the environment at risk.

For Santa Rosa, it comes down to business fairness. “How do we create a fair playing field for all of our businesses?” Guhin said. “People that are following the rules, getting permits, spending the money, the time, the effort to get ADA upgrades, fire upgrades, things any business has to do, shouldn’t have to compete against a business that’s ignoring those rules and doing it under the table, and has a completely unfair business advantage.”

Once Santa Rosa’s cannabis tax is in place, “we can address these that aren’t playing fair,” Guhin said.

Whistleblower best practices

In the past decade, the federal government cultivated a tax-snitch program approved in 2006. The IRS entices whistleblowers with hefty rewards — 15 to 30 percent of retrieved taxes and penalties that exceed $2 million from taxpayers with gross income exceeding $200,000. Awards to whistleblowers can be up to 15 percent if they report smaller tax cheats owing less than $2 million and who earn less than $200,000.

The IRS Whistleblower Program sent its 2016 report to Congress in January. Since 2007, information provided by tax snitches reaped the IRS $3.4 billion in revenue; whistleblowers received $465 million in monetary awards. In 2016, the program tightened its grip and made 418 awards to snitches totaling $61 million, up 322 percent from total awards in 2015. Average payout to an IRS snitch last year was $146,000.

IRS Publication 5251, The Whistleblower Claim Process and Timeline, covers best practices on submitting a successful whistleblower claim for award under Section 7623 of the tax code.

Form 3949-A, called Information Referral, is used to turn in a business or personal tax cheat. Form 211, Application for Award for Original Information, is filed to seek compensation for the referral.

The referral form has a checklist for alleged violations of income-tax law including false deductions, organized crime, unsubstantiated income, corruption, false documents, unreported income and narcotics income. Non-taxpaying cannabis growers and processors could fall into several such buckets. “Do you consider the taxpayer dangerous?” asks Form 3949-A. Federal tax snitches remain confidential, though information “may be disclosed to the Dept. of Justice” to enforce tax laws.

Square foot vs. gross receipts

Sonoma County and Santa Rosa considered taxing cannabis cultivators based on gross receipts or square footage. Some growers prefer a square-footage tax scheme, said Santa Rosa’s David Guhin, planning director. “In any new emerging industry, there are ways to use a system to benefit your business model,” he said.

Growers who achieve high density with certain plant hybrids “want square footage because they can reduce their effective tax rate,” Guhin said. Other strains may have valuable medical value but lower yield per square foot. Growers of such strains benefit from a gross-receipts tax.

As the tax is imposed, “we are going to have to adjust and work with the industry,” Guhin said. “I’m going to recommend gross receipts.”

Guhin estimates first-year gross receipts of roughly $50 million in Santa Rosa and cannabis taxes near $1 million (at 2 percent). Sonoma County estimated $6.3 million in first-year cannabis taxes.

Despite sincere efforts by county and city planners, “both numbers are bogus,” said Julie Mercer-Ingram, attorney in Santa Rosa-based CannaLegal. She sees Santa Rosa’s estimate as more realistic. “Their job is really hard. When you don’t have any data about what the operations will bring in, how big they will be, how could you possibly have an estimate?”

The county “based those numbers on people they thought were going to apply for permits,” said Jolene Strange, paralegal in the CannaLegal law practice in Santa Rosa, “before they removed AR (agriculture residential) and RR (rural residential) from the equation.”

Cultivators in those unincorporated parts of the county cannot now obtain permits. Others cannot grow cannabis because of land-use setbacks. In addition, the county based its estimate on cannabis market prices that are not viable and are dropping, Strange said. “Their numbers did not match up with cannabis (market) benchmarks,” she said.

Both a gross-receipts formula and canopy-square-footage scheme are allowed for cultivators under the county’s Measure A. It specifies a 10 percent gross-receipts tax or indoor growing tax rates up to $38 a square foot, $10 for outdoor growing and $22 for mixed cultivation. The gross-receipts formula allows for reduced taxes if a grower faces crop losses due to bugs, disease or bad weather.

With the square-foot tax scheme, “unless they make it specific to just the area that’s being cultivated,” said Strange, “they are having to pay taxes on an area of their garden” that produces nothing. The entire space of a greenhouse, including walkways accessible to wheelchairs, should not be included, said Strange, who in January joined the board of the Sonoma County Growers Alliance.

The cannabis tax is aimed at production. Some cannabis manufacturing businesses “are fairly large and have a lot of moving parts,” Guhin said, including business activities that aren’t geared toward generating cannabis products. “If they show gross sales of their production,” that would fall under the cannabis tax. Other business activities such as licensing discussion can be separated and taxed under regular business taxes, typically at lower rates.