Funding tax therapy has come full circle

The tax law is used for many purposes. Chief among those is to raise revenue for government operations. But tax law also encourages or discourages certain behavior to achieve economic, social or political goals.

Here’s an example. Section 280E of the law denies any deductions for trafficking in a controlled substance. Well, that’s good, you say.

Cannabis is a Schedule 1 controlled substance. Running a cannabis business means no business deductions when reporting income.

Operators may claim “cost of goods sold (COGS).” They are taxed on “gross profit,” which the tax law says is gross receipts minus COGS.

Some people like this rule, others do not. The rule relates to a value judgment of a business that involves trafficking in a controlled substance.

You may have known about this rule — it is frequently written about in the “popular press” because so many states now have legalized the cannabis business.

Here’s one you may not have heard about. A similar punitive treatment applies to income that you earn from investments. Just regular old investments, which are legal.

As is true with many weird things, there’s a history behind this. When the U.S. first enacted an income tax, following ratification of the Sixteenth Amendment, you could deduct business expenses.

Business expenses are those paid to operate a business. By allowing business deductions, the operator is taxed only on net income. Geez, even I know that, you say.

Point taken. But the law did not allow deductions for income earned from an investment. This meant that people were taxed on gross income from investments.

Stop yawning. Let me give you an example. It’s 1935 and you are operating the Proctor and Gamble Co. This is a business. You may deduct ordinary business expenses on the P&G corporate tax return.

Your side hustle is operating a boarding house in Cincinnati for P&G employees. Rent income is reported on your personal tax return. What about expenses?

Well, Mr. Smart Aleck, you might want to think about this one before answering. Turns out, it depends on whether this boarding house of yours is a business or an investment.

If a business, expenses are deductible. If an investment, no deduction. Your 1935 boarding house is akin to a 2022 cannabis business.

Why 1935? Because in 1942, Congress stepped in to cure this potential tax problem. Proving it could run a war and change the tax law at the same time, Congress said investment expenses will henceforth, which is how they spoke then, be deductible.

Problem solved! Until 1986. In 1986, Congress said that, starting now, which is how they spoke in 1986, investment expenses could only be claimed as itemized deductions, and only if they exceeded 2% of the taxpayer’s adjusted gross income.

In 1990, Congress tweaked things a bit, adding the “Pease amendment,” named after Donald Pease, a Democrat from Ohio.

Pease created a conflict for those who made “too much money.” Investment expenses, even if they cleared the two 1986 hurdles, could be cut back for those defined investment fat cats.

Well, you say, that’s what you get when the Democrats control the House and the Senate, and George H.W. Bush breaks his no new taxes pledge.

So you prefer 2017, when the Republicans held the presidency, the House, and the Senate. As part of the 2017 tax cuts, Congress said, for a while, which is how they spoke when writing that law, investment expenses are not deductible.

Not deductible. For anyone. Rich, poor, big or little. For a while. From 2018 to 2026.

What’s the logic there?

They needed money to pass the law through reconciliation. Fewer deductions, more government revenue.

So here we are again, with investments treated like trafficking in controlled substances. What can we do about this?

We can argue that we’re running a business. Argue, I say, because the difference between an investment and a business can be muddled.

Drug traffickers can deduct COGS. Investors can deduct cost of the investment. Some investments can be reported on IRS Schedule E with deductions claimed.

But if you run into a cannabis operator complaining about the tax law, pull up a chair and tell him you know exactly how he feels.

James R. Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected].