This Court Ruling Has the Potential to Crush the Marijuana Industry

Source: Flickr user Mark.

Can anything slow down the marijuana movement?

Over the past 19 years we've gone from exactly zero states having legalized the distribution of marijuana for medical purposes to 23 states and counting that now allow marijuana to be prescribed by physicians to treat various end-of-life ailments (e.g. terminal cancers) and chronic conditions such as glaucoma. Within the past three years we've also seen four states (and Washington D.C.) pass legislation allowing for the legal sale of recreational marijuana.

Marijuana has multiple appeals, depending upon who you ask.

For the consumer, it represents freedom from federal laws, while for the sick it's an opportunity to receive therapy which could improve symptoms. Marijuana is currently being studied in a handful of disease indications ranging from type 2 diabetes to epilepsy.

For individual states, marijuana represents an opportunity to generate revenue through taxation, which could help to fill in budget shortfalls. Education is of particular interest for most states, with Colorado voters, for instance, going to the polls soon to decide whether the $58 million in collected marijuana tax revenue should be refunded to the states' growers and citizens, or if it'll primarily be put toward funding education.

Source: Flickr user Phil Roeder.

Marijuana meets its match But earlier this month we learned that there very well may be something more powerful than the marijuana movement that could halt its growth: the Federal courts.

On July 9, 2015, in the case of Olive v. Commissioner, San Francisco's Ninth Circuit Court of Appeals upheld U.S. tax code section 280E which states that expenditures in connection with the illegal sale of drugs don't qualify for any deductions or credits. What this means is that marijuana-based businesses aren't able to deduct ordinary and necessary business expenses, and are thus being taxed on 100% of their gross profit as opposed to net profit.

As Forbes notes, even medical marijuana industries are running into a classic Catch-22. Either they avoid reporting certain gross profits to lower their tax bills and risk being prosecuted for tax evasion, or they report every cent of non-deductible gross profit and risk being prosecuted for selling a drug that's still considered to be illegal by the federal government.

Source: Flickr user Calgary Reviews.

The catch here is simple to understand: even if individual states pass laws legalizing marijuana and try to set up as friendly a business environment as possible for the marijuana industry, federal tax laws will continue to supersede state tax laws. Unless the IRS makes a change to Section 280E, there's veritably no way around paying taxes on gross profits for marijuana businesses -- and that could be devastating news.

Having to pay taxes on gross rather than net profits threatens to seriously eat into the profit margins of marijuana shops, and could threaten their ability to expand or even purchase new product. Seeing other marijuana businesses struggle to hang onto their profits may also deter consumers from applying to open their own shops.

Section 280E could also be a factor that banks use when determining whether or not to make loans to legal marijuana businesses. If marijuana businesses are unable to hang onto a significant portion of their profits because of the U.S. tax code, any loans to the industry could come with a markedly higher lending rate than ordinary businesses would receive.

One possible way around this for legal marijuana shops is to deduct expenses from clearly defined separate businesses. Medical marijuana shops, for example, can deduct expenses if they have separate care-giving businesses. Rent and other expenses may prove deductible, too, if the separate business activities dominate the medical marijuana practice. But without a second business, marijuana shops are exposed to the full brunt of the U.S. tax code.

The obstacles are mountingSadly for marijuana proponents, the Court of Appeals' decision to uphold the U.S. tax code represents just one of a series of obstacles to the marijuana industry.

Source: MyFuture.com via Flickr.

Financing could prove to be just as troublesome for marijuana shops. Most banks and credit unions are unwilling to lend to legal marijuana shops because they have one of two fears. Either they're worried that the federal government could prosecute them for violating the law (i.e., for laundering money, since the marijuana plant is still illegal federally), or they fear that the federal government will, at some point in the future, reinforce its superseding law over the individual state laws. If the federal government did so, it would likely wipe out legal marijuana shops' ability to repay their loans. Also, without a working relationship with banks, some customers are unable to use credit or debit cards to purchase marijuana in legal shops.

Legislation has been proposed in Congress to remove the federal government's ability to prosecute banks for providing banking services to the marijuana industry, but nothing has gained substantial traction.

Another problem is that the marijuana industry (in a commercial/legal sense) is so young that it doesn't quite have a grip on the dynamics of supply and demand yet. In Washington, where marijuana has now been sold legally on a recreational basis for the past year, 13.5 million tons of marijuana flowers were harvested. Unfortunately, only 10 million tons wound up being purchased by consumers. Some of the excess can be used for extract purposes, but a substantial portion of the excess marijuana flowers will go to waste. This excess supply has led to a roughly 70% plunge in marijuana prices on a per-gram basis within the state. As I noted last week, falling marijuana prices are great for the consumer, but for marijuana businesses that are being taxed up the nose it's unwelcome news.

Source: White House on Flickr.

And, of course, there are ongoing political roadblocks -- namely that lawmakers are in no rush to change federal marijuana policies. A vast majority of presidential candidates have taken a wait-and-see approach until clinical benefits data surrounding marijuana research has time to mature. Incidentally, while President Obama has acknowledged the potential importance of marijuana research and is eagerly watching the "experiments" being conducted in four recreation-legal states at present, he also encourages the young people of America to focus on more pressing issues other than marijuana. Translation: marijuana is not a priority of the current administration.

Keep your money far, far awayThe Circuit Court of Appeals' ruling coupled with a growing number of headwinds simply reconfirms what I've been saying for months now: marijuana appears to be a dangerous and unnecessary investment.

The allure is certainly there. The marijuana industry could be worth $35 billion, based on estimates from Greenwave Advisors, if the federal government legalized the drug across the board. If this were to happen, marijuana would become the best-selling legal drug in the United States, and it would represent an enormous opportunity for investors.

The problem here is that the timeline for the federal government softening its stance on marijuana is entirely unknown. It could be a year, a decade, or never! Without any concrete evidence to suggest that marijuana businesses have long-term staying power, my suggestion remains to keep your money far, far away from this industry.

The article This Court Ruling Has the Potential to Crush the Marijuana Industry originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.