Harvesting Highs but No Relief for the Lows: the Inconsistent Treatment of Marijuana Businesses by Bankruptcy and Tax Law

• Citation: Vol. 36 No. 2
• Publication year: 2020

Harvesting Highs but No Relief for the Lows: The Inconsistent Treatment of Marijuana Businesses by Bankruptcy and Tax Law

Lauren Timlin

HARVESTING HIGHS BUT NO RELIEF FOR THE LOWS: THE INCONSISTENT TREATMENT OF MARIJUANA BUSINESSES BY BANKRUPTCY AND TAX LAW

Abstract

Despite marijuana's varying levels of legalization in thirty-three states, the U.S. federal government still regards marijuana cultivation and distribution as federal crimes, leading bankruptcy courts to deny marijuana businesses the benefits of bankruptcy for fear of aiding the illegal activities.

Courts have historically prioritized protecting the bankruptcy trustee from federal prosecution over allowing creditors and debtors access to the intended benefits of the Bankruptcy Code. Court interpretations of the Controlled Substances Act and what constitutes illegal activity continue derailing marijuana businesses' attempts at repaying creditors through bankruptcy.

While Congress remains stubborn in recognizing marijuana businesses as legitimate sources of income for bankruptcy purposes, it has not hesitated in recognizing that very same income as taxable under the Internal Revenue Code.

This Comment argues that courts should change their approaches to bankruptcy for marijuana businesses and ultimately proposes a hybrid solution involving bankruptcy and tax laws as avenues for relief for the debtor, creditor, and trustee in marijuana bankruptcy cases.

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INTRODUCTION

The United States Bankruptcy Code (Code) exists to provide financial relief for debtors and protection to creditors who made failed investments. Despite this overarching purpose and the growing legality of marijuana on a state level, bankruptcy law as it currently exists does not allow individuals involved in the marijuana industry to take advantage of the protections of bankruptcy. This Comment will focus on how bankruptcy law's treatment of the marijuana industry as an illegal business endeavor prevents marijuana growers and dispensaries from benefiting from bankruptcy relief through chapter 11, 12 and 13 filings. More specifically, this Comment will argue that bankruptcy should be an avenue of relief for marijuana debtors facing financial distress by looking at (i) the background of bankruptcy for marijuana businesses, (ii) how court interpretations of federal laws inhibit these businesses opportunities for financial relief, and (iii) the inconsistent treatment of marijuana business income as taxable by the IRS yet inadequate to fund repayments to creditors in bankruptcy. This Comment will then propose a solution to these issues by allowing bankruptcy estate trustees to transfer to creditors tax deductions accumulated by these businesses as payment of debts, preventing trustees from exposing themselves to federal liability that would stem from distributing federally illegal assets.

Consider the hypothetical of retired Colorado resident, Buddy Kushner, who upon researching Colorado's laws regulating the marijuana industry, decides to dedicate his savings and time in retirement to cultivating cannabis to sell at his own marijuana dispensary. As a law-abiding citizen, Buddy first acquires the requisite permits and licenses necessary to legally register and operate his business under Colorado law.

Before Buddy's business becomes profitable, Buddy reaches a dangerously low point in his savings after buying a small building and all the equipment needed to grow and process the raw cannabis. In need of more capital, Buddy reaches out to friends and family for loans in exchange for an interest in his business and rents out the extra office in the building he purchased.

Colorado's high taxes on marijuana businesses and the federal government's income taxes, coupled with Buddy's inexperience as a marijuana business owner leaves Buddy overwhelmed with expenses. He decides to file for bankruptcy just two years after opening. Buddy merely wants bankruptcy protections so he can organize his finances enough to pay back creditors, while still maintaining enough of his 401(k) to maintain his modest lifestyle. However, when Buddy files his chapter 11 bankruptcy petition and plan for repaying his friends and

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family, the bankruptcy court denies confirmation of his plan, stating Buddy had filed in bad faith because any profits from his marijuana business are considered by federal laws as illegally obtained funds.

Buddy argues that he should be able to pay creditors back with the rental income he had been collecting from his tenant and his business's meager profits. He argues these funds are not illegal under federal law because the federal government had been collecting income taxes from both sources of income each year, and he kept meticulous records to prove it. His records include detailed expense reports that track all production and materials costs, as well as which loans funded such expenses.

The court denies Buddy bankruptcy relief, leaving him with legal fees that take away from the few funds he had to distribute to his creditors. His friends and family have to fight one another over who is repaid from Buddy's small pool of assets. Buddy cannot understand how the federal government collected taxes on his business's profits, his personal rental income, and his shareholder's dividends, yet deemed those incomes unacceptable for repaying creditors through a payment plan in bankruptcy.

Many marijuana businesses have found themselves in similar positions to Buddy.¹ Courts have denied conversion of a bankruptcy debtors' chapter 7 case to chapter 11 because the debtors' state-legal marijuana business was illegal under federal law, leading to what one court viewed as the debtors' failure to propose a confirmable plan in good faith as required by the Code.² Courts have also disallowed a chapter 11 debtor from using rental income to fund its payment plan because one of its building's tenants was a marijuana dispensary.³ Tax courts have reinforced taxation of these incomes by relying on section 61 of the Internal Revenue Code (IRC), stating that both business and rental incomes derived from legal and illegal sources are considered incomes subject to federal income taxations.⁴ Courts have gone a step further by enforcing taxation of a marijuana business's shareholders for both income derived as dividends from their pro rata shares of the business and the wages they had earned by working for the S corporation.⁵

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Following a brief background on bankruptcy law and its interaction with the marijuana industry in Part I of this Comment, Part II will argue how if not for courts' narrow interpretations of federal laws, marijuana businesses and farmers qualify for relief under chapters 11 and 12 of the Code. The Code's inclusion of these chapters suggests it intended bankruptcy to be an option available to all debtors who satisfy the criteria. Part III will outline how the inconsistencies between what bankruptcy and tax laws consider "income" display Congress's arbitrary agenda in treating the marijuana industry differently from other business ventures. Congress' treatment of income from marijuana businesses as illegal drug money simultaneously denies confirmation of debtors' plans to repay creditors with such income and contradicts its recognition of incomes from these businesses through the IRS's taxation of incomes gained from marijuana dealings.

Considering the possibility that Congress and the courts will be reluctant to alter their approaches to the marijuana industry, Part IV of this Comment proposes a solution that involves permitting bankruptcy trustees to repay creditors by transferring tax deductions accumulated by the marijuana businesses. By transferring tax deductions, bankruptcy trustees can avoid violating federal laws that prohibit distributing to creditors marijuana-related assets deemed illegal substances and properties under federal law.

I. Background

Though not a constitutionally guaranteed right, bankruptcy law exists to provide relief to both debtors and creditors when the risks of investments fail to pan out as planned. By definition, a debtor is incapable of repaying creditors all financial obligations.⁶ Thus, a debtor's insolvency initiates a zero-sum game among creditors to make claims on the debtor's property before other creditors do in accordance with federal law's "first in time, first in right" rule of priority.⁷

Bankruptcy laws permit individuals and businesses overwhelmed by debt to reorganize their financial obligations and the assets to pay those obligations, all while avoiding creditors' competitive attempts to collect their shares first.⁸ To prevent creditors from scrambling for relief, bankruptcy laws facilitate an organized distribution of debtors' available assets, allowing the debtor to move

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forward with their "fresh start" by substantially limiting the debts owed to creditors.⁹

The notion that bankruptcy law exists to give debtors filing in good faith a chance at a financial "fresh start" strongly supports the idea that the government is somewhat sympathetic to debtors in financial ruin, as well as creditors whose investments went south.¹⁰ The concern that creditors driven by their own interests will push out other creditors to increase their chances of being paid back in full is addressed by bankruptcy law's pausing of both debtor and creditor action towards the debtor's property with an automatic stay.¹¹ The automatic stay protects property of the estate and certain properties of the debtor from being claimed by creditors or certain other third-party lenders who might take collections into their own hands.¹² Bankruptcy offers solutions to these concerns that optimize the debtor's options for paying back debts while protecting creditors who made failed investments.

Debtors can file for bankruptcy in any of the chapters for which they qualify, but this Comment will focus on chapter 11 for marijuana dispensaries and chapter 12 for...