California’s underground pot market continues to thrive. Is the tax man to blame?

Lanette Davies is a devout Christian, and every month when she pays her state taxes, she prays she won’t be robbed.

Davies owns Canna Care, a medical marijuana dispensary in Sacramento. Like other state-legal cannabis businesses nationwide, her pot shop operates largely with cash. Most banks won’t transact with enterprises deemed illegal by the U.S. government. That forces Davies to stuff $10,000 in bills into her purse each month, and then carefully drive to an office of the California Department of Taxes and Fees Administration.

“It is really time-consuming and it can be dangerous,” said Davies, who opened Canna Care in 2008. “I am literally carrying that cash into the tax office and dumping it on the table. They run it through a counting machine and give me a receipt.”

Owners of legalized cannabis operations face a range of challenges, ranging from state regulations to black market competition. But taxes – local, state, federal – present a particular headache. They are a big reason why, in California and other states, only a small percentage of cannabis growers and retailers have chosen to get licensed and come out of the shadows.

In a March report, Fitch Ratings suggested that California may not realize the tax revenue – $1 billion a year – the state projected when Proposition 64, a legalization initiative, was put before voters in 2016.

“While it is still too early to assess California's revenue performance, comparatively high taxes on legal cannabis will likely continue to divert sales to illegal markets, reducing potential tax collections,” Fitch said in its report.

The taxes are high, particularly in California. The state’s new law comes with a 15 percent excise tax on legally grown weed. State sales tax is then applied to consumers who purchase it for recreational purposes. On top of that, most cities have adopted their own taxes, which range from 4 to 15 percent.

Add it all up, and state-legal cannabis in some parts of California could be taxed at an effective rate of 45 percent, Fitch said in a report last year.

Some state lawmakers blame the taxation for creating a price gap between legal and illegal pot that could doom California’s regulated market. Last month, Assembly members Tom Lackey, R-Palmdale, and Rob Bonta, D-Oakland, introduced legislation, AB 3157, that would reduce the state marijuana sales tax rate from 15 percent to 11 percent, and suspend all cultivation taxes until June 2021.

Washington is one state that has seen its tax revenues increase since 2015, when it replaced its three-tier cannabis tax with a single excise tax of 37 percent. Oregon’s recreational weed rate is even lower – a 17 percent state tax plus an optional 3 percent local tax.

California’s legalization has forced state and local tax agencies to gear up for collecting payments from all-cash businesses. At the California Department of Tax and Fee Administration, officials collect the monthly taxes by arranging with licensed cannabis businesses on where and when to make their money drops. “We encourage them to set up an appointment,” said Paul Cambra, a spokesman for the tax administration.

Cannabis businesses are also in a bind with the Internal Revenue Service. In 1982, Congress amended federal law to prohibit businesses trafficking in controlled substances from claiming normal business expense dedications. The code change was aimed at cracking down on cartels and organized crime trying to masquerade as legitimate businesses.

Two decades later, the IRS started using this obscure code – known as 280E – to go after state-legal medical marijuana dispensaries in California, Colorado and other states. Businesses compliant with the code had to pay an effective tax rate of roughly 70 percent.

Canna Care become one of the targets. Following a set of audits for 2006-08 tax returns, the dispensary was ordered by the IRS to pay the federal government $2.6 million in deductions it claimed for employee salaries, rent and other expenses.

In the weed world, Canna Care suddenly became a cause célèbre. Newspapers reported on how the federal government was going after a family shop “renowned for doling out buds with bibles.” In 2014, the dispensary went to U.S. Tax Court in San Francisco, challenging the IRS’ use of the 280E code. It lost. It has since appealed that ruling, but its chance of prevailing are not clear.

Davies said she incorporated Canna Care with her husband in 2005 after he and one of their daughters were stricken with bone diseases. The shop operates out of a north Sacramento business park, and now serves about 3,000 to 5,000 customers a year, with annual sales of $1.5 million, she said.

Davies fears the IRS – which has declined to comment – may ultimately force her out of business. Until then, Canna Care plans to keep fighting, she said, as are other dispensaries that have been taken to tax court.

“It is in God’s hands,” said Davies. “We opened this up as a ministry. We are a Christian organization. So if it goes against us, we just have to have faith. If they close me, they close me.”

For cannabis business owners, the choice of “going legit” is fraught with financial and legal uncertainties. The cost of their product spikes by getting licensed and paying state and local taxes. But it also provides some level of state protection. Paying federal taxes forces these enterprises to a 70 percent tax rate, but avoiding the IRS exposes them to charges of tax evasion, which the FBI used to take down Al Capone.

David Feuerstein, a New York lawyer who represents several state-legal cannabis businesses on the West Coast, said he advises his clients to fully comply with state and federal tax laws.

“Obviously, it is important to keep these companies in good standing,” said Feuerstein. “Being compliant is the best way to keep the federal government from bothering you right now.”

Yet even lawyers who represent state-legal marijuana businesses face financial risks. Sacramento lawyer Khurshid Khoja recently lost his two bank accounts with Umpqua Bank, after Umpqua started asking him about his state-legal cannabis clients.

Umpqua hasn’t commented, but the bank was apparently concerned about federal sanctions if its deposits were found to be tied to trade in controlled substances. Khoja says the bank’s action sends a chill over the entire legal profession, given that lawyers often represent clients accused of crimes. But he acknowledges he’s not the first lawyer with state-legal cannabis clients to lose his banking privileges.

“I definitely have had colleagues in the bar who have had similar experiences,” said Khoja, a principal in Greenbridge Corporate Counsel. “Some of the most prominent attorneys in the field have had to deal with this nonsense.”

Congress could resolve the issue by passing the SAFE Banking Act, legislation that would free banks to conduct business with state-approved marijuana growers and retailers. But as McClatchy reported in February, the GOP-led Congress has sidelined the legislation, which is unlikely to pass without a big shift in the House and Senate.

The cannabis industry was also hopeful that Congress would eliminate the 280E code in its recent federal tax legislation. That didn’t happen, although the tax law was changed in a way that could benefit some state-legal cannabis businesses, especially those that are “C Corporations.”

While it may be a pipe dream, Davies is optimistic that President Trump may work to decriminalize certain cannabis businesses, especially those involved with medicinal marijuana. Trump said as much on the campaign trail, before he appointed a well-known marijuana foe, Jeff Sessions, as Attorney General.

A registered Republican, Davies said she was outraged when U.S. attorneys during the Obama administration prosecuted several medical marijuana businesses before backing off during Obama’s second term.

“We had eight years of Democrats who could have dealt with this, but didn’t,” said Davies. “At least with Trump – as crazy as some of the things he does – he has said he understands the medical side. That gives me some hope.”

Stuart Leavenworth: 202-383-6070, @sleavenworth