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Jonathan G. Blattmachr, Bridget J. Crawford & Mitchell M. Gans, Estate and Gift Tax Valuation of Cannabis Business Interests, 16 Trusts & Estates 22 (2022), available at SSRN.

Valuation, a process considered both a science and an art, often lies at the heart of estate and gift tax planning. In the course of settling large estates, the size and appropriateness of valuation discounts are common sources of disagreement between taxpayers and the IRS. To this already tricky terrain, in Estate and Gift Tax Valuation of Cannabis Business Interests, three estate tax experts, Jonathan G. Blattmachr, Bridget J. Crawford, and Mitchell M. Gans, add another complication: cannabis. That is, how should cannabis business interests be valued for gift and estate tax purposes? Since the ownership of such a business is illegal under federal law but legal in over 30 states, what are taxpayers to do? These questions are both timely and cry out for guidance from the IRS.

Tax law has a long history of considering the treatment of illegal income. If it were excluded from gross income, thieves and law breakers would have an unfair advantage over law-abiding taxpayers. Thus, inclusion seems necessary to avoid the absurdity of a tax code that favors illegality. As early as the 1920s, it appeared settled that gains from an illegal business could be taxed, but questions remained over embezzlement. See United States v. Sullivan, 274 U.S. 259 (1927). In the 1940s, the Supreme Court held that embezzled funds were not gross income because the embezzler had an obligation to repay, much like a debtor. See Commissioner v. Wilcox, 327 U.S. 404 (1946). But the Court reversed itself 15 years later in James v. United States, 366 U.S 213 (1961). Even with this certainty, questions have arisen at the margins in trying to distinguish the tax treatment of swindling gains from legitimate loans that sour into bad debt. See, e.g., Kreimer v. Commissioner, T.C. Memo 1983-672.

Their illegal aspect places cannabis businesses in a lose-lose position because a cannabis business owner must include cannabis gains in her taxable income, but, pursuant to Internal Revenue Code Section 280E, she cannot deduct her costs (except for certain costs of goods sold). Given these limitations and the status of cannabis as a controlled substance, Blattmachr, Crawford, and Gans are prescient in questioning the wisdom of treating income derived from cannabis sales unfavorably and, in turn, whether the quasi-legal status of cannabis business interests poses a fundamental challenge under traditional valuation principles. Value for gift and estate tax purposes is supposed to be determined with reference to a hypothetical sale between a willing buyer and seller. See Treasury Regulations Section 25.2512-1. Yet in the case of cannabis, such a sale would be illegal for federal purposes even if legal under state law. Does the disallowance of such a sale invalidate the willing buyer and seller principle for cannabis business interests?

This kind of question is hardly novel, and yet the IRS has never provided guidance to taxpayers. As discussed by Blattmachr, Crawford, and Gans, a similar issue arose a decade ago with respect to artwork by Robert Rauschenberg that combined a canvas with a taxidermied bald eagle, an endangered species that cannot be sold legally under federal law. The estate of the art dealer who owned the piece claimed that the value should be zero because it could not be sold, while the IRS claimed it was worth $65 million. The two eventually reached an agreement wherein the painting was donated to the Museum of Modern Art and no deduction was taken by the estate for the donation. This settlement still left the valuation question unsettled and the IRS has not clarified the issue since.

Thus, a larger, central problem that the authors identify is a lack of guidance from the IRS on issues where it has the ability to provide clarity. Whether this failure stems from well-documented IRS understaffing and underfunding or simply reflects institutional reluctance to wade into issues that the agency deems controversial, the IRS has left cannabis business owners guessing. Even if, as Blattmachr, Crawford, and Gans assume, the IRS would argue for full inclusion, questions remain on whether large valuation discounts should apply and whether any cannabis business liabilities can be deducted for estate tax purposes. The risks involved and the possibility of seizure by the federal government seem like reasonable factors to consider in valuing such interests, but it is an open question how the IRS would respond to such claimed discounts.

The cannabis industry, along with other illegal enterprises generating income and accumulating assets, are not going away. Nor are the related valuation questions. Blattmachr, Crawford, and Gans have uncovered a gap in the federal transfer tax system that could result in unfair taxation of one segment of business owners now operating within a quasi-legal regulatory environment. Given the booming cannabis industry, this is an essential article for legal scholars with an interest in tax policy, cannabis industry participants engaged in estate planning, and estate planning practitioners.

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Cite as: Goldburn Maynard, Flying Blind: Planning for Death when Holding Illegal Assets, JOTWELL (August 15, 2022) (reviewing Jonathan G. Blattmachr, Bridget J. Crawford & Mitchell M. Gans, Estate and Gift Tax Valuation of Cannabis Business Interests, 16 Trusts & Estates 22 (2022), available at SSRN), https://trustest.jotwell.com/flying-blind-planning-for-death-when-holding-illegal-assets/.