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Tax Issues Related to Marijuana Business Operations

23 states (including the District of Columbia) have legalized some form of (medical) marijuana distribution and use, 4 of which (Colorado, Washington, Oregon and Alaska) have, to varying degrees, decriminalized the recreational use of marijuana.  However, it remains a crime under federal law.

  1. Businesses that traffic in marijuana are prohibited under IRC §280E from deducting their trade or business expenses (but not costs of goods sold).
  2. The legal ramifications for persons who lease space or provide services to businesses that sell marijuana remain largely unclear.

Possession and Trafficking of Marijuana

Federal statutory schemes that are being used to regulate marijuana business include:

  1. the Internal Revenue Code (“IRC”); and
  2. the Bank Secrecy Act (“BSA”).

Internal Revenue Code

Businesses which are illegal under federal law are still obligated to pay federal income tax–IRC §61(a) does not differentiate between income derived from legal and illegal sources.

Generally, businesses are allowed to deduct ordinary and necessary expenses incurred in carrying on a trade or business under IRC §162(a).  However, IRC §280E provides that “no deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances.  Since marijuana is listed as a Schedule I controlled substance under the Controlled Substances Act, the IRS’ position is that IRC §280E applies.

IRC §280E was precipitated by the 1981 Edmondson[1] case, where the Tax Court allowed a drug dealer to deduct costs of goods sold, packing costs, and phone, car, and home office expenses.  Based on the pervading public opinion at the time, Congress created IRC §280E to deny persons trafficking in controlled substances the right to deduct business expenses, but explained that the disallowance of those deductions did not preclude a deduction for the cost of any of the goods sold.  Possibly more significantly (as we shall see in the CHAMPS case), IRC §280E does not preclude the deduction of expenses attributable to a legal trade or business merely because the taxpayer is also involved in trafficking in a controlled substance.

With respect to the cost of goods sold, on January 23 of this year, the IRS issued a Chief Counsel Advisory (“CCA”) providing guidance with respect to how taxpayers can determine the cost of goods sold if they are subject to IRC §280E limitations. The CCA distinguished between the activities of trafficking and producing marijuana.  While IRC §280E clearly precludes an IRC §162 deduction for ordinary and necessary business expenses related to trafficking marijuana, the CCA allows a cost-of-sales deduction for production-related expenses.  In particular, the CCA conceded that production-related wages, rents, and repair expenses are appropriately allocable to cost of sales and can be deducted.  Marketing and general business expenses, however, remain nondeductible. Note that, since IRC §280E was enacted in 1982, taxpayers should apply the inventory accounting methods that applied at that time under Regs. §1.471.

Bank Secrecy Act

The Department of Justice (“DOJ”) has stated that various money laundering statutes, the unlicensed money remitter statute and the Bank Secrecy Act are in effect with respect to marijuana related conduct, and that financial transactions with proceeds generated by marijuana related conduct can form the basis for prosecution.  As federally insured banks are prohibited from processing funds from marijuana related businesses, most marijuana businesses cannot open and operate bank accounts (even if they are in compliance with state and local law).  Unfortunately, as many marijuana businesses are operated on a cash basis because many banks will not/cannot do business with them, substantiating expenses can be challenging.

Ethical Considerations

Although the California State Board of Accountancy has not taken an official position for CPAs servicing marijuana businesses, CPAs should be aware of an unofficial paper drafted by the AICPA which advises CPAs to be wary of offering services to marijuana businesses because they may inadvertently violate a “good moral character” rule promulgated by their state’s governing professional board.

Practitioners providing services to a marijuana business must consider the risks, including, but not limited to, the uncertainty surrounding enforcement of applicable federal laws and related IRC provisions.  In addition, CPAs should consider whether representation is covered by their professional liability insurance policy.

Of course, it goes without saying that practitioners must take precautions to ensure that representation does not result in aiding and abetting a criminal enterprise.

Ethical Considerations Regarding Tax Services

Circular 230 authorizes the Secretary of the Treasury to regulate tax professionals who practice before the IRS.  That statute requires professionals to demonstrate “good character and reputation.”  While it is unclear how such characteristics are to be defined, it is possible that a tax professional who provides assistance to a violator of federal law is not demonstrating good character or reputation.

In preparation of income tax returns, businesses subject to IRC §280E limitations may consider attaching a disclosure statement (Form 8275), providing that the taxpayer is operating in compliance with state law (and has made adjustments to account for any IRC §280E limitations applicable to the taxpayer).  Such disclosure may protect the client and the tax preparer against penalties.

Case Law and Legislation

CHAMP

In a 2007 case, Californians Helping to Alleviate Medical Problems (“CHAMP”), the Tax Court allowed business deductions for the “patient care” portion of a medical marijuana dispensary which provided caregiving services to persons with debilitating diseases.  The organization charged a fee to its members for caregiving services, which fee included providing those persons with medical marijuana as well as support groups, lunches for low-income members, hygiene supplies, counseling, massages, social events, field trips, and online computer access.

The Tax Court agreed with the taxpayer’s assertion that its primary business was the provision of caregiving services.  As such, business deductions for the caregiving portion of the business were permitted, and IRC §280E did not preclude those deductions “simply because the taxpayer was also involved in trafficking in a controlled substance.”

The CHAMP case is precedent for marijuana businesses to argue that, by engaging in a business that does not involve the sale of marijuana, the taxpayer may deduct business expenses that are properly allocable to the legal business.  Of course, the taxpayer must still adequately substantiate all expenses.

Olive

The Olive case involved a medical marijuana dispensary that did not provide caregiving services.  The dispensary had most of its business expenses disallowed because of IRC §280E.  While the court disallowed some of Olive’s costs-of-goods-sold, that was because of a lack of substantiation, not because of the nature of the expenses.

Appropriations Act of 2015

In December 2014, Congress passed the Consolidated and Further Continuing Appropriations Act of 2015 (the “Appropriations Act of 2015”), which included language barring the DOJ from using funds to prevent states from implementing laws legalizing medical marijuana.  Nevertheless, in the Olive appeal (No. 13-70510 (9th Cir. 2015)), the Ninth Circuit just recently affirmed the Tax Court’s decision despite the plaintiff’s argument that the Appropriations Act of 2015 should have precluded the government from defending the appeal.

In CHAMP the court held that IRC §280E did not preclude an organization from claiming deductions for those portions of its activities not related to its provision of medical marijuana to its members.  The issue in Olive was that the dispensary not only sold medical marijuana, but provided a” comfortable environment” for people to “medicate,” where patrons received free refreshments and counseling services.  Analogizing to the example of a bookstore offering reading areas with chairs, free refreshments and advice from staff, the Ninth Circuit said that all of Olive’s activity was related to the sale of a controlled substance, so IRC §280E applied.

The significance of the existence of a legal, “second” trade or business is that a number of medical marijuana dispensaries are selling items such as pipes, rolling papers, T-shirts, vaporizers, books, garden supplies and other items that are not controlled substances.  As IRC §280E does not apply to the income or expenses related to those products, the IRS will have to allow taxpayers to allocate the expenses between those items that are not controlled substances and disallow only the expenses that are related to the trafficking component.

Public Policy and Attitudes

When IRC §280E was enacted (in 1982), public policy was strongly anti-drug, and no state had yet authorized the sale or use of marijuana.  Evidencing that public policy regarding marijuana has changed significantly:

  1. 23 states and the District of Columbia now permit the medical use of marijuana, and 4 have legalized recreational use.
  2. According to Gallop, in 1985 only 23% of Americans supported the legalization of marijuana; by late 2013, that figure had risen to 58%.
  3. Members of Congress are constantly introducing bills on marijuana issues.  Just this year (2015), two measures related to marijuana taxation have been introduced: the Marijuana Tax Revenue Act of 2015 (H.R. 1014) and the Small Business Tax Equity Act of 2015 (H.R. 1855).

On the states’ rights side, it was in response to the National Conference of State Legislatures’ resolution asking the federal government to allow states to “set their own marijuana and hemp policies without federal interference,” which led to the passage of the Consolidated and Further Continuing Appropriations Act of 2015, which included the language barring the DOJ from using funds to prevent states from implementing laws legalizing medical marijuana.

STATES WHICH ALLOW SALES OF (MEDICAL) MARIJUANA

REGULATED MEDICAL MARIJUANA USE PERMITTED

REGULATED RECREATIONAL MARIJUANA USE, CULTIVATION, AND/OR SALE PERMITTED

 

Alaska

Alaska

Arizona

Colorado

California

Oregon

Colorado

Washington

Connecticut

Delaware

Hawaii

Illinois

Maine

Maryland

Massachusetts

Michigan

Minnesota

Montana

Nevada

New Hampshire

New Jersey

New Mexico

New York

Oregon

Rhode Island

Vermont

Washington

District of Columbia

 

[1] Edmondson, T.C. Memo, 1981-623.

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