Tax law has not been kind to medical marijuana. Although cannabis has been legalized in 29 states and the District of Columbia for medical purposes, it remains outlawed at the federal level. As a result, it has been the subject of harsh tax treatment by Congress and the U.S. Tax Court.
26 U.S.C. 162(a) allows “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year on any trade or business” including salary and travel expenses. The statute explicitly denies deductions for activities such as bribes, kickbacks, lobbying and paying fines and penalties, but does not have any kind of blanket prohibition on deductions for illegal activities. In Edmondson v. Commissioner, 42 T.C.M. 1533 (1981), the U.S. Tax Court held that a sole proprietor’s business deductions for selling amphetamines, cocaine and marijuana were allowable under the law. The taxpayer was permitted to deduct the expenses for purchasing a small scale, packaging and telephone, and he was further allowed automobile expenses for carrying out drug trafficking. Angry about the result in this matter, Congress changed the tax code in 1982.
26 U.S.C. 280E (hereafter “Section 280E”) states “[n]o 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 (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” Marijuana and other cannabis remains a Schedule I narcotic under federal law. This change was unnoticed, obscure and unchallenged for many years because of the broad public policy of being tough on drugs and their dealers (think of the “War on Drugs” from previous presidential administrations). This was well before California became the first state to legalize cannabis for medical use in 1996, leading to several other states to follow suit.
Medical marijuana dispensaries have frequently challenged the IRS in the U.S. Tax Court over the applicability and constitutionality of Section 280E. Most of the time, the Tax Court has agreed with the Internal Revenue’s position. In Canna Care Inc. v. Commissioner, T.C. Memo 2015-206 (2015), the Tax Court rejected the argument that the medical marijuana business cannot be considered “trafficking” because it was not illegal under California law because the controlling definition is the federal version, not the state vision. It also rejected the argument that marijuana should not be considered a Schedule 1 drug. Almost all attempts to take tax deductions for selling medical cannabis have been denied.
However, there have been some partial victories for dispensaries. In Californians Helping to Alleviate Medical Problems (CHAMP) v. Commissioner, 128 T.C. 173 (2007), the Tax Court determined that if a portion of the marijuana business involved the trafficking of marijuana and the other portion focused on counseling customers on the appropriate use of cannabis, then the business may be able to take tax deductions relating to the counseling business. Many marijuana businesses since have tried to replicate this successful “multiple lines of business” holding. Yet, in Olive v. Commissioner, 139 T.C. 2 (2012), the Tax Court shot down the Vapor Room’s attempt to claim “multiple lines of business” due to the sloppy recordkeeping and the fact that allowing the patrons to lounge and use the cannabis on site free of charge did not constitute a separate business.
In Feinberg v. Commissioner, T.C. Memo 2017-211 (2017), the Tax Court confirmed that subtracting cost of goods sold from gross receipts to arrive at gross income was permissible because it is not a tax deduction. Rather, cost of goods sold is an offset to gross income for the purpose of arriving at the value of taxable income. Fortunately, the Cohan rule allows taxpayers to deduct the cost of goods sold even when records are not well keep or receipts have been lost or misplaced, so long as the amount claimed is reasonable and credible. This is a boon to many dispensaries reluctant to keep detailed records on products, suppliers and clients to shield everyone involved from potential criminal prosecution.
Absent a change in federal law, the courts do not seem inclined to determine that Section 208E is unconstitutional. Luckily, the Rohrabacher-Farr amendment (first enacted in 2014 and renewed every year since) limits the ability of the federal government to prosecute medical marijuana by prohibiting the Justice Department from spending funds to hamper state cannabis programs. As a result, most state-legal dispensaries can safely operate without fearing that federal agents will storm in and shut them down.
However, the cost of running a medical marijuana dispensary remain high. Although the business may offset gross income with the cost of goods sold, the dispensary will have to absorb the cost of salaries, travel expenses, marketing and advertising without being able to take a business expense deduction for these operations. As a result, federal income taxes may have to be paid on the entirety of the gross income minus cost of goods sold.
The dispensaries will also have to contend with state taxes as well. In Michigan, the Department of Treasury issued a bulletin early in 2018 that it expects medical marijuana card holders to pay a 6% use tax when they purchase cannabis from a licensed dispensary or a caregiver (a person allowed to grow marijuana plants for up to five patients). Since there is a perception that these transactions continue to operate under the radar of the state taxing authorities, one can expect a step-up in enforcement of the use tax in the medical marijuana arena.
Despite the chilling effect of Section 280E on the medical marijuana industry, these business owners should educate themselves on the available off-sets and exceptions available to them by law by consulting with a knowledgeable tax professional in this area. A small investment in tax and legal advice can save thousands of dollars down the road.