Businesses in a few States are legally cultivating and selling marijuana. States like California, have legalized marijuana for medicinal use, while other states like Colorado and Washington have legalized marijuana for recreational use. There are businesses sprouting up all over the country as the new gold rush is on. This time, it is for people in the marijuana business. However, the problem is that the Federal Government still recognizes marijuana as a controlled substance. In this article, we will discuss the challenges of being in the business of marijuana.
Since the Federal Government classifies marijuana as a controlled substance, and the cultivation and sale is prohibited, legal marijuana companies cannot open bank accounts. Their entire business is done in cash. They receive cash, have armed security, and they store cash at different places. The money they spend is all in cash, and the recordkeeping requirements are burdensome, because these companies have to keep receipts for all transactions. Further, in a business that is all cash, it is hard to trace what income and expenses are. Not to mention that an all cash business promotes things like skimming off the top, which can promote other illegal or criminal behaviors in an already controversial industry. These businesses cannot open bank accounts because the Federal Government does not allow money received from an illegal source to be deposited into the Federal Reserve Banks. This is an issue that needs to get cleaned up.
The next set of problems is a tax problem. Since the cultivation and distribution of marijuana is illegal, when it comes time to file a tax return, anyone in the marijuana business has to report all of their income, however, they cannot deduct ANY of their expenses.
Internal Revenue Code
280E Expenditures in connection with the illegal sale of drugs.
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 (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.
There have been challenges to the United States Tax Court, and in decision after decision, the Tax Court has upheld IRC §280E. The problem is that in the State in which these businesses are established, they are legitimate businesses. They are issued permits from the states to grow and sell marijuana. They do it out in the open. They have store fronts, and operate just like any other business. They produce income, and in order to receive that income, they have expenses, just like any other business. The problem stems from the Federal Government continuing to classify marijuana as an illegal controlled substance, which means that the sale, and cultivation of the substance are banned.
Yesterday, the Office of Professional Responsibility Director Karen Hawkins, issued a statement that in early 2015, the IRS will issue guidance to tax professionals on how to deal with clients in the marijuana business. She said: “I’m going to stay away from the controlled substances issue and focus on what the tax courts have said, so cost of goods sold is in play, but anything else that’s in play is going to depend on whether it’s part of the trade or business of cultivating or sale, or whether it’s a subsidiary trade or business that just happens to have a connection.”
You heard that right. So cultivating and trade are off the table, which means that in order to deduct expenses, marijuana businesses often have to get creative, by offering other services or products that while may be related to marijuana, are not directly linked to the cultivating and trade of the substance itself.
Under current law, IRC §280E allows marijuana dispensaries to deduct only their cost of goods sold — all other normal and ordinary business expenses are rejected by the IRS, including marketing, training, transportation, meals and entertainment, and a host of other big-ticket expenses.
In 2007, the United States Tax Court heard the court case of Californians Helping to Alleviate Medical Problems Inc. v. Commissioner of Internal Revenue. The 2007 court case opened the door for the current business diversification trend, when the U.S. Tax Court in Californians Helping to Alleviate Medical Problems Inc. v. Commissioner of Internal Revenue — called the CHAMP case — allowed a California medical marijuana dispensary to allocate almost 90 percent of certain expenses to the non-marijuana aspects of its business.
In the CHAMP case, the U.S. Tax Court rejected the IRS’s argument that once a business begins selling marijuana, all of its business deductions and credits are barred. Instead, businesses could possibly allocate some expenses to non-marijuana revenue streams.
Another popular technique to reduce a dispensary’s tax burden is to use the IRS’ own regulations against it, when capitalizing indirect costs and allocating them to deductions for cost of goods sold. Under cost of goods sold, there is guidance from the IRS that says you have to capitalize your indirect costs in relation to your inventory, like accounting and professional fees, and that’s what accountants for some marijuana businesses are promoting to their clients. A lot of dispensaries are capitalizing certain ordinary and necessary business deductions in relation to their inventory.
Marijuana businesses are scrutinized a lot by the IRS, when then leads to IRS audits. In the audit, the IRS will state that the use of the cost of goods sold loophole is incorrectly applied, and disallow a lot of expenses of those in the marijuana business. The use of these certain tax deduction tactics will sometimes lead to an IRS appeals conference. Although more expensive for the client to hire a professional to take the case to appeals, those in the marijuana business are seeing good results from these appeals.
The IRS will typically settles tax disputes over 280E issues with marijuana dispensaries, because it’s in the federal government’s best interest to continue collecting money from the industry. Ultimately, if the IRS asserted the full letter of the law in their interpretation of 280E, they would bankrupt an entire industry and kill a big revenue stream.
This is all fine, but we as practitioners need some real guidance, so the press release from the IRS yesterday is welcome news to practitioners that have clients in the marijuana industry. Guidance will be something that we can hang our hat on and go to, so that we can properly advise our clients.
This is one area where the States and the Federal Governments need to get on the same page.
Reference: Whitney S. Boan Protecting Your Rights