Issue
Is there a business deduction for expenses incurred in marijuana related enterprises?
Related Tax Rules or Regulations
Internal Revenue Code Section 61
Internal Revenue Code Section 280E
Prior to 1982, an illegal business was able to reduce its revenue by the cost of any product it sold (Cost of Goods Sold, or COGS), as well as other ordinary and necessary general and administrative (G&A) business expenses like rent, packaging, utilities, travel expenses, and even the cost of a small scale used to weigh the controlled substances sold by the taxpayer. In 1982, the IRS enacted Section 280E which dictated that businesses that trafficked in controlled substances, as defined by the Controlled Substance Act, could no longer deduct its expenses.
However, the Senate Report providing for the change in this law clearly indicated that even a business subject to Section 280E should be able to deduct its Cost of Goods Sold. A marijuana enterprise could deduct the cost of purchasing or growing its product, but not any of its other business expenses.
Illegal income is still income and is therefore taxable under IRC § 61 which clearly states that taxable income includes revenue from all sources, illicit or otherwise. Thus, even illegal businesses under federal law are required to report all of its revenue on a tax return and pay taxes thereon. After all, this is how the law finally caught up with reputed mobster Al Capone.
Of even more importance is the fact that IRC § 280E provides that “no deduction is allowed for any amount incurred in a business that consists of trafficking in controlled substances.” Because marijuana finds itself on Schedule I of the Controlled Substances Act, the IRS has the legal authority necessary to deny the deductions of any entity or enterprise that sells the drug.
In 2002, in what is probably the most clarifying case on the issue, the U.S. Tax Court decided Californians Helping to Alleviate Medical Problems, 128 T.C. 173, (2002). In this case, the IRS denied all of the G&A deductions of a medicinal marijuana facility. The taxpayer in this case, CHAMP, convinced the Court that only a portion of its business involved the selling of marijuana, while the rest of its enterprise was counseling customers on which type of marijuana was the best remedy for their particular medical issue or problem. Thus, the court held that the business expenses attributable to consulting were not barred by § 280E. In contrast, Another California medicinal marijuana facility in 2011 was denied all of its general and administrative (G&A) deductions for 2008 and 2009, and was assessed millions of dollars in taxes by the IRS.
Later in 2011, in Olive v. Commissioner, 139 T.C. 2 (2011), pursuant to § 280E, another taxpayer with a medical marijuana enterprise was denied all of its G&A deductions. Also, because the taxpayer failed to adequately substantiate its COGS, the IRS made a failed attempt to deny this deduction. The Tax Court instead determined that on industry average, a medicinal marijuana dispensary’s COGS represented 75% of its gross revenue and, contrary to the IRS position, permitted this amount as a deduction. Interestingly in Olive, the taxpayer attempted with unsuccessful results to make the same argument used in the Californians case. The taxpayer argued that it was in a business with multiple lines or facets, like patient counseling inherently different and apart from selling a controlled, illegal substance.
After Olive, it seem clear that it would be difficult for any medicinal or recreational facility to achieve the same result that CHAMP did in the Californians case.. On the other hand, Olive made clear that marijuana facilities are entitled to a deduction for their COGS. This is a clear signal to the industry that marijuana businesses should maximize their COGS while minimizing the G&A expenses that would be denied by § 280E. However, making the calculation as to what costs are related to COGS and which are G&A expenses correctly under the law is a tricky proposition that requires expert legal tax advice.
If you have questions about the deductibility of expenses for any type of business, call THE TAX EXPERTS AT THE Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
