Federal and Pennsylvania Tax Deduction Limitations on Medical Marijuana Businesses

by Cozen O'Connor
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Cozen O'Connor

The growing, processing, dispensing, and use of medical marijuana became legal in Pennsylvania on May 18, 2016, under the Medical Marijuana Act, Act 2016-16 (S.B. 3), 35 P.S. § 10231.101, et seq. (the Act). Medical marijuana organizations, however, face significant tax disadvantages in operating their businesses because marijuana remains a schedule I controlled substance under federal law. Among those obstacles, medical marijuana organizations are subject to limitations in deducting their business operating expenses — even if those business expenses are not otherwise illegal.

Federal Treatment

While medical marijuana businesses are illegal under federal law, they are still obligated to pay federal income tax because income from both legal and illegal sources is taxable. However, businesses that traffic controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) are not permitted deductions in calculating federal taxable income for ordinary and necessary business expenses.

As a general rule, to calculate federal taxable income, businesses are allowed to deduct ordinary and necessary expenses paid or incurred in carrying on the trade or business, except that they may not deduct specific kinds of illegal payments such as illegal bribes or kickbacks. IRC Section 280E provides an even broader restriction and prohibits deductions for expenses incurred as part of a business consisting of trafficking schedule I or II controlled substances, even if those business expenses are otherwise lawful. For example, rents, salaries, telephone, and transportation expenses are not deductible to businesses trafficking in controlled substances but would be deductible for other types of businesses.

Taxpayers that conduct multiple businesses may be less affected by Section 280E. If a taxpayer has two separate trade or businesses, one of which is the trafficking in controlled substances and the other being lawful, the taxpayer may deduct ordinary and necessary business expenses attributable to the taxpayer’s separate lawful trade or business. In 2007, the Tax Court held in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173 (2007) that a business that operated primarily as a caregiving business but also contained a dispensary could deduct ordinary and necessary business expenses related to its caregiving business, but it could not deduct expenses related to its dispensary.

Taxpayers that traffic in controlled substances may alleviate part of the burden of Section 280E if they choose to or are required to use an accrual method of accounting. Section 280E does not prevent accrual method taxpayers from reducing gross revenues for costs of goods sold (COGS) of illegal controlled substances. Under the accrual method, COGS, which includes inventory and production costs, is an offset to gross revenues, not a deduction and therefore is not covered by Section 280E. Cash method taxpayers, however, are prohibited from deducting expenses attributable to the costs of their inventory or production from taxable income under Section 280E.

Chief counsel’s office has interpreted the COGS adjustment to apply only to inventory costs allowable under Section 471, which was in effect in 1982 when Section 280E became the law. CAA 201504011 (Jan. 23, 2015). As a result, special rules apply in determining COGS for marijuana organizations.

Various forms of legislation have been proposed that would repeal the tax penalty under Section 280E for marijuana businesses, some of which would impose an excise tax regime on the sale of marijuana products or an occupational tax on production facilities and export warehouses.

Pennsylvania Treatment

Medical marijuana organizations subject to Pennsylvania Corporate Net Income Tax (e.g., C corporations, joint-stock associations, business trusts, limited liability companies, or other entities classified as corporations for federal income tax purposes) will face the same obstacles for Pennsylvania income tax purposes as they do for federal income tax purposes, since federal taxable income is the starting point for calculating Pennsylvania taxable income and there are no Pennsylvania statutory adjustments that would negate the prohibitions contained in Section 280E. These organizations will not be able to deduct ordinary and necessary business expenses in calculating their Pennsylvania taxable income, except as to COGS if they use an accrual method of accounting. Medical marijuana organizations that grow or sell marijuana and also provide other services in Pennsylvania, such as patient counseling, drug education, or other caregiving services, may deduct businesses expenses arising from that portion of their business.

To date, Pennsylvania courts have not addressed the deductibility of business expenses for Pennsylvania Personal Income Tax purposes by individual growers and medical marijuana organizations that are pass-through entities not subject to Pennsylvania Corporate Net Income Tax (e.g., S corporations, general and limited partnerships, limited liability companies treated as partnerships for federal income tax purposes, etc.). Based on recent Pennsylvania Department of Revenue guidance, it appears that individual growers and processors and medical marijuana organizations that are not subject to Corporate Net Income Tax (i.e., that do not calculate Pennsylvania taxable income starting with federal taxable income) should be able to deduct ordinary, reasonable, and necessary business expenses associated with the business activity. While this provides a tax benefit to operating as a pass-through entity, it is not clear what types of business expenses will be viewed as ordinary, reasonable, and necessary for the purposes of this deduction.

Conclusion

The takeaway is that while the Act legalizes medical marijuana in Pennsylvania, federal tax rules impose significant tax burdens on such businesses. For the time being, medical marijuana organizations that operate in Pennsylvania and are formed as entities subject to Pennsylvania Corporate Net Income Tax will not be entitled to deduct their business expenses in calculating their Pennsylvania taxable income. However, subject to future guidance on this issue, the current rules generally permit ordinary, reasonable, and necessary business expense deductions for pass-through entities that are not subject to Pennsylvania Corporate Net Income, and instead, calculate Pennsylvania taxable income pursuant to the provisions of the Pennsylvania Personal Income Tax.

Marijuana is still classified as a Schedule I controlled substance by the U.S. Drug Enforcement Agency, and as such it remains a federal crime to grow, sell and/or use marijuana. Any content contained herein is not intended to provide legal advice to assist with violation of any state or federal law.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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