As we have previously reported, despite the growing number of States that have authorized the use of marijuana in various forms, the federal government has continued to crack down on dispensaries. (Our recent articles discussing these efforts can be read here, here, here, andhere.) In addition to direct criminal prosecution for drug trafficking, federal authorities have used various other techniques in an effort to quash the growing marijuana industry. One such technique disallows marijuana dispensaries from taking business deductions on their federal income taxes pursuant to I.R.C. § 280E, and this statute remains in effect in spite of the efforts of numerous states and FinCEN to at least partially legitimize the sale of marijuana.
I.R.C. § 280E states:
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.
As we have previously explained, because the sale of marijuana remains listed as a controlled substance under the Controlled Substances Act (CSA), state authorized marijuana dispensaries are still deemed by federal authorities to violate federal law. Therefore, pursuant to I.R.C. § 280E, federal income tax deductions for business expenses are not available. In fact, the United States Supreme Court has concluded that there is no medical necessity defense to the federal law prohibiting cultivation and distribution of marijuana – even in states which have created a medical marijuana exception to a comparable ban under state law. U.S. v. Oakland Cannabis Buyers Co-op., 532 U.S. 483 (2001).
In the District of Columbia and the 20 states that have either decriminalized or legalized marijuana in one form or another, state sanctioned medical marijuana dispensaries have attempted to pay their fair share of taxes to the government – federal, state and local – like any other business. However, because their business primarily involves a product deemed to be criminal under federal law, they are denied deductions for the costs of doing business that any other ordinary business can take.
When it comes to state taxation, an additional problem faced by state sanctioned marijuana dispensaries is that most of the states which have legalized the use of marijuana “piggy-back” their state corporate income tax on the federal income tax. That is, after the federal income tax has been calculated based on federal law, these states will impose a tax of a percentage of the federal corporate income tax (with certain adjustments in most instances). In those cases, not only is the federal government denying the benefits of claiming certain business deductions that any other business would have, but the state governments are equally denying these tax benefits despite the businesses being situated in a state that has legalized the use and sale of marijuana.
As we have previously reported, the effect of I.R.C. § 280E can be drastic on dispensaries. According to a 2013 CNNMoney report, the inability of dispensaries to take business deductions has resulted in dispensaries paying an effective tax rate as high as seventy-five percent (75%). The practical effect of this massive tax burden makes business operations difficult, if not impossible.
However, there is currently some hope for marijuana dispensaries in two respects. First, I.R.C. § 280E is limited to the sale of (or “trafficking in”) marijuana. Thus, if a taxpayer is engaged in selling medical marijuana and also in another business, such as care-giving to health patients, the taxpayer may be able to deduct business expenses in connection with the care-giving function. See Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 14 (2007). Note, however, that “the taxpayer’s characterization will not be accepted when it appears that the characterization is artificial and cannot be reasonably supported under the facts and circumstances of the case.”Id. Second, while I.R.C. § 280E disallows any business deduction for a marijuana seller’s ordinary and necessary business expenses, costs of goods sold – that is, the carrying value of goods sold during a particular period – are excluded from this rule. To be sure, while marijuana businesses are disallowed ordinary and necessary business expenses deductions, they are allowed a deduction for the costs incurred for the purchase, conversion, materials, labor, and allocated overhead incurred in bringing the marijuana inventories to their present location and condition. Therefore, marijuana businesses have an incentive to capitalize as inventory all costs associated to the purchase of marijuana and then in future years successfully deduct these costs as costs of goods.