Update: IRS Continues To Use Anti-Drug Trafficking Tax Code Provision To Limit The Ability Of Marijuana Dispensaries to Deduct Business Expenses

As we have previously reported, despite the growing number of States (18 in total) that have sanctioned the use of marijuana in various forms, the federal government has continued its efforts to crack down on dispensaries. (Our recent articles discussing these efforts can be read here, here, and here.). In addition to prosecutions for violating federal law, federal authorities have used various other techniques in an effort to quash the burgeoning marijuana industry. One such technique disallows marijuana dispensaries from taking business deductions on their federal income taxes pursuant to 26 I.R.C. § 280E.

26 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.

Pursuant to this statute, federal income tax deductions for business expenses commonly used by small businesses (such as deductions for office rent or mortgage payments, electricity, phone and internet services) are not available to state sanctioned marijuana dispensaries because they are still deemed by federal authorities to violate the Controlled Substances Act.

In response, the IRS issued a series of letters to the Congressmen strongly refuting their position:

Section 280E of the Code disallows deductions incurred in the trade or business of trafficking in controlled substances that federal law or the law of any state in which the taxpayer conducts the business prohibits. For this purpose, the term “controlled substances” has the meaning provided in the Controlled Substances Act. Marijuana falls within the Controlled Substances Act. See Californians Helping to Alleviate Medical Problems, Inc. v. C.I.R., 128 T.C. No. 14 (2007). The United States Supreme Court has concluded that no exception in the Controlled Substances Act exists for marijuana that is medically necessary. U.S. v. Oakland Cannabis Buyers Co-op., 532 U.S. 483 (2001).

The effect of 280E can be drastic on dispensaries. According to a recent 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, beginning in 2010, IRS’s use of Section 280E to deny marijuana dispensaries the ability to deduct business expenses has come under increased scrutiny. In November of 2010, a group of U.S. Congressmen led by Rep. Pete Stark of California sent a letter to the IRS explaining that “the legislative intent, in drafting [280E], was to deny the benefit of tax deductions and credits to those who violate our laws against trafficking in illegal drugs,” not to prohibit businesses which are compliant with state or local laws from deducting business expenses. The Congressmen requested that the IRS issue a revenue ruling holding that “deductions or credits shall be allowed for amounts paid or incurred during the taxable year in the carrying on of a trade or business if the activities which comprise the trade or business are conducted in compliance with state or local law.” A copy of the letter can be read here.

The IRS’s letter concluded that “because neither section 280E nor the Controlled Substances Act makes exception for medically necessary marijuana, we lack the authority to publish the guidance that you request. The result you seek would require the Congress to amend either the Internal Revenue Code or the Controlled Substances Act.” A copy of the IRS’s letter can be read here.

In response to this letter, on May 25, 2011, Rep. Stark introduced H.R. 1985, the Small Business Tax Equity Act of 2011, which would have amended the Internal Revenue Code to allow for a deduction for expenses in connection with the trade or business of selling marijuana intended for patients for medical purposes pursuant to State law. However, the bill died in the House Ways and Means Committee and did not make it to the floor for a vote.

Thus, as it now stands, while the threats of criminal prosecution and asset seizure for marijuana distribution are undoubtedly severe, the IRS’s current interpretation of 280E could have an equally devastating impact on the industry.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of administrative law, constitutional law, regulatory compliance, white collar criminal defense and litigating against the IRS and the U.S. Department of Justice. You can reach an attorney by emailing us at contact@fuerstlaw.com or by calling us at 305.350.5690.