As marijuana businesses have been legalized in many states (24 at last count), the issues of how they can report their income and pay their taxes are relevant to more tax practitioners than ever before.
Marijuana is classified as a Schedule 1 drug under the Controlled Substances Act (CSA), which is the statute prescribing federal U.S. drug policy. Under the CSA, the manufacture, importation, possession, use and distribution of certain substances is regulated. Thus, for federal purposes, the sale of marijuana is an illegal business. This position has been substantiated in the Tax Court and affirmed by the Ninth Circuit Court (Olive, Martin, (2012) 139 TC 19, affd (2015, CA9)).
For tax reporting purposes, the big stumbling block is IRC Sec 280E, which was passed in 1982 during the Reagan administration and which prohibits deductions or credits in connection with the trade or business of trafficking in illegal drugs. This prohibition applies even if the sale of marijuana is permitted under state law.
Thus, taxpayers in the business of selling marijuana cannot reduce their taxable income through either related deductions or credits.
However, while related business expenses, such as those otherwise allowed under Sec 162, are not deductible, cost of goods sold (COGS) is allowed. This is because IRC Sec 61(a)(3) provides that “gross income” includes net “gains derived from dealings in property,” and this property includes controlled substances produced or acquired for resale. These “gains derived from dealings in property” refer to gross receipts less COGS, or the adjusted basis of merchandise sold during the taxable year. This result is necessary to conform to the language of the 16th Amendment to the US Constitution, which gave Congress the authority to tax “income” but not “gross receipts.” When property is sold, only the gain from the sale is income. Gain is well recognized as gross receipts (gross sales price) less the basis (cost) of the property sold (see Section 1.61-3 (a) of the Income Tax Regulations; Sec 1001 (a), Sec 1011 (a), and Sec 1012 (a)); and S. REP. NO. 97-494 (Vol. I), at 309 (1982)). The Senate bill was adopted in conference (CONF. REP. NO. 97-760, at 598 (1982), 1982-2 C.B. 650).
Cost of Goods Sold (COGS) – For a business selling marijuana, COGS clearly includes the cost of the marijuana itself. What else might COGS include? Advice from the IRS Chief Counsel (20150411 (12/10/14)) provides some guidance for determining COGS in this situation, as summarized here:
When Sec 280E was enacted in 1982, an “inventoriable cost” was a cost capitalized to inventories under Sec 471 and its regulations. Thus, for example, a marijuana reseller in that era using an inventory method would have capitalized the invoice price of the marijuana purchased, less trade or other discounts, plus the costs of transportation and other necessary charges incurred in acquiring possession of the marijuana. Similarly, a marijuana producer using an inventory method would have capitalized direct material costs (e.g., marijuana seeds or plants), direct labor costs (e.g., those due to planting, cultivating, harvesting or sorting), indirect costs as listed in Category 1 of Reg Sec 1.471- 11(c)(2)(i) and possibly Category 3 indirect costs as listed in Sec 1.471-11(c)(2)(iii).
Sec 263A was enacted 4 years after Sec 280E; it expanded the types of inventoriable costs compared to the rules under Sec 471. A reseller still is required to treat the acquisition costs of property as inventoriable. However, a reseller also is now required to capitalize purchasing, handling and storage expenses. In addition, both resellers and producers are required to capitalize a portion of their service costs, such as the costs associated with their payroll, legal and personnel functions. Thus, under Sec 263A, resellers and producers of property are required to treat some deductions as inventoriable costs. However, Sec 280E and the flush language at the end of Sec 263A(a)(2) prevent a taxpayer who is trafficking in a Schedule I (such as marijuana) or Schedule II controlled substance from obtaining a tax benefit by capitalizing disallowed deductions. If a taxpayer subject to Sec 280E were allowed to capitalize the additional Sec 263A costs, Sec 263A would no longer affect only timing and would become a provision that converted nondeductible expenses into capitalizable costs. Thus, the Chief Counsel’s office concluded that a taxpayer trafficking in a Schedule I or Schedule II controlled substance is entitled to determine inventoriable costs using Sec 471’s applicable inventory-costing regulations as they existed when Sec 280E was enacted.
Multiple Businesses – If a taxpayer selling marijuana is engaged in multiple trades or businesses, just one of which involves the sale of marijuana, only those expenses related to marijuana sales are disallowed under IRC Sec 280E (Californians Helping to Alleviate Medical Problems, Inc, (2007) 128 TC 173). However, sloppy bookkeeping practices can lead to problems in the event of an audit, so it is recommended that each business be operated separately, as the use of separate accounting for each can establish which expenses do not apply to the marijuana trade. Expenses that are shared by the businesses can be allocated by a reasonable method.
Excise Tax – Many states levy excise taxes on the sale of legal marijuana. According to a Chief Counsel Announcement (CCA 201531016), the taxpayer who pays state marijuana excise tax should treat that expenditure as a reduction in the amount realized on the sale of property under IRC Sec 164(a) – not as part of the inventoriable cost of that property or as a deduction from gross income. In addition, the CCA noted that IRC Sec. 280E doesn’t preclude this treatment because, although it prohibits deductions and credits for marijuana-related businesses, this excise tax is neither a deduction from gross income nor a tax credit.
Seized Items – A taxpayer cannot include cash or the cost of controlled substances seized by law enforcement in his or her COGS (Beck, Jason R., (2015) TC Memo 2015-149).
Banking Issues – According to federal law, banks and financial services companies cannot knowingly establish accounts with businesses that sell illegal drugs. This can lead marijuana businesses to have problems making federal deposits using the required electronic funds transfer. The business may have to make arrangements for its payroll service or another trusted third party to make electronic deposits on its behalf.
Tax Return Preparer – Another potential problem is that the Bank Holding Company Act treats accountants and tax-return preparers as financial institutions (16 CFR 313.3(i)(2)(h); 16 CFR 313.3(k)(2)(viii)) for purposes of information disclosure. Tax-preparation services are listed as financial activities in 12 CFR 225.28(b)(6)(vi) and referenced in Sec 4(k)(4)(G) of the Bank Holding Company Act. Does this fact, in conjunction with the banking Issues discussed previously, preclude an accountant or tax return preparer from establishing a business account with a business that sells illegal drugs? The answer to that question is unclear at this time.
Now that many states have legalized this fledgling industry, you can expect court challenges and perhaps even federal legislation as the business model evolves and more states legalize it.
As marijuana businesses have been legalized in many states (24 at last count), the issues of how they can report their income and pay their taxes are relevant to more tax practitioners than ever before.