Section 280E - The Technical Side
The use of marijuana has been legalized in many states now. Nevertheless, marijuana is still listed as a Schedule I controlled substance under the Controlled Substance Act, and therefore, its possession, use and distribution remains a crime under federal law. Many believe that will change soon, but until it does, there are ramifications to be aware of in order to stay compliant.
The U.S. Supreme Court has ruled that the federal government has a right to regulate the sale of marijuana, even when a state’s laws permit marijuana to be used for medical purposes. This conflict between state and federal law presents those who engage in the business of selling marijuana, as well as their customers, with a predicament: Continue operating because it is legal in their state or shut down for fear of federal criminal prosecution? In addition to the threat of criminal prosecution for drug trafficking, federal authorities have used various other weapons to subdue the mmj industry. One such weapon is the Internal Revenue Code Section 280E, which stipulates:
In the few jurisdictions where one may find state-sanctioned marijuana dispensaries, these businesses have attempted to pay their fair share of taxes to the government. They attempt to pay their federal, state and local tax liabilities any other business. However, because their business primarily involves a Schedule I drug, they are denied deductions for the costs of doing business, which all other businesses can take.
Because the sale of marijuana remains listed as Schedule I drug, state-authorized marijuana dispensaries are still deemed by federal authorities to violate federal law. Therefore, pursuant to IRC § 280E, federal income tax deductions for business expenses are not available.
State taxation raises additional problems. For instance, most of the states that have legalized the use of marijuana follow the federal income tax rules, like Colorado. 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 business deductions that any other business can claim, the state governments are too in spite of the fact that these businesses operate in states that legalized the possession, distribution and use of marijuana.The practical effect of this massive tax burden makes business operations extremely difficult.
Complying with the guidance document would require any bank wishing to service a dispensary to fully audit the dispensary’s business practices as compared to similarly situated dispensaries but based upon nonexistent auditing standards. While we appreciated FinCEN’s efforts to begin the process of allowing marijuana-related businesses to receive much-needed financial services, the guidance document raises far more questions than it answers, and we question whether it will provide any relief to the industry.
However, there is currently some hope for marijuana dispensaries in two respects. First, Section 280E is limited to the sale of marijuana. Thus, if a taxpayer is engaged in selling medical marijuana and also in another business, such as aiding sick patients, the taxpayer may be able to deduct business expenses in connection with the caregiving function. There are also other workarounds regarding this line thought.
For example, in Californians Helping to Alleviate Medical Problems, the Tax Court held Section 280E did not preclude the taxpayer from deducting expenses attributable to a trade or business other than that of illegal trafficking in controlled substances, simply because the taxpayer is also involved in trafficking a controlled substance. Obviously, the taxpayer’s characterization of a deduction will not be approved automatically by the IRS if it appears to be artificial and cannot be reasonably supported by the facts and circumstances of the individual case. Substance and form are key.
Second, while Section 280E disallows any business deduction for a marijuana seller’s ordinary and necessary business expenses; and therefore, costs of goods sold (COGS), the carrying value of goods sold during a particular period are excluded from this rule.
So, 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 with the purchase of marijuana and then in future years successfully deduct these costs as costs of goods sold.
In practice, the cost of goods sold route has proven universally applicable in the mmj industry. If you need help maximizing the benefits of these methods, please contact us to help you set it up.