Medical marijuana is now legal in at least 23 states and the District of Columbia, and two of those states, Washington and Colorado, have legalized marijuana for recreational use. If you are one of the many taxpayers out there thinking about operating a medical or recreational marijuana retail store there are some unique tax consequences that you will face as you file your annual business tax return. Regardless of which State you are operating in you are well advised to retain the best tax attorney you can find to bullet proof your tax return in accordance with IRS Code 280E which disallows deductions for any amount paid or incurred in carrying on any trade or business consisting of trafficking of controlled substances which is prohibited by Federal law. Does State law conflict with IRS tax law? Stay with us on TaxView as we explore the Kafkaesque surreal and adverse tax consequences of operating a retail marijuana store in states where it is legal to do so.
Martin Olive operated a sole proprietorship in 2004 he called the Vapor Room Herbal Center (Vapor). Vapor sold medical marijuana in California, pursuant to the California Compassionate Use Act of 1996. The Vapor Room was open weekdays from 11am to 8:30pm and weekends noon to 8pm and sold nothing but medical marijuana. Vapor’s sole source of revenue was its sale of medical marijuana. Employees explained to customers the benefit of vaporizing marijuana as opposed to smoking it and helped customers operate the vaporizers. Olive filed his income tax return for 2004 and 2005 reporting sales of over $1M in 2004 and over $3M in 2005. Vapor’s Cost of Goods Sold (COGS) or how much Vapor paid for the marijuana was high. For every million in sales Vapor COGS was $900K in 2004. In 2005 Vapor’s $3M in sales had a COGS of $2.8M. In addition Vapor had normal administration costs associated with any retail business.
The IRS audited Vapor’s returns for 2004 and 2005 and the IRS disallowed all Vapor’s expenses relying on Section 280E. Based on examination of Vapor’s bank statements the IRS determined tax deficiencies for Vapor of over $600K and $1M for 2004 and 2005. Vapor appealed to US Tax Court and the Court rendered its Opinion in Olive v IRS in 2012. Judge Kroupa almost immediately points out that while numerous medical marijuana dispensaries were formed in California to dispense medical marijuana to recipients, medical marijuana is nevertheless a “controlled substance” under Federal Law.
The case did not go well for Vapor. Judge Kroupa found that Olive’s testimony was “rehearsed, insincere and unreliable”. The Court also found that Vapor’s reported revenue was substantially understated. Worse yet is that Olive did not dispute that he under-reported Vapor’s receipts. Moreover, the Court could not ascertain the actual amount of COGS even with the help and an expert Henry C Levy CPA. Unfortunately for Vapor, the Court found Levy’s testimony to be “unreliable”. The Court eventually estimated a COGS based on a percentage of sales, but at a much lower percentage than Vapor originally reported. The IRS, however, even wanted the COGS disallowed citing Section 280E. Just when the IRS was about to vaporize Vapor into a puff of smoke, the Court took notice of another California caseCalifornians Helping to Alleviate Medical Problems (CHAMP)..
CHAMP provided counseling and other caregiving services including medical marijuana. The IRS audited CHAMP and determined that all of CHAMP’s expenses were nondeductible under Section 280E in connection with the trafficking of a controlled substance. CHAMP appealed to US Tax Court. Judge Laro noted that CHAMP furnished its services at is main facility in San Francisco California where customers received medical marijuana. The IRS argued that all of CHAMP expenses where in connection with the illegal sale of drugs and therefore all expenses were nondeductible under Section 280E. The Court disagreed. Citing the Senate Finance Committee report, the Court found that COGS would be exempt from 280E in order “to preclude possible challenges on constitutional grounds.” Senate Finance Report S. Rept. 97-494 (Vol. 1). Likewise citing Champs, Judge Kroupa’s Vapor Opinion also concluded that Section 280E did not apply to Vapor COGS. Nevertheless, the Court disallowed all other expenses incurred by Vapor, even though the Vapor Room was a legitimate operation under California law, citing CHAMP US Tax Court.
What does all this mean for any of you out there who want to run a legal retail operation in a state where sale of medical or recreational marijuana is legal? First, until and if Congress changes the law, COGS may be the only deduction you are allowed for marijuana retail expense. That being said, make sure you have excellent books and records that separates out the marijuana retail portion of your business from any other retail operations you may have so all expenses can be deducted. Second, get support from State government and local tax departments on how best to set up your business so that you are not in violation of Section 280E of the IRS code. In other words, be prepared to deal with the fact that the Federal Government still views what you are doing as illegal, and make sure your COGS is well documented. Finally be prepared for an IRS audit, retain the best tax attorney you can afford, and file a bullet proof tax return with full disclosure to the Federal Government as to exactly how your deductions are not subject to Section 280E limitations. Years later if you get audited by the IRS you will be happy you did.
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Chris Moss CPA