Marijuana businesses--no deductions allowed

[Number Six]

It looks like completely legal marijuana businesses are faced with up to 70% in taxes on their gross sales, because under the law they cannot deduct expenses: http://www.nytimes.com/2015/05/10/us/po ... taxes.html

[Burnaby49]

Not the case in Canada. Even illegal businesses can, if they report their income, deduct verifiable expenses.

[noblepa]

I've read that legal (at least in a state such as Colorado, that allows marijuana sales) sellers have another problem. There are federal laws that make banks liable if they knowingly accept funds from illegal activities.

Even though several states have legalized the sale and use of marijuana, it remains a federal crime, albeit one that is not enforced. But many banks, wary of running afoul of federal banking laws, are refusing to open accounts for the sellers, so many of them are sitting on small mountains of cash, with no safe place to deposit it.

[Famspear]

Not the case in Canada. Even illegal businesses can, if they report their income, deduct verifiable expenses.

In the United States, the prohibition on deduction of expenses related to illegal drug activity is found in a specific Internal Revenue Code provision:

§ 280E - Expenditures in connection with the illegal sale of drugs

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.

[LaVidaRoja]

I seem to vaguely recall that somewhere in the past 12 months, a California medical marijuana dispenser went to tax court and lost on the deductions issue. This was to set up for an appeal to the Ninth Circuit. Given that the language is specifically in the Code, the only way for the Courts to overturn it is if it gets all the way up to the Supreme Court. Meanwhile, I imagine that there is some considerable lobbying going on in DC.

[Dr. Caligari]

§ 280E - Expenditures in connection with the illegal sale of drugs

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.

Section 280E was enacted in the 1980s, IIRC. It was a reaction to a Tax Court case in which the IRS asserted a tax deficiency against a convicted heroin trafficker, who successfully argued that the deficiency had to be reduced by all of his business expenses. Congress was outraged, but should not have been; if the Code treats illegal income as taxable income, it should allow ordinary and necessary business expenses.

Section 280E applies only to "below the line" expenses; drug dealers can still deduct their cost of goods sold. The legislative history indicates that Congress believed that it would be unconstitutional to not permit deduction of COGS, because that would have made the tax one on capital, not income.

[Arthur Rubin]

For those who are interested, for the purpose of the California state income tax, even fewer deductions are allowed for "Illegal" (under California law) dispensaries, but most deductions are allowed for "legal" dispensaries.

This was a topic at the 2014 tax update seminar I attended.

(Nice to know my continuing education is going to a good cause.) And, if I had any dispensaries as clients, I would be worried about asset seizure.

[davids]

Arthur - do you mean to say you would be worried about clients' assets being seized, or the assets of attorneys representing them?

[Number Six]

Thanks for the tax analysis on the topic.

Industrial hemp is still classified as an illegal drug even though you would not see a (desirable) drug effect even if you ingested a pound or smoked the equivalent. http://en.wikipedia.org/wiki/Hemp

Probably the farmers licensed to grow it as well as the distributers are facing the same dilemma as the marijuana dispensers.

[jcolvin2]

Section 280E disallows deductions, but has generally been interpreted as allowing for the direct costs of production (costs of goods sold). Generally, the tax law has been modified over the last 30 years to require more and more in the way of the capitalization of expenses into inventory costs (e.g., Section 263A).

In Chief Counsel Memo 201504011, the IRS came to the bizarre conclusion that taxpayers are allowed to use the inventory rules that were in effect at the time (1982) when Section 280E was enacted:

ISSUE 1: How does a taxpayer trafficking in a Schedule I or Schedule II controlled
substance determine COGS for the purposes of §280E?

To resolve this issue, we will consider: (1) when and how an item becomes an
inventoriable cost; (2) what Congress intended to include within the meaning of
inventoriable costs when they enacted §280E; and (3) whether Congress changed their
definition when they enacted §263A.

To be deductible by a business enterprise, a business expense (e.g., salaries; rent)
must be “ordinary and necessary” within the meaning of §162 and must satisfy the
timing requirements of §461. Once these requirements are satisfied, the amount of that
expense is deducted in the current taxable year, unless another provision of the Code
or regulations requires this deduction to be deferred to a subsequent taxable year,
capitalized to an asset, or disallowed entirely. See, e.g., §§267(a)(2); 471(a); 263A(a);
280E. For example, in the case of a producer of property, inventory-costing rules
typically require the capitalization of costs that are “incident to and necessary for
production or manufacturing operations or processes” (e.g., §1.471-11(b)(1)) or costs
that “can be identified or associated with particular units or groups of units of specific
property produced” (e.g., §1.263A-1(e)(2)). Thus, when one of these inventory-costing
regulations applies, a producer must capitalize, as an inventoriable cost, what otherwise
would have been a deduction under §162 and must keep that cost in inventories until
the taxable year that the producer sells the merchandise. At that point, the producer
includes those costs in COGS and accounts for COGS as an adjustment to gross
receipts.

As noted above, the legislative history of section 280E states that “[t]o preclude possible
challenges on constitutional grounds, the adjustment to gross receipts with respect to
effective costs of goods sold is not affected by this provision of the bill.” When §280E
was enacted in 1982, “inventoriable cost” meant a cost that was capitalized to
inventories under §471 (as those regulations existed before the enactment of §263A).
The specific regulations are §1.471-3(b) in the case of a reseller of property and
§§1.471-3(c) and 1.471-11 in the case of a producer of property. Thus, a marijuana
reseller using an inventory method would have capitalized the invoice price of the
marijuana purchased, less trade or other discounts, plus transportation or other
necessary charges incurred in acquiring possession of the marijuana. Similarly, a
marijuana producer using an inventory method would have capitalized direct material
costs (marijuana seeds or plants), direct labor costs (e.g., planting; cultivating;
harvesting; sorting), Category 1 indirect costs (§1.471-11(c)(2)(i)), and possibly
Category 3 indirect costs (§1.471-11(c)(2)(iii)).

Section 263A increased the types of costs that are inventoriable compared to the rules
under §471, but did not revolutionize inventory costing. A reseller still is required to treat
the acquisition costs of property as inventoriable. Now, a reseller also is 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, personnel functions. Thus, under §263A, resellers
and producers of property are required to treat some deductions as inventoriable costs.
Section 263A is a timing provision. It does not change the character of any expense
from “nondeductible” to “deductible,” or vice versa. For a taxpayer to be permitted to
treat an expense as an inventoriable cost, that expense must not run afoul of the flush
language at the end of §263A(a)(2) — “Any cost which (but for this subsection) could
not be taken into account in computing taxable income for any taxable year shall not be
treated as a cost described in this paragraph.” See §1.263A-1(c)(2)(i).

Read together, §280E and the flush language at the end of §263A(a)(2) prevent a
taxpayer trafficking in a Schedule I or Schedule II controlled substance from obtaining a
tax benefit by capitalizing disallowed deductions. Congress did not repeal or amend
§280E when it enacted §263A. Furthermore, nothing in the legislative history of §263A
suggests that Congress intended to permit a taxpayer to circumvent §280E by treating a
disallowed deduction as an inventoriable cost or as any other type of capitalized cost.
In fact, the legislative history of §263A(a)(2) states that “a cost is subject to
capitalization . . . only to the extent it would otherwise be taken into account in
computing taxable income for any taxable year.” If a taxpayer subject to §280E were
allowed to capitalize “additional §263A costs,” as defined for new taxpayers in §1.263A1(d)(3),3 §263A would cease being a provision that affects merely timing and would
become a provision that transforms non-deductible expenses into capitalizable costs.
Thus, we have concluded that a taxpayer trafficking in a Schedule I or Schedule II controlled substance is entitled to determine inventoriable costs using the applicableinventory-costing regulations under §471 as they existed when §280E was enacted.

ISSUE 2: May Examination or Appeals require a taxpayer trafficking in a Schedule I or
Schedule II controlled substance to change to an inventory method for that controlled
substance when the taxpayer deducts otherwise inventoriable costs from gross income?

A cash-method producer of a Schedule I or Schedule II controlled substance, such as
marijuana, typically will deduct all production costs in the taxable year paid and, thus,
will not have any adjusted basis in the product that it produces. When §280E is applied
in the case of a producer trafficking in a Schedule I or Schedule II controlled substance,
and all deductions from gross income are disallowed, the producer’s taxable income for
each taxable year will be significantly higher than what it would have been if the
producer had used a permissible inventory method and recouped its production costs
through COGS. Furthermore, the producer will not be able to take those disallowed
production costs into account in any future taxable year. Thus, in this scenario, the
overall cash method does not clearly reflect income because of the operation of §280E.4
Stated differently, even a producer trafficking in a Schedule I or Schedule II controlled
substance is subject to tax on “gains derived from dealings in property,” not on gross
receipts. Section 61(a)(3). This rule regarding “gains derived from dealings in property”
applies equally to a reseller trafficking in a Schedule I or Schedule II controlled
substance.

In our view, Examination and Appeals have the authority under §446(b) to require a
taxpayer to change from a method of accounting that does not clearly reflect income to
a method that does clearly reflect income regardless of whether that change results in a
positive or negative §481(a) adjustment.5 When a producer or reseller of a Schedule I or Schedule II controlled substance uses a method of accounting that causes a tax
result contrary to the Sixteenth Amendment, to §61(a)(3), and to the legislative history
of §280E, the proper exercise of the above-mentioned authority is warranted. Section
446(b). See also Rev. Proc. 2002-18. See also IRM 4.11.6.7.1 (05-13-2005).
Consequently, if a producer or reseller of a Schedule I or Schedule II controlled
substance is deducting from gross income the types of costs that would be inventoriable
if that taxpayer were properly using an inventory method under § 471, it is an
appropriate exercise of authority for Examination or Appeals to require that taxpayer to
use an inventory method, to use the applicable inventory-costing regime (as discussed
under Issue (1) of this memo), and to change from the overall cash method to an overall
accrual method.6 However, if that taxpayer is not required to use an inventory method
(for example, small taxpayers properly using the modified cash method under Rev.
Proc. 2001-10 or Rev. Proc. 2002-28 or farmers), it is not an appropriate exercise of
authority for Examination or Appeals to require that taxpayer to use an inventory
method. Instead, Examination or Appeals should permit that taxpayer to continue
recovering, as a return of capital deductible from gross income, the same types of costs
that are properly recoverable by a taxpayer both trafficking in a Schedule I or Schedule
II controlled substance and using an inventory method under § 471. Thus, for example,
a producer of a Schedule I or Schedule II controlled substance should be permitted to
deduct wages, rents, and repair expenses attributable to its production activities, but
should not be permitted to deduct wages, rents, or repair expenses attributable to its
general business activities or its marketing activities.

JC Comments: The IRS apparently believes that inventory law was trapped in amber by Section 280E. Does this mean accountants who do this work will have to become tax historians? Anyone have a master tax guide from 1982 for sale?

[fortinbras]

Besides not allowing for business expenses, the federal law also prevents MJ dispensaries from having bank accounts (and apparently any credit card purchases at dispensaries). This has led to all sorts of problems, primarily the accumulation of enormous sums of cash not kept in banks. I have not heard of any armed robberies of dispensaries, but that may be only because I am so distant from them (dammit). The dispensaries being an all-cash enterprise suggests that, if the proprietors cannot deduct their expenses, they are simultaneously in such a position that it is easy for them to misrepresent to the IRS the full amount of their revenue. I would not be surprised if, somehow, the mob got into the dispensary business - not to introduce other drugs but merely because it is such a cash-only poor-documentation operation that it would facilitate money laundering from illegal dealings.

[Arthur Rubin]

Arthur - do you mean to say you would be worried about clients' assets being seized, or the assets of attorneys representing them?

Both. Fees paid from "drug money" can also be seized from third parties. (This is not to say that the attorneys might not be required to claim the fees as income, even if they couldn't keep them. "Claim of right" might apply. The training I received didn't cover that question.)

[davids]

Arthur - do you mean to say you would be worried about clients' assets being seized, or the assets of attorneys representing them?

Both. Fees paid from "drug money" can also be seized from third parties. (This is not to say that the attorneys might not be required to claim the fees as income, even if they couldn't keep them. "Claim of right" might apply. The training I received didn't cover that question.)

That's a very interesting angle. I have had marijuana dispensaries and delivery services approach me inquiring about representation before, but never have taken them on as clients. The first time I got a call about it, I thought it was a joke, and suggested they needed to combine their delivery service with a pizza kitchen. Now that I think about it, that's not such a bad idea!

This whole issue is one of those things that renders our government about as functional as a banana republic! There really should be action on the Federal level to either fully respect states' rights in this area, or to do the opposite. Anything else makes the rule of law look random.

[Cpt Banjo]

Section 280E applies only to "below the line" expenses; drug dealers can still deduct their cost of goods sold. The legislative history indicates that Congress believed that it would be unconstitutional to not permit deduction of COGS, because that would have made the tax one on capital, not income.

I'm not sure the constitutional objection relates to taxing capital. After all, Congress can impose a gross receipts tax, which effectively denies a deduction for COGS. See Spreckels Sugar Refining Co. v. McClain, 192 U.S. 397 (1904), upholding a gross receipts tax against the objection that it was an unapportioned direct tax.

But how could a gross receipts tax on illegal drug sales square with the 5th Amendment's protection against self-incrimination? In Leary v. United States, 395 U.S. 6 (1969), former Harvard lecturer and acid-dropper Timothy Leary's conviction under the federal Marihuana Tax Act of 1937 was overturned because compliance with the Act would have subjected Leary to a risk of self-incrimination.

In fact, there is a case pending in Colorado in which the Colorado tax on pot dealers is being challenged on self-incrimination grounds (among other arguments). No Over Taxation v. John Hickenlooper, Denver District Court, 14-CV-32249, filed on June 9, 2014, claims that paying the tax requires the taxpayer to incriminate himself under federal law. In addition to Leary, the plaintiff is relying on a 1973 Colorado Supreme Court case that overturned a conviction for selling marijuana without a license because compliance with the licensing requirement would have required that person to violate his constitutional right against self-incrimination and reveal a violation of federal law.

[Famspear]

Section 280E applies only to "below the line" expenses; drug dealers can still deduct their cost of goods sold. The legislative history indicates that Congress believed that it would be unconstitutional to not permit deduction of COGS, because that would have made the tax one on capital, not income.

I'm not sure the constitutional objection relates to taxing capital. After all, Congress can impose a gross receipts tax, which effectively denies a deduction for COGS. See Spreckels Sugar Refining Co. v. McClain, 192 U.S. 397 (1904), upholding a gross receipts tax against the objection that it was an unapportioned direct tax....

I agree. I see nothing in the language of Article I or the Sixteenth Amendment that prohibits the imposition of a U.S. federal tax on gross receipts -- and nothing that requires that such a tax be apportioned.

A tax on gross receipts would be a tax on the receipt of something that is obviously "property" (whether it be money or something else) -- but it would not be a tax on the property by reason of its ownership.

Further, the Congress could impose a tax on gross receipts and call that tax an income tax -- without any constitutional infirmity. As the U.S. Court of Appeals for the Third Circuit has stated:

It is not necessary to uphold the validity of the tax imposed by the United States [in this case, the federal income tax] that the tax itself bear an accurate label [ . . . ]

It could well be argued that the tax involved here is an "excise tax" based upon the receipt of money by the taxpayer. It certainly is not a tax on property and it certainly is not a capitation tax; therefore, it need not be apportioned. [ . . . ] Congress has the power to impose taxes generally, and if the particular imposition does not run afoul of any constitutional restrictions then the tax is lawful, call it what you will.

--from Penn Mutual Indemnity Co. v. Commissioner, 277 F.2d 16 (3d Cir. 1960) (footnotes not reproduced).

[Famspear]

Section 280E applies only to "below the line" expenses; drug dealers can still deduct their cost of goods sold. The legislative history indicates that Congress believed that it would be unconstitutional to not permit deduction of COGS, because that would have made the tax one on capital, not income.

.....But how could a gross receipts tax on illegal drug sales square with the 5th Amendment's protection against self-incrimination? In Leary v. United States, 395 U.S. 6 (1969), former Harvard lecturer and acid-dropper Timothy Leary's conviction under the federal Marihuana Tax Act of 1937 was overturned because compliance with the Act would have subjected Leary to a risk of self-incrimination.

In fact, there is a case pending in Colorado in which the Colorado tax on pot dealers is being challenged on self-incrimination grounds (among other arguments). No Over Taxation v. John Hickenlooper, Denver District Court, 14-CV-32249, filed on June 9, 2014, claims that paying the tax requires the taxpayer to incriminate himself under federal law. In addition to Leary, the plaintiff is relying on a 1973 Colorado Supreme Court case that overturned a conviction for selling marijuana without a license because compliance with the licensing requirement would have required that person to violate his constitutional right against self-incrimination and reveal a violation of federal law.

See also Marchetti v. United States, 390 U.S. 39 (1968), at:

http://scholar.google.ca/scholar_case?c ... s_sdt=3,44

An individual can report, on his U.S. Federal income tax return, the amount of his total gross receipts from carrying on the trade or business of marijuana (marihuana) sales, with the description "other income" or "FIFTH AMENDMENT" -- without taking any related deductions.

Obviously, under Marchetti and Leary, the filing requirements under the Federal Marihuana Tax Act of 1937 are a different matter with respect to the Fifth Amendment privilege. I agree that the Colorado tax just might be in the same category as the Act of 1937.

[Cpt Banjo]

An individual can report, on his U.S. Federal income tax return, the amount of his total gross receipts from carrying on the trade or business of marijuana (marihuana) sales, with the description "other income" or "FIFTH AMENDMENT" -- without taking any related deductions.

This would work only if the statute specifically included in gross income the gross receipts from carrying on the trade or business of selling marijuana or some other illegal substance. Although gross receipts aren't really income, this situation would be similar to Section 7872's including in gross income the imputed interest income from a below-market loan, something that's not really income either, but which can be justified as an excise on the making of a below-market loan.

[Famspear]

An individual can report, on his U.S. Federal income tax return, the amount of his total gross receipts from carrying on the trade or business of marijuana (marihuana) sales, with the description "other income" or "FIFTH AMENDMENT" -- without taking any related deductions.

This would work only if the statute specifically included in gross income the gross receipts from carrying on the trade or business of selling marijuana or some other illegal substance. Although gross receipts aren't really income, this situation would be similar to Section 7872's including in gross income the imputed interest income from a below-market loan, something that's not really income either, but which can be justified as an excise on the making of a below-market loan.

Well, the taxpayer’s cost to acquire the marijuana (assuming he bought it and didn’t just steal it from some poor farmer) would be, in a sense, a “merchandise inventory” cost that would be includible in his basis, if we read section 280E to deny only “deductions” (and credits), and not to deny the ordinary subtraction of basis from gross receipts in arriving at “gross income.” Under cases such as Burnet v. Logan, 283 U.S. 404 (1931) (citing Doyle v. Mitchell Bros. Co., 247 U.S. 179 (1918)) etc., etc., the term “gross income” (when applied to the sale of an asset) generally means the gain (the amount realized less the amount of adjusted basis) in the asset sold. So, I agree that gross income would not be equal to gross receipts in that case. The correct “gross income” figure to be reported would be the gross receipts less the applicable basis in the “inventory.” (And of course, expenditures not properly chargeable to the inventory cost would, because of section 280E, be non-deductible as noted above). And, even if Congress intended section 280E to prohibit a “deduction” for an “expenditure” otherwise includible in basis (i.e., includible in inventory cost), I’m not sure that such a prohibition would pass constitutional muster. I haven’t researched the case law on section 280E.

However, the requirement -- that the taxpayer report the illegal gain as gross income on a U.S. federal income tax return (as opposed to some other kind of tax return) -- would pass constitutional muster with flying colors. And, the taxpayer could still, under the case law, report the gain and describe it as “other income” or “FIFTH AMENDMENT.”

If instead the taxpayer were to report the “gross receipts” as gross income, rather than just the gain as gross income, the taxpayer would actually be over-stating his gross income (IF he had any basis -- any inventoriable cost -- applicable to the sold product).

By contrast, if he had no costs allocable to the inventory cost (let’s say he stole the marijuana, and none of his expenses were part of any “inventory cost”), then the amount of gross receipts actually would be equal to gross income, since he would have no basis in the product.

[Cpt Banjo]

even if Congress intended section 280E to prohibit a “deduction” for an “expenditure” otherwise includible in basis (i.e., includible in inventory cost), I’m not sure that such a prohibition would pass constitutional muster. I haven’t researched the case law on section 280E.

I agree that as it's currently written, 280E doesn't ban a deduction for COGS, including whatever expenses are properly allocable to inventory cost. But if Congress really wanted to disallow even a COGS deduction I think it could do so by amending 280E to provide that gross income includes the gross receipts from the sale of illegal drugs. My point was that from a purely tax law standpoint I don't see the constitutional issue the drafters of 280E were worried about, unless they thought the only way to prohibit the deduction of COGS would be to impose a separate gross receipts tax on illegal drug sales, which would have implicated the self-incrimination protection of the 5th Amendment under the Leary rationale.

In other words, if Congress can constitutionally include something in gross interest income that by no stretch of the imagination is income (i.e., imputed interest under Section 7872), it should be able to constitutionally include something else in gross income that isn't income (i.e., gross receipts) but that arises from a transaction that can be subjected to an excise (i.e., the sale of drugs).

[Dr. Caligari]

The legislative history of section 280E, including Congress's thoughts on the constitutional issue, is summarized in this IRS ruling:

http://www.irs.gov/pub/irs-wd/201504011.pdf