Deduction for Seized Marijuana Goes Up in Smoke

By James A. Beavers, J.D., LL.M., CPA, CGMA

The Tax Court held that the owner of two medical marijuana dispensaries could not deduct the operating expenses of the dispensaries as ordinary and necessary business expenses or the cost of marijuana and marijuana-based products that the Drug Enforcement Administration (DEA) seized from one of the dispensaries as costs of goods sold.

Background

Jason Beck was the owner and operator of two medical marijuana dispensaries in California, one in San Francisco and one in West Hollywood, under the business name Alternative Herbal Health Services (AHHS). The San Francisco location was open from 2001 to 2007, and the West Hollywood location was opened in 2004 and currently remains open. Under California law, the sale of marijuana for medical purposes is legal; however, under federal law, marijuana is a controlled substance that is illegal to sell for medical or recreational purposes.

Beck's dispensaries sold various strains of marijuana, marijuana seeds, prerolled marijuana joints, and edible food items prepared with marijuana. Beck did not grow marijuana at either dispensary to sell but rather purchased marijuana from growers. Customers who purchased marijuana and edibles from the petitioner's dispensaries were able to smoke and consume those products there, but the dispensaries did not sell pipes, papers, or vaporizers. Beck and his employees also conducted the following activities with customers at no charge: education on the effects of various strains of marijuana on the body; education on the use and benefits of vaporizers; discussions on the various types of marijuana that were for sale; discussions on how to grow marijuana and the best grow shops to buy supplies from; counseling as to how to load various smoking devices; and loading, grinding, and packing marijuana for customers' use.

Beck accepted only cash from customers at the dispensaries. He kept rudimentary records, including cash register Z tapes, to track most of the sales at the dispensaries, other than sales through a vending machine at the West Hollywood location, for which no records were kept. However, Beck or his employees at some point destroyed most of what few sales records were kept.

Despite California's approval of Beck's business, the federal government took a dim view of the enterprise, and in January 2007, the DEA obtained a search warrant for the West Hollywood dispensary. In the search, the DEA seized marijuana, food products suspected to contain marijuana, and marijuana plants. The DEA agents scooped up all the cash found at the dispensary and, pursuant to another search warrant, seized money from Beck's bank account, which the DEA claimed were the proceeds of marijuana trafficking.

Beck's Income Tax Return for 2007

Beck timely filed a 2007 tax return, reporting W-2 wage income and Schedule C income for AHHS (classifying it as a "health care" business). On the AHHS Schedule C, he reported $1,700,000 in gross receipts with $1,429,614 in COGS and $194,094 in expenses. The gross receipts and COGS entries on his 2007 tax return each included $600,000 attributable to the value of the marijuana seized by the DEA. All gross receipts and expenses reported on Beck's 2007 tax return were from the sale or expenses of marijuana or edibles. All expenses reported on his Schedule C pertained to the marijuana dispensaries. The accountant who prepared Beck's return did not do the bookkeeping for the businesses, and the returns were prepared based on the numbers Beck provided, without any supporting documentation.

Not surprisingly, the IRS audited Beck's 2007 return. It disallowed the Schedule C expense deductions relating to the operation of the AHHS dispensaries and the COGS deduction for the goods seized by the DEA. Beck challenged the IRS's determinations in Tax Court. Besides making the claim the IRS could not "accept tax revenue" from illegal products, Beck argued that he could deduct the Schedule C expenses for AHHS and that he was entitled to a COGS deduction for the seized goods or, in the alternative, a Sec. 165 loss for them.

The Tax Court's Decision

The Tax Court held that Beck could not deduct the Schedule C expenses of the AHHS dispensaries as Sec. 162 ordinary and necessary business expenses or the cost of the goods seized in the DEA raid as COGS or Sec. 165 expenses. The court disallowed the deductions because Beck had failed to substantiate any of their amounts, but it also discussed whether the expenses and costs would have been deductible if he had substantiated them. For both, it found that they were also not deductible under the applicable substantive law.

With regard to the Schedule C expenses, the court explained that under Sec. 280E, a taxpayer may not deduct amounts paid or incurred in carrying on a trade or business of trafficking in controlled substances that is prohibited by federal law. In Californians Helping to Alleviate Med. Problems, Inc. (CHAMP), 128 T.C. 173 (2007), the Tax Court had previously determined that medical marijuana is a controlled substance under Sec. 280E and that a California medical marijuana dispensary's dispensing of medical marijuana pursuant to the California Compassionate Use Act (CCUA) was "trafficking" within the meaning of Sec. 280E. Therefore, the court held that the expenses from the AHHS dispensaries were not deductible under Sec. 280E.

The court also observed that in its decision in CHAMP, it had held that a taxpayer could have some deductions disallowed under Sec. 280E and others that were not disallowed, provided that the taxpayer carried on two separate businesses and one of those was not trafficking in controlled substances. In CHAMP, the Tax Court found that the taxpayer had two businesses, one of which was the distribution of marijuana and the other of which was providing caregiving services, and it allowed the taxpayer to deduct the expenses related to the caregiving services business. However, because there was no evidence that the AHHS dispensaries sold anything other than controlled substances, the court determined that all of the expenses would have been disallowed under Sec. 280E.

Regarding the marijuana and marijuana products seized, the court concluded that, even if Beck had not totally failed to substantiate the costs of the goods the DEA seized in its raid, the costs would not be deductible as COGS because the goods were confiscated, not sold. The court also concluded that Beck could not take a deduction for the costs of the goods under Sec. 165 as a loss sustained during the tax year and not compensated for by insurance or otherwise because in addition to prohibiting deductions under Sec. 162, Sec. 280E also prohibits deductions under Sec. 165.

Reflections

An obvious takeaway from this case is that practitioners who deal with budding entrepreneurs in the business of medical (and in states where legal, nonmedical) marijuana sales should make sure that they understand the importance of good recordkeeping. Because most of these businesses currently are forced to deal mainly in cash, whether they want to or not, the IRS will undoubtedly be quick to question the validity of income and expense amounts on their returns and whether expenses claimed are for expenses that are actually deductible under Sec. 280E. In addition, practitioners should also be aware of the possible ethical and legal pitfalls that come with advising marijuana businesses. See "Marijuana Business and Sec. 280E: Potential Pitfalls for Clients and Advisers".

Beck, T.C. Memo. 2015-149

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