In recent years, a number of states have legalized marijuana to one degree or another. Some states have legalized marijuana for recreational purposes, while others are allowing marijuana possession and growing. Some states have legalized marijuana only for medicinal purposes. And while these states have legislated to decriminalize marijuana to varying levels, depending on the state, the fact remains that marijuana continues to be illegal under federal law.
In the wake of this relaxation in marijuana prohibition laws, businesses (often termed dispensaries) whose main product is marijuana are springing up in states where marijuana has become legal. These businesses are accounting for and reporting the results of their operations just like any other for-profit business, with gross receipts, cost of goods sold (COGS), and other deductions. While these states have no issues with the way these dispensaries are being run and are paying their state income taxes, the problem, or pitfall, is the existing federal prohibition. Because of this, the way financial information is reported for federal tax purposes by a business that is trafficking in a controlled substance is very different than for state purposes.
Interestingly, the federal government has classified marijuana as a Schedule 1 drug according to the Controlled Substances Act (CSA), P.L. 91-513, the same classification as heroin. This classification means that it is perceived to have no medicinal value and a high potential for abuse. By comparison, cocaine and methamphetamine are classified under the CSA as Schedule 2 drugs, which is a less restrictive category. The distinction is that Schedule 2 substances are viewed legally as having some medicinal value. This does not necessarily mean marijuana is believed to be more dangerous than Schedule 2 substances, just that no proof has been established of its medicinal value; therefore, it is under greater regulatory scrutiny. And while the substance remains illegal, chances for that proof to be obtained through clinical trials are virtually nonexistent.
Marijuana's criminal classification at the federal level has other serious ramifications for marijuana policy even in states where recreational use and possession have been legalized. Many state-legal marijuana businesses, for instance, must function as cash-only enterprises, since many banks are nervous about dealing with businesses that are essentially breaking federal law. Businesses also cannot claim several deductions and, as a result, their effective income tax rates can soar to as high as 90% or more.
Sec. 280E provides:
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 . . . which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
This means, essentially, that for federal tax purposes, marijuana businesses pay income taxes on their gross profit instead of their net income because below-the-line deductions are not allowed.
The IRS requires that gross income be reported from whatever source it is derived (Sec. 61). Accordingly, the income generated from trafficking in marijuana, even though it is classified as an illegal substance, must be reported for federal tax purposes. This raises a dilemma for some: Do they risk tax evasion if they do not report their income, or do they risk criminal prosecution if they do? And for those who choose to report the income and take the prosecution risk, deductions are minimal and, therefore, their tax bills are quite high.
The IRS has issued guidance to provide that the calculation of gross profit would include a deduction for COGS. COGS, historically, is not considered an expense but rather a component of gross income. On the other hand, the other deductions normally allowed in a for-profit business are specifically excluded by Sec. 280E. These other deductions include items such as utilities, wages, rent, taxes, and repairs. For example, if a marijuana business buys goods for $10 and resells them for $20, the business is required to report a $10 profit. The COGS is $10. For a business trafficking in an illegal substance, no other deduction is allowed.
The complexity comes in determining what is legitimately included in COGS. Any deduction that could be attributable to general business activities or marketing activities would be difficult to establish as being part of COGS. However, sometimes the line between what is or is not COGS is not so easy to discern.
An additional twist was addressed in Loughman, T.C. Memo. 2018-85. In this case, the business was an S corporation. The IRS determined that the wage payments made to the owners from their medical marijuana dispensary business were not deductible by the S corporation under the Sec. 280E regulations, resulting in higher flowthrough income to the owners. At the same time, the wages paid to them from the business, which are required to be reasonable for an S corporation, were picked up on their personal return. This treatment effectively caused them to be taxed twice on the same income. The taxpayers argued that this was contrary to the purpose and intent of Subchapter S. However, the court drew a distinction between their gross income from wages and their passthrough income from owning the S corporation, and stated the Loughmans were free to operate as any type of business entity.
To give an example of the disparity of taxes paid by a state-legal marijuana business compared to a for-profit business, the National Cannabis Industry Association selected two similarly situated businesses and found the effective tax rates were 55% for the marijuana-related business compared with 30% for the similarly situated nonmarijuana business. This is strong evidence of the hugely disproportionate tax bills for these businesses authorized by state law but treated as criminal under federal law.
Congress has proposed several options for addressing the problems caused by Sec. 280E. A few of the options considered are: (1) to legalize marijuana; (2) to change marijuana's schedule classification; (3) to make a specific exception in the statute for marijuana; and (4) to change the wording to include only those substances deemed illegal by both federal and state law. To date, however, none of these proposals have made any headway in the legislative process.
Mark G. Cook, CPA, CGMA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.