The recreational marijuana industry exists in an environment of legislative uncertainty resulting from states legalizing recreational marijuana while it is still considered illegal at the federal level. For the recreational marijuana industry, legalization did not occur until 2012 when Colorado first legalized it and has since been followed by three other states and Washington D.C. The dichotomy between state and federal laws has created interesting accounting and financial effects; including how financial institutions, CPAs, and the individual marijuana businesses themselves are affected by the inconsistencies in the laws from an accounting and finance perspective.
From a financial institution standpoint, one of the most important aspects that is influenced by the differing state and federal laws includes providing services to marijuana-related businesses while still adhering to federal banking regulations. Banks are subject to a number of federal regulations that they must follow regardless of states' stances on recreational marijuana. When considering the accounting and financial effects from a marijuana business owners perspective, there are a number of important aspects that can be considered. These include the tax rates applied to business owners, the environment in which the business operates, and the accounting methods used. From a CPAs perspective, there are numerous facets to consider such as following available guidance and providing services to marijuana businesses while remaining in accord with accounting standards.
The accounting and financial effects of the inconsistent laws from these perspectives are not mutually exclusive and often connect to each other so that an effect in one area often causes effects in the other areas as well. The purpose of this study is to identify and examine the accounting and financial effects of the inconsistencies between state and federal laws on the recreational marijuana industry.
Federal Legislation and Considerations
Past regulation-related research explores differences in societal opinions regarding the ethicality of the use and legalization of certain drugs. For example, although the use of performing-enhancing drugs (PEDs) by athletes is viewed as creating an unfair advantage and an un-level playing field by some, Osei-Hwere, et al. note that sports fans are equally divided as to whether PED use should be allowed in certain sports (2014). Likewise, much has been written regarding the morality of the use and legalization of marijuana. On the one hand, some argue that marijuana smoke is toxic and could lead to the use of more serious, dangerous drugs; however, others note that marijuana is an effective treatment for certain conditions, thereby reducing suffering (Clark, 2000), and that its legalization would reduce crime rates, save taxpayer money and generally benefit both individuals and communities (Cussen, 2000).
Recreational marijuana is an emerging industry in the United States due to four states and Washington, D.C. recently passing measures to legalize the recreational use of the drug. However, marijuana is still illegal federally because it is a Schedule I drug under the Controlled Substances Act (CSA) (CSA, 2012). Schedule I drugs are those that the federal government lists as having a high potential for abuse, no accepted medical use, and lack of safety even under medical supervision (CSA, 2012). The illegality of marijuana at the federal level allows for a number of civil and criminal penalties that can be assessed against people who cultivate, sell, or distribute marijuana even if legal by state standards (Gramlich and Houser, 2015), and the federal government has prosecuted individuals for the use and possession of marijuana even when such use and possession was permitted under state law (Barkacs, 2010). This creates a unique dichotomy between federal and state laws.
According to the Internal Revenue Code (IRC), gross income is defined as all income from whatever source derived (26 U.S.C. [section] 61(a), 2012). As recognized in James v. United States (1961), there is no inclusion of the word "lawful" when describing the sources through which income can be derived. This means that although marijuana is considered illegal by the federal government it is still subject to federal income taxes. It is treated the same as all other income, whether legal or illegal.
The federal government further allows for a business to deduct all ordinary and necessary business expenses from its gross income (26 U.S.C. [section] 162(a), 2012). At the time the business expense deduction was created it did not differentiate between businesses participating in a legal trade from an illegal trade. This allowed for people conducting illegal businesses to continue to deduct their business expenses from gross income, thus reducing their amount of taxable income and, in turn, taxes due. This was highlighted in Jeffery Edmondson v. Commissioner (1981) where Edmondson made the argument, and won the argument, that he should be allowed to deduct the expenses related to his business of selling amphetamines, cocaine, and marijuana. However, this deduction is no longer available for businesses that are involved in trafficking Schedule I or II controlled substances as defined in the CSA due to the passage of Section 280E of the IRC (26 U.S.C. [section] 280E, 2012).
To further explain why Section 280E was created, the Joint Committee's General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (1983) states that:
There is a sharply defined public policy against drug dealing. To allow drug dealers the benefit of business expense deductions at the same time that the U.S. and its citizens are losing billions of dollars per year to such persons is not compelled by the fact that such deductions are allowed to other, legal enterprises. Congress believed that such deductions must be disallowed on public policy grounds. (p.264) This exclusion was created before any states legalized marijuana for medical or recreational use. The application of Section 280E to marijuana businesses that are legal at the state level but illegal at the federal level demonstrates how, although legal within their state, these businesses are still coping with the difficulties of complying with federal laws.
Although marijuana-related businesses cannot deduct their business expenses from gross income, Section 280E does not preclude businesses from deducting cost of goods sold (COGS). Continuing to allow businesses to adjust gross income by the amount of COGS was done to prevent possible challenges on the grounds of unconstitutionality (Joint Committee on Taxation, 1983). In Californians Helping to Alleviate Medical Problems, Inc. (CHAMP) v. Commissioner of Internal Revenue (2007), the government acknowledged that Section 280E prevents taxpayers from deducting business expenses, but it does not prevent businesses from claiming COGS. However, because marijuana-related businesses fall under Section 280E, the IRS Office of Chief Counsel issued Chief Counsel Advice which clarified that businesses should determine their COGS using the inventory costing methods that existed when Section 280E was enacted (McElroy, 2015).
A consequence of administering Section 280E in legalized states is that many cases have been brought against the Internal Revenue Service (IRS) on the basis of deducting Section 280E expenses with varying results. In CHAMP v. Commissioner of Internal Revenue (2007), the court held that the taxpayer's caregiving services and furnishing of medical marijuana were separate business for the purposes of Section 280E. This allowed the taxpayer to deduct the portion of expenses related to the primary, lawful caregiving portion of its business. However, in Olive v. Commissioner of Internal Revenue (2015), the court found that the taxpayer's business was of limited scope and consisted of trafficking marijuana, which places it under the constraints of Section 280E. Even where permitted by state law, marijuana businesses are considered to be trafficking Schedule I drugs for the purpose of determining the applicability of Section 280E (Canna Care, Inc. v. Commissioner of Internal Revenue, 2015).
As the number of states legalizing marijuana for medical and recreational use has increased, many have argued in federal courts that marijuana should no longer be subject to the Section 280E exclusion. However, this is not the judiciary's decision to make and must be addressed by Congress in order to be changed (Olive v. Commissioner, 2015). The same argument has also been made to the IRS to which the response was the same, Congress would have to change the IRC or the CSA (Keyso, 2011).
Due to the increasing number of states legalizing marijuana for medical and/or recreational use, the Department of Justice (DOJ) has issued numerous memos to address various aspects of the discrepancies in the legality of marijuana at the state and federal levels. The DOJ has focused its enforcement of the CSA to reflect the priorities of the federal government (Cole, 2013). These priorities include items that would be important to the federal government regardless of the state legalization of marijuana, including preventing the distribution of marijuana to minors and preventing driving while under the influence of marijuana (Cole, 2013). Although the DOJ has listed priorities for their enforcement of the CSA, they have also clearly stated that businesses involved in the cultivation, distribution, or sale of marijuana are in violation of the CSA and can be subject to potential prosecution (Cole, 2011). In addition to potential violations of the CSA, the DOJ also issued a memo addressing the potential violations of applicable laws that financial institutions could face in providing services to marijuana businesses (Cole, 2014).
Banks and financial institutions are subject to numerous...