Marijuana business and sec. 280E: potential pitfalls for clients and advisers.

• Author: Gramlich, Jeffrey

A relatively new industry in the United States involves the cultivation and sale of marijuana under newly enacted state laws. Twenty-three states and the District of Columbia have passed statutes permitting the medical use of marijuana, (1) and four states--Alaska, Colorado, Oregon, and Washington--now permit, in regulated settings, the sale of marijuana for recreational use. (2) Exhibit 1 on p. 527 summarizes marijuana's legal status across U.S. states. However, the cultivation and sale of marijuana remains illegal under the federal Controlled Substances Act. (3)

This article examines the unique income tax issues that are faced by regulated marijuana businesses and their CPAs. According to Marijuana Business Daily, "the federal tax situation is the biggest threat to [medical marijuana] businesses and could push the entire industry underground." (4) While other taxes, such as excise and sales taxes, are also of direct concern to these businesses, this article does not address them.

State statutes that have legalized one or more aspects of marijuana-related activities remove the threat of state-level prosecution. However, federal laws criminalizing these activities remain. (5) Civil and criminal punishments can be assessed against anyone who grows, sells, imports, or holds controlled substances. Schedule I of the Controlled Substances Act lists drugs, including marijuana, that the federal government has determined to have (1) a high potential for abuse, (2) no currently accepted medical use in the United States, and (3) lack of safety for use even under medical supervision. (6) Although President Barack Obama's administration has encouraged the Justice Department not to prosecute marijuana distributors who comply with state-level laws, (7) the federal law remains, and indeed the Drug Enforcement Agency has used it to raid marijuana businesses that are legal under state statutes and regulations. (8)

Enacted in 1982 (14 years before California became the first state to legalize medical marijuana), Sec. 280E prohibits marijuana businesses from deducting their ordinary business expenses specifically because marijuana is a Controlled Substances Act Schedule I drug. As a result, while voters in some states have legalized certain regulated marijuana sales, these businesses face exceedingly large tax bills because their business expenses are not deductible. This penalty is lessened in Colorado as the state specifically disavows Sec. 280E in calculating taxable income for state income tax purposes. (9)

Federal Taxation of Illegal Activities

In 2010, lawmakers in Arizona, California, Colorado, and Massachusetts sent a letter to the IRS requesting that it stop enforcing Sec. 280E in the states that had legalized marijuana sales. (10) The IRS responded that Congress would need to change either the Controlled Substances Act or Sec. 280E. (11) The federal government is able to collect taxes from marijuana businesses because Sec. 61(a), which defines "gross sales," does not "differentiate between income derived from legal sources and income derived from illegal sources." (12)

For example, in James, (13) the Supreme Court held that because an embezzler had no obligation to repay embezzled funds, the stolen money would fall under Sec. 61(a), which taxes "all income from whatever source derived." The Court explained that the term "gross income" refers to both lawful and unlawful gain. In reaching this conclusion, the Court recounted the language in Rutkin (14) that there "has been a widespread and settled administrative and judicial recognition of the taxability of unlawful gains of many kinds."

Sec. 162: Deduction of Business Expenses

Sec. 162(a) prescribes:

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including--

(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;

(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and

(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

After James reaffirmed that illegal income was indeed taxable, the Supreme Court clarified that those illegal businesses could also deduct their business expenses. In the 1966 case of Tellier, (15) a taxpayer who had been found guilty of securities fraud tried to deduct his legal fees for his defense. The Court held that the deductions were permitted under Sec. 162(a). According to the Court, "the federal income tax is a tax on net income, not a sanction against wrong-doing." (16)

The ability to deduct business expenses under Sec. 162 is limited to those types of expenses that are not expressly excluded. While illegal businesses may report income, take many business deductions, and pay income taxes, certain exceptions exist in the Code. Examples of these nondeductible exceptions under Sec. 162(c)(1) include illegal bribes and kickbacks and payments to foreign governments under the Foreign Corrupt Practices Act of 1977. (17) Sec. 280E, which contains the exclusion that affects marijuana businesses, disallows businesses "trafficking in controlled substances" from deducting their regular business expenses. Sec. 280E penalizes traffickers of controlled substances by denying deductions from gross income for business expenses.

According to the Joint Committee's 1982 General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982,

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. (18) However, as noted in the Joint Committee report, (19) to preclude possible challenges on constitutional grounds, Sec. 280E does not prohibit adjustments to gross receipts for the cost of goods sold.

Business Expenses Incurred in Trafficking in Controlled Substances

Sec. 280E was precipitated by the 1981 Edmondson (20) Tax Court case, which allowed a seller of amphetamines, cocaine, and marijuana to deduct costs of goods sold, packing costs, and phone, car, and home office expenses. Although other expenses were disallowed in Edmondson for lack of substantiation, Congress created Sec. 280E in response to the case to deny sellers of controlled substances the right to deduct business expenses based on public policy grounds. (21) Under Sec. 280E:

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. [Emphasis added.]

Ultimately, however, as noted above, one type of business expense deduction is allowed under Sec. 280E: cost of goods sold. This was affirmed in the 2012 Tax Court case, Olive. (22) The Olive case involved a San Francisco medical marijuana...