In what many consider to be the biggest electoral victory for marijuana reform since 2012, when Colorado and Washington first approved the drug for recreational use, voters in several states backed recreational and medical marijuana ballot initiatives on Nov. 8, 2016.
My home state of Florida passed the use of medical marijuana, and now we must wait to see what steps the Florida Legislature takes. In addition to Florida, voters in Arkansas and North Dakota approved medical marijuana provisions, while California, Maine, Massachusetts, and Nevada approved recreational marijuana initiatives. Montana voters also approved rolling back restrictions on an existing medical marijuana law.
In a “Tax Court Corner” article I wrote last year, I explained how the federal government views marijuana. To summarize, we must think back to 1981, when first lady Nancy Reagan was touring the country with her “Just Say No” message and America had declared a war on drugs.
During that time, there was a US Tax Court case where the IRS reconstructed a drug dealer’s income. Because of his complete honesty, the Tax Court took his word for the amount of cocaine, marijuana, and amphetamines that he sold (it is very uncommon for a drug dealer to keep written records of income and expenses). The court gave the claimant the benefit of the doubt on his cost of goods sold (COGS) and some travel expenses he had when his income was reconstructed.
In 1982, Congress enacted Internal Revenue Code Section 280E, which basically states that someone who is doing something illegal can only deduct their COGS.
What does this have to do with marijuana becoming legal in several states? Well, marijuana is still considered a federally banned controlled substance. As such, marijuana dispensaries in states where they are legal are in fact illegal by federal law. At tax time, those in the marijuana business can still only deduct their COGS.
However, since the enactment of Section 280E, there have been a couple of Tax Court cases when the court allowed deductions for marijuana dispensaries – if they separated the caregiving part of their business from their sales of marijuana for medicinal purposes. For recreational marijuana, if the sales of paraphernalia or other items were set up, those expenses could be fully deducted.
So, have we found a way around Section 280E?
First, if you have a client who is involved in the marijuana industry and you don’t know Section 280E inside and out, refer him or her to someone who does. This code section is very detailed and you could cost your client a lot of money if you are ignorant of the law.
I have a client who runs a marijuana dispensary for medicinal purposes. Another component is that he offers counseling and support to his patients, outside of just selling marijuana. What we did was form two separate C corporations. Notice that I didn’t say S corporations. Why not? The amount of money that these companies make pushes the client into the highest tax bracket of 39.6 percent if we use a pass-through entity. The highest corporate tax bracket is only 35 percent.
For the dispensary, where we can only deduct COGS, we only run the expenses of the cost of the marijuana and anything else, like shipping, that make up the total COGS. For the other C corporation, we run the other expenses, such as payroll and the portion of the rent that the caregiving takes up. Effectively, what we have done is find a work-around.
The same strategy can be employed with recreational marijuana. For instance, you would have the dispensary and then a shop that sold T-shirts, coffee, food, whatever. You would separate the two businesses and use the same strategy.
However, I caution you on a couple of things. These companies must keep impeccable records. They will be audited and the case could end up in Tax Court. Also, you must show that the expenses that you are running under the company that is providing caregiving cannot be expenses of the dispensary.
Taxation for the marijuana industry is complicated and complex. However, our firm has chosen to specialize in it.
About Craig W. Smalley, EA
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.