Tax Court Corner: How the US Tax Court Views Legalized Marijuana
There are 23 states and the District of Columbia that have legalized marijuana. Although only four states have legalized it for recreational use, the rest have legalized it for medicinal purposes. The problem arises at the federal level. Marijuana is still classified as an illegal Class I controlled substance. Those within the borders of a state that has legalized marijuana, and are in the business of sales and distribution of marijuana, are at odds with federal law. That being said, these businesses cannot open bank accounts and, according to Code Section 280E, cannot deduct their business expenses.
Since 1996, California, the first state to legalize marijuana for medicinal purposes, has had business owners who make their money legally by state code and illegally by federal code. Probably the most famous US Tax Court marijuana case is Californians Helping to Alleviate Medical Problems Inc. v. Commissioner. An opinion was issued on May 15, 2007.
The petitioner provided counseling and other caregiving services to its members, who were individuals with debilitating diseases. The petitioner also provided its members with medical marijuana pursuant to the California Compassionate Use Act of 1996. The petitioner charged its members a membership fee that generally reimbursed the petitioner for its costs of the caregiving services and for the medical marijuana.
The IRS determined that all of the petitioner’s expenses were nondeductible under Section 280E because, the IRS determined, the expenses were incurred in connection with the trafficking of a controlled substance. The business was set up where each of the petitioner’s members paid a membership fee in consideration for the right to receive caregiving services and medical marijuana. The caregiving services were extensive; however, a portion of what was paid to the petitioner was for the reimbursement of medical marijuana.
In the response, the judge quoted Edmondson v. Commissioner, T.C. Memo. 1981-623. In this case, Jeffrey Edmondson reported income and expenses from the sale of marijuana, amphetamines, and cocaine in 1975. With reporting of the income, he also reported cost of goods sold (COGS) on that sale of the illegal substances.
The Tax Court allowed the COGS in Edmondson, as it did in Californians. The rest of the expenses in Edmondson were not taken into account. However, in Californians, the other expenses that were not COGS were split between the sale of medical marijuana and caregiving expenses. The additional expenses for caregiving were deductible, but the other expenses that had to do with the sale of medical marijuana were not. This case opened the door for COGS to be deducted by those selling marijuana.
In Olive v. Commissioner, Martin Olive ran a sole proprietorship called the Vapor Room Herbal Center. Its principle business was the retail sale of medical marijuana. The taxpayer had deficiencies in tax for $367,531 in 2004 and $1,146,633 in 2005. The petitioner’s Schedules C for 2004 and 2005 reported that the Vapor Room’s COGS were $993,337 and $2,812,478, respectively.
The IRS sent Olive a notice of deficiency for the years in question, after audit, based on the fact that the amounts for expenses were disallowed and the COGS lacked substantiation. Upon ruling, the Tax Court found that there was a lack of substantiation of COGS by Olive, but disagreed with the IRS that there were no amounts for COGS. Under the “Cohen Rule,” (named so after Cohen v. Commissioner, which stated that the Tax Court could make reasonable adjustments without substantiation), the court relied on an expert witness and considered 75.16 percent of the COGS to be the COGS for the Vapor Room.
In Canna Care Inc. v. Commissioner, notices of deficiency were given in regards to 2006, 2007, and 2008 tax returns. The Tax Court once again found that under Section 280E, no deduction was allowed for operating expenses due to the fact that marijuana is a controlled substance and, at the federal level, is considered trafficking in the sale of narcotics. In the Canna Care case, the petitioner offered other services similar to those in the Californians case, and the expenses for those services were allowed.
One thing came to light in all of these cases: “Taxpayer trafficking in controlled substance determines COGS by using applicable inventory-costing regulations under Code Section 471 as they existed when Section 280E was enacted. And IRS Examination or Appeals may change to inventory method for that controlled substance when the taxpayer currently deducts otherwise inventoriable costs from gross income.”
When calculating inventory, Van Pickerill & Sons Inc. v. United States stated that a requirement when the use of inventories is necessary to determine the income of a taxpayer, the taxpayer must use the best accounting practice to determine the amount of income (Section 471(a)). In spite of the use of the word “best,” multiple accounting methods may satisfy the best accounting practice requirement for any given business. The court and the IRS are caught between what is legal under state law and when the exact same thing is illegal under federal law.
In Jason R. Beck v. Commissioner, the Tax Court ruled that although the COGS were deductible to marijuana businesses, the cost of marijuana seized by federal authorities could not go into the calculation of COGS. Even though marijuana is legal in a state, federal government law enforcement can raid legal state marijuana facilities, and in the Beck case, the court said these amounts are not deductible.
Are Things Changing?
In a May 2016 memorandum, the IRS Small Business/Self-Employed Division instructed its Collection employees not to automatically deny offers in compromise by people in the marijuana business simply on public policy grounds.
As more and more states legalize marijuana in some form or another, the state and federal government need to get on the same page.
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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...