Thursday, February 19, 2015

Tax Issues For Marijuana Businesses

By Adam R. Maingot and Brian R. Harris

Thirty-four states and the District of Columbia have passed laws permitting the use of marijuana in some form. Although Amendment 2 recently failed this November, the Florida Legislature passed the Compassionate Medical Cannabis Act of 2014 (MCA) in June, which permits non-euphoric, low Tetrahydrocannabinol (THC) and high Cannabidiol (CBD) cannabis. States can authorize medical marijuana, but it remains illegal at the federal level. The Controlled Substances Act (CSA) federally criminalizes all forms of cultivation, distribution, and possession of schedule I controlled substances, including marijuana. Operating and servicing marijuana-related businesses therefore implicate numerous federal and state banking and taxation concerns. 

For example, section 280E of the Internal Revenue Code instructs that no deduction or credit shall be allowed for any amount paid or incurred in relation to a trade or business that involves trafficking a schedule I substance. 21 U.S.C. § 801, et seq. Thus, while other businesses can deduct payroll, rent, utilities, and other business expenses, medical marijuana businesses generally cannot. The initial court decisions applying section 280E have generally favored the government. See Olive v. Commissioner, 139 T.C. 2 (2012). However, the scope of section 280E generally does not apply to the cost of goods sold.

The inability to deduct these operating expenses could result in marijuana businesses effectively being taxed at a higher rate than the top corporate income tax bracket of 35 percent. The disallowance of these deductions can in turn impact other tax provisions, including basis for depreciation calculation (§ 167), capitalization (§ 263A), cost allocation (§ 460), inventory (§ 471), and others.

Corporations that distribute medical marijuana or otherwise promote medical marijuana might desire to seek tax-exempt status under section 501(c)(3), which applies to those organized for charitable, scientific, or educational purposes. The IRS has ruled that because manufacturing and distributing marijuana remains illegal at the federal level, organizations whose purpose is to advocate and engage in activities that contravene federal law do not serve a substantial nonexempt federal purpose and do not qualify for an exemption under section 501(c)(3). IRS Priv. Ltr. Rul. 2012-24-036 (Mar. 19, 2012).

These tax issues also impact individuals. Notably, individuals are generally entitled to deduct unreimbursed medical expenses that exceed 10 percent of their adjusted gross income on their federal income tax returns. However, the IRS has determined that individuals may not deduct controlled substances as medical expenses. IRS Pub. 502 (2013). For individuals who own marijuana businesses, the inability of the business to deduct operating expenses might increase the individual's base for computing self-employment taxes.

Other issues abound, including obligations under the Bank Secrecy Act (BSA) to report marijuana-related business activity, state sales tax treatment of medical marijuana sales, and whether attorneys can ethically advise clients on operating a business that is legal under state law but remains illegal under federal law. Although medical marijuana laws provide new business opportunities for savvy entrepreneurs, the evolving legal and tax environment leaves many questions unanswered for the both the owners and their advisors.