USA Today: “new pot shops that voters approve may not be able to survive a drug war-era tax code
Huffington Post: “Nearly half of U.S. states have legalized marijuana in some form, whether medical or recreational. But marijuana remains illegal under federal law, and as a result, the legitimate businesses selling the drug are subject to sky-high tax rates. Dispensaries can’t deduct traditional business expenses like advertising costs, employee payroll, rent and health insurance from their combined federal and state taxes. That means dispensary owners around the U.S. often face effective tax rates of 50 to 60 percent — and in some states, those rates soar to 80 percent or higher, according to members of the pot industry who spoke to The Huffington Post. In other words, the federal government rakes in tax revenue from pot shops while prohibiting them from accessing the same financial benefits afforded to non-cannabis businesses. ‘We now have thousands of basically small- and medium-sized businesses across the country in over 20 states that are perfectly legal, who are being discriminated against in terms of the tax system because they can’t deduct legitimate business expenses,’ Rep. Earl Blumenauer (D-Ore.) told The Huffington Post. ‘Their effective tax rate is two, maybe three times higher depending on where they are in their business cycle’.”
Benjamin Moses Leff, Associate Professor of Law, American University Washington College of Law, published an excellent law review article about Internal Revenue Code Section 280E, a troublesome tax statute for state-legal medical marijuana dispensaries.
“In recent years, many states have legalized marijuana while the federal government has not. But marijuana industry insiders consider not federal criminal law but federal tax law to be the biggest impediment to the development of a legitimate marijuana industry. State-sanctioned marijuana sellers are required to pay federal income taxes pursuant to I.R.C. § 280E, a formerly largely symbolic provision that Congress enacted to punish drug dealers, but which now could potentially drive legitimate marijuana sellers underground.
This Article proposes a tax strategy that enables state-sanctioned marijuana sellers to avoid the impact of § 280E by qualifying as a tax-exempt organization. The IRS has already stated that a marijuana seller cannot be exempt under I.R.C. § 501(c)(3) because the so-called ‘public policy doctrine’ does not permit a charity to have purposes that are contrary to law. This Article proposes for the first time that the public policy doctrine does not apply to § 501(c)(4) organizations, which opens the door for marijuana sellers to qualify as tax-exempt. The organization would have to be operated to improve the social and economic conditions of a neighborhood blighted by crime or poverty by providing job training, employment opportunities, and improved business conditions for commercial development in the neighborhood, just like many existing community economic development corporations that run businesses.
This novel argument is more than just a ‘tax loophole’ to avoid the impact of § 280E. Rather, IRS recognition of tax-exempt status for marijuana sellers could actually provide a mechanism to resolve the federalism issues raised by the conflict between state and federal marijuana laws. A federal policy that incentivizes marijuana sellers to be nonprofit, neighborhood-based organizations in effect ties federal approval to local support.”
Marielys Rosado Barreras wrote in Law360: “The use of marijuana (in various quantities and forms) has been legalized (in a variety of ways) in 20 states and the District of Columbia. Nonetheless, marijuana is still listed as a Schedule I controlled substance under the Controlled Substance Act (CSA), and therefore its possession, use and distribution remains a crime under federal law. Further, the U.S. Supreme Court has ruled that the federal government has a right to regulate and criminalize the sale and use of marijuana, even when a state’s laws permit marijuana to be used for medical purposes. For example, in Gonzales v. Raich,
Thus, the court held that even small amounts of home-grown marijuana triggered the CSA because there was a threat of unwanted commodity diversion that could disrupt Congress’ regulatory control over interstate commerce. “
Sacramento Bee: “Sacramento’s Canna Care dispensary, an evangelical medical marijuana provider renowned for doling out buds with Bibles, is waging a public fight with the Internal Revenue Service over an $873,167 tax penalty sought under a tax code aimed at illegal drug traffickers. On Feb. 24, the U.S. Tax Court in San Francisco is due to hear Canna Care’s challenge over whether the IRS can impose the hefty tax demand under a 1982 law intended to close a loophole that allowed a Minneapolis cocaine and methamphetamine dealer to claim tax deductions for a scale, his apartment rent and telephone expenses. In the case of Canna Care, the IRS has refused to accept $2.6 million in business deductions for employee salaries, rent and other costs after auditing 2006, 2007 and 2008 federal tax returns for the north Sacramento dispensary. However, the IRS did allow the dispensary, which handles about $2 million in medical marijuana transactions a year, to deduct the costs of the marijuana itself.”
FoxNews: “The Obama administration took the unprecedented step Friday of clearing the way for banks to do limited business with marijuana sellers, releasing guidelines for how financial institutions can work with pot shops in states where it’s legal. The move immediately was greeted with relief from the budding marijuana industry. Before the guidance, banks largely had avoided the new pot shops in Colorado for fear of federal prosecution — leaving marijuana sellers running cash-only operations. . . . It’s unclear, though, to what extent banks will engage those businesses. One industry group, the Consumer Bankers Association, voiced legal concerns despite the new guidelines and urged Congress to get involved.”
thedailybeast: “How prohibitionists and nanny staters are trying to keep marijuana illegal—or at least inconvenient. In 2012, voters in Colorado and Washington passed full-on, no-hemming-or-hawing pot legalization by large majorities. Lawmakers in each state have spent the better part of the past year figuring out how to tax and regulate their nascent commercial pot industries . . . . Unfortunately, it’s starting to look like both states are going to treat pot in a manner similar to alcohol during Prohibition. Not only are pot taxes likely to be sky high, various sorts of restrictions on pot shops may well make it easier to buy, sell, and use black-market marijuana rather than the legal variety.
Forbes: “When Congress banned marijuana in 1937, it did so in the guise of taxation, imposing a prohibitive levy on cannabis and created criminal penalties for those who failed to pay it. Marijuana taxes also played a prominent role in what may be the beginning of the end for pot prohibition: the legalization measures that voters in Colorado and Washington approved last fall . . . . The dilemma is especially clear in Washington, where I-502 specified a 25 percent excise tax at three levels: sales between producers and processors, between processors and retailers, and between retailers and consumers. That’s in addition to the standard state sales tax of 8.75 percent.”
Huffington Post: “‘Marijuana Industry Eager to Pay Taxes — and Cash in on Deductions’ says a recent McClatchy headline. There’s a conundrum: The state-legal marijuana industry (1) understands that a new federal excise tax would give it legitimacy, but (2) seeks repeal of the discriminatory Reagan-era statute saying that taxpayers ‘trafficking’ in ‘narcotics’ cannot deduct ordinary business expenses on their Federal income tax returns. But that current no-tax-deduction rule makes marijuana advertising nondeductible – and that probably makes sense. For most proponents of marijuana legalization, advertising is a frill, not an essential. But for opponents of legalization, marijuana advertising is anathema.
Huffington Post: “the Internal Revenue Service has been systematically targeting medical marijuana establishments, relying on an obscure statute that gives the taxing agency unintended power. The IRS has been functioning as an arm of justice, employing the U.S. tax code as a weapon in the federal government’s ongoing war against legal cannabis. The majority of Americans favor legalization of marijuana, while 18 states and the District of Columbia have already legalized medical marijuana. But pot businesses in those states are vulnerable to the federal government’s strategic application of IRS Code Section 280E, a law enacted in 1982 after a drug dealer claimed his yacht and weapons purchases as legitimate business expenses — and long before medical marijuana was first legalized in California in 1996. Now the IRS is applying a rule originally aimed at illegal (and often violent) drug trafficking to businesses that are entirely legal under their states’ laws. Medical marijuana dispensaries are facing audits and heavy tax bills that could force them out of business.
American University Washington College of Law Professor Benjamin Leff thinks there is a way that medical marijuana dispensaries in states that have legalized medical marijuana can avoid the application of Internal Revenue Code Section 2080E that causes taxpayers to pay extraordinarily high federal income taxes. Professor Leff wrote an article in Slate called “How legal marijuana sellers can beat a draconian tax” in which he states:
“‘The federal tax situation is the biggest threat to businesses and could push the entire industry underground,’ . . . . sellers of controlled substances—in other words, drugs, including marijuana—are not permitted to deduct any ordinary business expenses other than the cost of the goods they are selling. That’s because of section 280E of the federal tax code . . . . I teach tax law, and I have a solution: Marijuana sellers should operate as nonprofit ‘social welfare organizations’.”
I am not a professor of tax law, but I do hold a masters in law degree (LL.M.) in income tax from New York University School of Law and have studied and written about Code Section 280E. My opinion is that the IRS and the federal courts are not going to allow taxpayers to violate federal criminal law (growing, possessing and selling marijuana) and avoid paying federal income taxes or the application of Code Section 280E.
CNN Money: “entrepreneurs in the nascent medical marijuana industry face a unique burden: an effective federal income tax rate that can soar as high as 75%. The hefty levy is the result of a 1982 provision to the tax code, known as 280E, . . . . the rule bars those selling illegal substances from deducting related expenses on their federal income taxes. . . . Jim Marty, an accountant in Colorado specializing in medicinal marijuana tax law, said he has one client that didn’t turn a profit in 2009, 2010 or 2011. In 2012, though, she was handed a $300,000 tax bill from the IRS for those three proceeding years.”
For more on Section 280E read:
Forbes: “With 15 states having legalized the sale of medicinal marijuana, the only thing growing faster than the number of 24-year old males with questionable glaucoma prescriptions is the IRS’s scrutiny of this controversial industry. While local law may have blessed the existence of medicinal marijuana facilities, the IRS is not bound by such decisions. The IRS cares only about tax collections, and during 2012 it threw down the gauntlet, presenting a flurry of challenges to medicinal marijuana dispensaries that indicate the Service’s willingness, and more importantly, its ability, to tax the industry out of existence. In early March, the IRS audited tax returns of a Marin County, California facility and denied all of the company’s deductions — payroll, rent, utilities…everything – for 2008 and 2009, resulting in an assessed tax in the “millions and millions” according to the facility’s founder and director.”
Read the Tax Court’s opinion involving Martin Olive’s dispensary called The Vapor Room in the case of Olive v. Commissioner, 139 T.C. 2, (2012).
Arizona Republic: “The West Valley could see as many as a dozen medical-marijuana dispensaries if every applicant selected in a bingo-style state lottery earlier this month opens for business. But it’s unclear exactly where the proposed dispensaries, which would be allowed to grow and sell marijuana, would open. A state confidentiality law prohibits the Department of Health Services from releasing the locations of the dispensaries or the names of selected applicants.”
The story mentions White Mountain Health Center Inc., Arizona Organix Inc., PP Wellness Center, Branden Orr, Daniel Coogan, owner of Golden Leaf Wellness Inc., Michael Morrow and Valley of the Sun Medical Dispensary Inc.
On August 2, 2012, the U.S. Tax Court issued its decision in the case of Martin Olive vs. Commissioner of the Internal Revenue Service. Martin Olive, a young man unconcerned with the normal formalities of operating a business, owns a relatively well known medical marijuana dispensary in San Francisco, California, called the Vapor Room Herbal Center that used to operate in a 1,250 square foot store in a low income neighborhood. The Tax Court said that Mr. Martin “consciously opted not to keep adequate books and records and that action was in reckless or conscious disregard of rules or regulations.” The Vapor Room was in the news recently because it announced that it was going out of business.
Martin Olive started the Vapor Room in 2004 and operated it as a sole proprietorship rather than through an entity that would protect him from the debts and liabilities of the business. Martin operated the business as a cash business and apparently did not keep records of any kind other than journals written by him that contained income and expense information. The IRS assessed deficiencies against Martin Olive of $692,501 for 2004 and $1,199,814 for 2005 plus accuracy-related penalties to $138,500 for 2004 and $239,963 for 2005. On his federal income tax returns Martin Olive reported that the Vapor Room’s “principal business” is “Retail Sales” and that its product is “Herbal.”
The court ruled:
The Tax Court was not impressed by witnesses who testified on behalf of the Vapor Room. The Court said:
“Petitioner’s testimony and the testimony of his other witnesses was rehearsed, insincere and unreliable. We do not rely on petitioner’s testimony to support his positions in this case, except to the extent his testimony is corroborated by reliable documentary evidence. We also do not rely on the uncorroborated testimony of petitioner’s other witnesses, three of whom are (or were) patrons of the Vapor Room and all of whom are closely and inextricably connected with the medical marijuana industry and with a desired furtherance of that movement.”
The Court found that Martin Olive’s gross receipts for the were $1,967,956 om 2004 and $3,301,898 in 2005.
Cost of Goods Sold
The case is a road map for how medical marijuana dispensaries should not conduct their businesses. For example, the self-prepared journals in which Martin Olive wrote his income and expenses were ignored by the Court as proof of any expenses. The Court said:
“Petitioner argues nonetheless that the ledgers alone are sufficient substantiation for taxpayers operating in the medical marijuana industry because, he states, that industry “shun[s] formal ‘substantiation’ in the form of receipts.” We disagree with petitioner that the ledgers standing alone are sufficient substantiation. The ledgers did not specifically identify the marijuana vendors or reflect any marijuana that was received or given away. The ledgers neither were independently prepared nor bore sufficient indicia of reliability or trustworthiness. The substantiation rules require a taxpayer to maintain sufficient reliable records to allow the Commissioner to verify the taxpayer’s income and expenditures. . . .
Neither Congress nor the Commissioner has prescribed a rule stating that a medical marijuana dispensary may meet that substantiation requirement merely by maintaining a self-prepared ledger listing the amounts and general categories of its expenditures. It is not this Court’s role to prescribe the special substantiation rule that petitioner desires for medical marijuana dispensaries and we decline to do so. . . .
Petitioner consciously chose to transact the Vapor Room’s business primarily in cash. He also chose not to keep supporting documentation for the Vapor Room’s expenditures. He did so at his own peril. . . . Petitioner asserts that he minimized the Vapor Room’s use of checks because he did not want his bank to know that the Vapor Room was a medical marijuana dispensary. We find that assertion incredible, especially given that petitioner informed the bank that his business was named ‘Vapor Room’. . . .
Petitioner informs us that California did not allow medical marijuana dispensaries to earn a profit for the years at issue. The need to report no profit may improperly cause a dispensary to understate gross receipts or to overstate expenditures. We are especially wary here, where petitioner by his own admission understated his gross receipts and took steps to disguise his cash withdrawals from his business to conceal them from his employees”
Martin Olive did win one big victory. Despite lacking any records of the cost of goods sold and saying it didn’t believe his expert witnesses, the Court accepted the testimony of Henry C. Levy, C.P.A. that the average COGS of a medical marijuana dispensary is 75.16% of its gross receipts despite stating that “we generally found Mr. Levy to be unreliable” and “his testimony improperly consisted mainly of legal opinions and conclusions.”
Section 280E
Section 280E of the Internal Revenue Code provides that a taxpayer may not deduct any amount for a trade or business where the “trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances. Selling marijuana is a controlled substance for the purposes of Section 280E. Martin Olive argued that the Vapor Room that in addition to selling marijuana the Vapor Room operated the separate business of “care-giving.” Unlike the Tax Court case of Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), where the Court found that CHAMP did operate a separate business and allowed deductions for expenses of that business, the Court in this case found no evidence that Martin Olive had any business other than selling marijuana.
The Court’s discussion of why it found that CHAMP operated two businesses and the Vapor Room did not is instructive for all medical marijuana dispensaries.
“The record establishes that the Vapor Room is not the same type of operation as the medical marijuana dispensary in CHAMP that we found to have two businesses. The differences between the operations are almost too numerous to list. The dispensary there was operated exclusively for charitable, educational and scientific purposes and its income was slightly less than its expenses. . . . The director there was well experienced in health services and he operated the dispensary with caregiving as the primary feature and the dispensing of medical marijuana (with instructions on how to best consume it) as a secondary feature. . . . Seventy-two percent of the CHAMP dispensary’s employees (18 out of 25) worked exclusively in its caregiving business and the dispensary provided its caregiving services regularly, extensively and substantially independent of its providing medical marijuana. . . . It rented space at a church for peer group meetings and yoga classes and the church did not allow marijuana on the church’s premises. . . . It provided its low-income members with hygiene supplies and with daily lunches consisting of salads, fruit, water, soda and hot food. . . . Its members, approximately 47% of whom suffered from AIDS, paid a single membership fee for the right to receive caregiving services and medical marijuana from the taxpayer. . . . The names of the dispensaries are even diametrically different. The name of the dispensary there, ‘Californians Helping To Alleviate Medical Problems,’ stresses the dispensary’s caregiving mission. The name of the dispensary here, ‘The Vapor Room Herbal Center,’ stresses the sale and consumption (through vaporization) of marijuana.”
The opinion does not state how much Martin Olive owes for 2004 and 2005, but it must be a big number. Also unmentioned is whether the IRS audited Martin Olive for years after 2005. I suspect that it did because of what it found in its 2004 and 2005 audits.
For more on this case read “Tax deductions for medical pot business go up in smoke, court rules” and “Bad News for Medical Marijuana Dispensaries (and Especially for the Vapor Room).”
On August 2, 2014, the Tax Court held that: (i) Martin Olive underreported gross receipts from the sales of medical marijuana by the Vapor Room medical marijuana dispensary, (ii) IRS Section 280E prevented him from deducting business related expenses, and (iii) he was liable for accuracy-related penalties. The court did allow Olive to deduct his cost of goods sold. The case is Olive v. Commissioner, 139 T.C. No. 2 (Aug. 2, 2012). The court said:
“A vaporizer is an expensive apparatus that extracts from marijuana its principal active component and allows the user to inhale vapor rather than smoke. Petitioner chose the name of his business to publicize that the Vapor Room had the requisite equipment to allow patrons to vaporize marijuana there. …
Petitioner’s testimony and the testimony of his other witnesses was rehearsed, insincere and unreliable. We do not rely on petitioner’s testimony to support his positions in this case, except to the extent his testimony is corroborated by reliable documentary evidence. We also do not rely on the uncorroborated testimony of petitioner’s other witnesses, three of whom are (or were) patrons of the Vapor Room and all of whom are closely and inextricably connected with the medical marijuana industry and with a desired furtherance of that movement. …
We hold that the Vapor Room’s gross receipts for the respective years were $1,967,956 and $3,301,898. …
We conclude that the Vapor Room’s COGS for each year at issue equals 75.16% of the Vapor Room’s gross receipts for the year, as further adjusted to take into account our finding that petitioner gave away 6.5% of the Vapor Room’s purchases. …
The parties agree that § 280E disallows deductions only for the expenses of a business and not for its COGS. … [We] reject petitioner’s contention that § 280E does not apply because the Vapor Room was a legitimate operation under California law. We have previously held that a California medical marijuana dispensary’s dispensing of medical marijuana pursuant to the CCUA was “trafficking” within the meaning of § 280E. [Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173 (2007).] That holding applies here with full force. …
Respondent argues that petitioner is liable for the accuracy-related penalty to the extent he has understated the Vapor Room’s gross receipts and failed to substantiate the Vapor Room’s COGS and expenses. Petitioner’s sole argument in brief is that the penalty does not apply because, he states, any inaccuracy underlying an understatement was “accidental, not substantial, and/or not negligent on the part of the taxpayer.” Petitioner asserts that the Vapor Room was his first business and that he was not instructed on the proper way to keep the books and records of a business. We agree with respondent that the accuracy-related penalty applies in this case.”
Forbes: “If you live in a state with legal medical marijuana dispensaries you probably know that the feds do what they can to stamp them out. . . . The nationwide crackdown involves a multi-pronged approach, and that’s not easy for the dispensaries or for the people who rely on them. . . . In the meantime, the dispensaries remain in the crosshairs. Notable cases include California’s massive Harborside Health Center.”
Read other articles on income taxes and medical marijuana dispensaries:
Entities that actually obtain a dispensary registration certificate from the Arizona Department of Health Services will be required to file federal income tax returns that are substantially different than tax returns of other businesses. Medical marijuana dispensaries must keep financial books in a way that will assist the dispensaries’ CPAs in preparing the federal and state income tax returns. A particularly troublesome issue arises from Internal Revenue Code Section 280E that prohibits deductions for expenses paid or incurred in connection with trafficking in marijuana.
Dispensaries should hire an accountant and tax advisor who have experience representing and advising medical marijuana dispensaries. They should not pay an inexperienced person to learn on the job. Here are two people who have experience dealing with the federal income tax treatment of medical marijuana dispensaries.
The Bay Citizen: “IRS Claims Harborside Health Center Owes $2.5 Million in Back Taxes on Sales of $22 Million – Oakland’s Harborside Health Center — the largest medical marijuana dispensary on the West Coast — lost the first round in a high-stakes battle with the Internal Revenue Service that could spell trouble for the booming pot industry. In a letter to Harborside late last week, the IRS ruled that the dispensary cannot deduct standard business expenses such as payroll and rent, because it is involved in what the agency terms ‘the trafficking of controlled substances,’ said Luigi Zamarra, Harborside’s chief financial officer. . . .If the IRS ultimately prevails, ‘we would close our doors and go away because the business model wouldn’t work,’ he said.”
See also “Harborside’s Death Tax,” which says:
“The federal government is attempting to tax Oakland’s Harborside Health Center — perhaps the country’s largest and most prominent medical marijuana dispensary — out of existence. “
Read Richard Keyt’s article called “IRS is in the Early Stages of a War to Kill Medical Marijuana Dispensaries.”
Arizona Republic: “Last week, the Tempe City Council had its first hearing on the possibility of amending the city’s tax code so that those purchasing the drug in Tempe could be charged a 2-percent municipal sales tax.”
Taxes.com: “Henry Wykowski . . . represented Californians Helping to Alleviate Medical Problems . . . in that dispensary’s landmark 2007 case against the IRS. Now, many of the growing number of California dispensaries facing what could amount to debilitating audits have sought out Wkyowski’s services. . . . ‘The most successful dispensaries do more than strictly offer cannabis.’ Says Wykowski, ‘I personally believe that a large part of the government decided that because they had not been successful through the DEA to shut [the dispensaries] down, maybe they could tax them out of business’.”
Answer: Yes. In 2007 the United States Tax Court issued its opinion in the case of Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner of Internal Revenue. The issue in this case was what business expenses could a California medical marijuana dispensary deduct on its federal income tax return in light of Internal Revenue Code Section 280E, which states:
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.
In the CHAMPS case, the IRS conceded that the taxpayer could deduct its cost of goods sold, which included $575,317 for marijuana. Based on news reports about recent IRS audits of big California medical marijuana collectives, it appears that the IRS wants to revisit Section 280E and how it applies to medical marijuana dispensaries.
Warning to All Would-Be and Existing Medical Marijuana Dispensaries about Federal Income Taxes
The IRS is auditing a number of high dollar revenue medical marijuana dispensaries in California. See for example “IRS tells California Medical Marijuana Dispensary it Owes Millions in Unpaid Taxes” and “Millions at Stake in IRS Audit of Oakland Medical Marijuana Dispensary.” I believe that the ultimate goal of the IRS is to change the result in the CHAMPS case, which will have the practical affect of putting almost all state legal medical marijuana dispensaries out of business. If a dispensary spends $1,000,000 to grow its marijuana in 2011 and none of that expense is deductible because of Section 280E, then the dispensary will pay federal income taxes of $340,000 that it would not pay if the expense were deductible. This means it actually will cost the dispensary $1,340,000 to grow $1,000,000 of marijuana.
I do not know why the IRS conceded in CHAMPS that the taxpayer could deduct the cost of goods sold. COGS was the taxpayer’s biggest expense. I believe the IRS regrets conceding in CHAMPS that the COGS was deductible. I predict the IRS will disallow the COGS of the medical marijuana dispensaries it audits. I believe the IRS wants to litigate this issue in federal district court rather than in Tax Court with the ultimate goal of having the 9th Circuit Court of Appeals rule that COGS is not deductible by a state legal medical marijuana dispensary. If the IRS can get one or more appellate courts to agree that the COGS is not deductible, the practical result may be to kill the medical marijuana industry in every state that has legalized it.
Tax Court vs. Federal District Court & Circuit Courts of Appeal
The CHAMPS case was a U.S. Tax Court case that had a good result for the medical marijuana dispensaries in states that have legalized the growing and sale of medical marijuana. Neither federal district courts nor Circuit Courts of Appeal are required to follow the decisions of the Tax Court. That is why the IRS wants to relitigate Section 280E in the federal district courts and then the appropriate Circuit Court of Appeals. The IRS wants to reverse the CHAMPS case by winning at the Circuit Court of Appeals level.
When the IRS conducts an audit and demands more taxes from a taxpayer, the taxpayer who wants to dispute the results of the audit has two choices:
Tax court decisions cannot be appealed. Federal district court decisions can be appealed by the losing party to the appropriate Circuit Court of Appeals, which is the 9th Circuit for California and Arizona. district courts. Any legal medical marijuana dispensary that is assessed additional taxes by the IRS will want to pay the additional taxes and have the Tax Court rule on the dispute. The practical problem with this tactic, however, is that most dispensary taxpayers will not have the cash to pay the amount of taxes in dispute and will be forced to litigate in the federal district court.
The choice of venue to litigate the dispute is significant. Dispensaries will want to pay the tax and go to the Tax Court where they expect the Court to apply the holdings of the CHAMPS case. Clearly the IRS does not want these medical marijuana dispensary Section 280E cases to go to the Tax Court where the CHAMPS case is bad precedent for the IRS. What the IRS is doing is going after dispensaries that have high income and expenses so that when it demands more taxes, the dispensaries most likely will not have the money to pay the amount in dispute and must then go to the U.S. district court. Because the amount of tax dollars in dispute will be so big, the loser in the district court will appeal to the 9th Circuit Court of Appeals where the IRS hopes it will get a favorable Section 280E ruling that will effectively allow it to tax legal medical marijuana dispensaries out of existence.
The Marin Alliance for Medical Marijuana is being audited by the IRS. When asked how much the IRS is demanding in back federal income taxes, Lynnette Shaw, the owner of this dispensary, would not disclose the amount, but she said, “It’s a staggering sum, millions and millions.” I’m guessing this dispensary does not have a few spare millions of dollars lying around to pay the IRS so it can litigate the dispute in tax court.
Related Stories:
Disclaimer
Although I have a masters degree in income tax law from New York University Law School, I am no longer a practicing tax lawyer. I recommend that every dispensary hire a good experienced tax CPA or tax lawyer to advise the dispensary on the federal and state income tax issues arising from the operation of a medical marijuana dispensary.
Circular 230 Notice: Pursuant to recently-enacted U.S. Treasury Department regulations, I am required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including websites linked to, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
Sacramento Bee: Harborside Health Center in Oakland, California “handles $22 million in annual medical marijuana transactions. Now Harborside is attracting scrutiny from the Internal Revenue Service. Since last year, the IRS has been auditing 2008 and 2009 federal tax returns for the Oakland location, one of two outlets Harborside operates for 70,000 medical marijuana users. . . . Harborside and other California dispensaries – which currently pay more than $100 million in state sales taxes in addition to local fees – may be in peril if the IRS rigidly enforces its tax code.”
Marin Independent Journal: “The Internal Revenue Service has notified the Marin Alliance for Medical Marijuana in Fairfax that it owes millions of dollars in unpaid back taxes, according to the alliance’s founder and director, Lynnette Shaw. Shaw said the IRS audited the alliance’s tax returns for 2008 and 2009 and disallowed all of its business deductions. She said that although dispensaries throughout the state are being audited by the IRS, the alliance is the first to be told it can’t deduct business expenses. ‘Every dispensary in the nation, past, present and future is dead if this is upheld,’ Shaw said. . . . Shaw said the IRS disallowed her deductions — for buying marijuana, hiring employees, securing office space and more — based on section 280E of the federal tax code, which states that no deduction shall be allowed for any business trafficking in controlled substances.”
This story is a wake-up call and warning to all prospective Arizona medical marijuana dispensaries. Despite the CHAMPS case, which was decided in the U.S. Tax Court, the IRS apparently is disallowing ALL deductions of medical marijuana dispensaries. Prospective Arizona medical marijuana dispensaries should consider this fact when doing budgets and financial projections for their dispensary businesses. See “Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner of Internal Revenue.”
The American Independent: “Federal agencies have stepped up efforts to crack down on medical marijuana, and while high-profile ATF raids may be more immediately shocking, there is a less direct tactic being used that could spell the death of medical marijuana across the country, according to its opponents. In the last several months, the IRS has begun targeting medical marijuana dispensaries in California, declaring that some owe millions in back taxes as a result of a section of U.S. tax code that the IRS is now applying to medical marijuana dispensaries.”
Given the recent enactment of the Arizona Medical Marijuana Act, we anticipate a number of new business enterprises in the Arizona market attempting to comply with its “dispensary” provisions. Thoughtful entrepreneurs engaged in this fledgling industry will be wondering whether they will be permitted to deduct the expenses incurred in their business operations. This article will consider relevant tax provisions and attempt to provide a meaningful “rule of thumb” that these businesspersons, or their tax preparers, may find useful.
Background
The Arizona Medical Marijuana Act authorizes the establishment of nonprofit medical marijuana dispensaries (“dispensaries”). These dispensaries are to be licensed, tightly regulated, and inspected and are intended to provide medical marijuana to qualified patients, with their doctor’s approval, or their designated caregivers. Although, under Arizona Revised Statutes Section 36-2806, these dispensaries are to be nonprofit entities (but they need not be tax-exempt organizations for IRS purposes), they are clearly authorized by Arizona Revised Statutes Section 36-2801 to receive payment for all expenses incurred in their operations. As a result of receiving such revenue, they will undoubtedly be required to file income tax returns. Before considering these tax returns, however, an important legal issue must be dealt with. Is this business legal or illegal?
Although this may seem like a strange question to be asking, given that we are able to review specific Arizona statutes that authorize the business and provide detailed rules on numerous aspects of the creation and operation of such dispensaries, we would be remiss if we failed to do so. Since, however, the focus of this article is not the legality of a dispensary, we will rely on existing analysis of the issue as it has arisen in connection with California statutes, which have been around for the past decade and a half.
Since the passage of the Compassionate Use Act of 1996 and the California Medical Marijuana Program Act, California businesses have been wrestling with a number of legal issues and have had the opportunity to create a growing base of case law that will undoubtedly provide precedence as these same issues arise under Arizona law. The most important issue is whether the creation of these state statutes that authorize the possession and use of marijuana for medical purposes provides some protection, some defense, from Federal prosecution for the possession or use of illegal drugs.
A number of cases make it clear that the possession and use of marijuana, even for medical purposes, is still illegal under Federal law. See, for example, Footnote 10 of the California Supreme Court case, People v. Kelly (2010). According to the Controlled Substances Act, marijuana remains a Schedule I drug and, state statutes authorizing medical use to the contrary, Federal law does not contain any exception for “medical use”. Furthermore, Federal law still supersedes state law (Gonzalez v. Raich US Sup. Ct (2005)). In short, except perhaps for certain, specific research purposes, no use of marijuana is legal.
Thus, it would appear that any person or business possessing marijuana, even if in compliance with state medical use laws, is involved in an illegal business activity. This fact explains the many legal conundrums arising in advice given in the industry. Should a doctor merely “approve” of a patient’s medical use of marijuana or may she “recommend” it? May the product be “sold” or must it be given away (in exchange for a donation)? What is the difference between distribution by a “dispensary” and a “collective”? It should be noted that these issues arise, not necessarily as a result of any ambiguity in the state statutes, but because of concern over exposure to legal liability at the Federal level.
One may find some comfort (but, perhaps, not much) in statements issued by/on behalf of the Department of Justice (DOJ). In 2009, the Attorney General indicated that even though the DOJ does not condone any possession or use of marijuana, in an effort to use its resources efficiently, it would limit its prosecution efforts and target only dispensaries being used as a front for dealers of illegal drugs. However, in the DOJ guidelines issued in October 2009, I believe it expressed its intention more broadly, that is, it intended to prosecute “for profit” enterprises. Its statements have also indicated that it will not require its agents to prove any violation of specific state (Medical Use) statutes during such prosecutions (that is, such statutes do not matter and, even if followed precisely, offer no defense).
Thus, although AS 36-2811(B) clearly states that those complying with the provisions of the Arizona Medical Marijuana Act are not subject to arrest, prosecution or penalty for their possession or use of marijuana, this statute should not provide much comfort for anyone using or possessing marijuana for medical purposes. It may serve to give guidance to state police on the proper use of their resources but will apparently not affect Federal law enforcement officials. For further analysis of this issue, and others, you may wish to consider the White Paper on Marijuana Dispensaries, issued by the California Police Chief Association’s Task Force in April 2009 (www.counties.org. , under the CSAC Advocacy tab), as a possible starting point.
We will leave the resolution of this issue to the interested lawyers among you. For the remainder of this article, we will assume that a medical marijuana dispensary is an “illegal” business activity for Federal tax purposes.
Tax Guidelines (more…)
Question: I know that in 2007 the U.S. Tax Court ruled in the CHAMPS case that Section 280E of the Internal Revenue Code prohibits deducting from gross income any business expenses that are paid or incurred in connection with trafficking in marijuana. Is there a way that my nonprofit entity that operates an Arizona medical marijuana dispensary can deduct any of its expenses from its gross income on the dispensary’s federal income tax return?
Answer: Yes. In the CHAMPS case, the IRS conceded that the taxpayer could deduct its cost of goods sold, which included $575,317 paid for marijuana. The fight in the CHAMPS case was over what business expenses the taxpayer could deduct. The IRS argued that the taxpayer had only one business – trafficking in marijuana – and therefore none of its business expenses other than its cost of goods sold were deductible. The taxpayer successfully argued that it operated two businesses – its medical marijuana sales business and its care-giver business. The Tax Court agreed with the taxpayer and allowed the taxpayer to allocate its expenses to its two separate businesses and deduct expenses attributable to the care-giver business.
If your Arizona medical marijuana dispensary wants to be able to deduct anything from its gross income above and beyond its cost of goods sold, the dispensary must engage in one or more trades or businesses that do not involve medical marijuana. Every would-be dispensary should carefully study the CHAMPS case and learn how CHAMPS operated its care-giver business, which was very extensive and real. The case illustrates that the sale of medical marijuana was in fact a small portion of everything that the dispensary offered to its patients. Note also that the salaries paid to management and staff were very nominal – $14,914 paid to officers and directors and $44,799 salaries paid to 25 employees of a dispensary that collected just over $1,000,000 in gross revenue.
Example 1: Dispensary 1 operates a 2,000 square foot retail dispensary in Phoenix where its sole activity is displaying its products and selling products to patients over the counter. This dispensary’s entire business involves trafficking in marijuana so it cannot deduct any of its expenses from its federal income tax return.
Example 2: Dispensary 2 operates a 2,000 square foot retail dispensary in Phoenix, but next door to the dispensary it has an additional 2,000 square feet of space where it provides other services and products to the public such as:
Dispensary 2 can now:
Consider this simple allocation of dispensary 2’s expenses:
For more on this important topic, see “IRS is in the Early Stages of a War to Kill Medical Marijuana Dispensaries.”
Although I have a masters degree in income tax law from New York University Law School, I am no longer a practicing tax lawyer. I recommend that every dispensary hire a good experienced tax CPA or tax lawyer to advise the dispensary on the federal and state income tax issues arising from the operation of a medical marijuana dispensary.
Circular 230 Notice: Pursuant to recently-enacted U.S. Treasury Department regulations, I am required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including websites linked to, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
I heard a news report on the radio yesterday that quoted Arizona state legislator Steve Farley as saying that HB 2557 will be modified to tax sales of medical marijuana a a mere 100%. Whoopee! See Ray Stern’s story called “Medical Marijuana Tax Proponent Aims Lower; State Rep. Steve Farley Now Wants 100 Percent Tax, Not 300 Percent.”
The following is the text of a February 7, 2011, report from the House Ways & Means committee about HB 2557. The Bill is now sponsored by only three legislators – Farley, Ash, Chabin:
Overview
HB 2557 creates a nonprofit medical marijuana dispensary transaction privilege tax classification and imposes a transaction privilege tax (TPT) and a use tax on dispensaries.
History
Approved by the voters at the November 2, 2010 general election, Proposition 203, known as the Arizona Medical Marijuana Act, allows qualifying patients with debilitating medical conditions to obtain certain amounts of marijuana from nonprofit medical marijuana dispensaries.
TPT is Arizona’s version of sales tax. Under this tax, the seller is responsible for remitting to the state the entire amount of tax due based on the gross proceeds or gross income of the business. While the tax is commonly passed on to the consumer at the point of sale, it is ultimately the seller’s responsibility to remit the tax. Currently, there are 16 different transaction privilege tax classifications that are mostly taxed at a rate of 6.6 percent (except the mining classification) of their respective tax bases.
Use tax is paid by persons who use, store or consume any tangible personal property upon which tax has not been collected by a retailer. Scenarios in which use tax is collected include out-of-state retailers or utility businesses making sales to Arizona purchasers, Arizona purchasers buying goods using a resale certificate where the goods are used, stored or consumed in Arizona contrary to the purpose stated on the certificate, or where a purchase is made in another state and the sales tax or excise tax imposed is less than the Arizona use tax rate.
fiscal impact
A fiscal note prepared in 2010 by the Joint Legislative Budget Committee for SB 1222 (medical marijuana; transaction privilege tax) estimated that annual reported medical marijuana sales in Arizona would be $25,500,000.
Provisions
- Establishes a transaction privilege tax classification for nonprofit medical marijuana dispensaries, comprised of the business of selling or dispensing medical marijuana to qualified patients.
- States that the tax base for the nonprofit medical marijuana dispensary classification is the gross proceeds or gross income derived from the business.
- Sets the tax rate for the tax base at 300 percent.
- Stipulates that anyone engaged in business as a nonprofit medical marijuana dispensary who sells other tangible personal property at retail must separately account for those sales.
- Specifies that if separate records of sales of other tangible personal property are not kept, the tax shall apply to the person’s entire gross proceeds or gross income from the business.
- Excludes the tax revenues collected under the nonprofit medical marijuana dispensary classification from being designated for the statutory distribution base of TPT revenues (A.R.S. § 42-5029).
- Exempts medical marijuana dispensed by a registered nonprofit medical marijuana dispensary from the TPT imposed under the retail transaction privilege classification.
- Levies an excise (use) tax on the storage, use or consumption of tangible personal property purchased from a nonprofit medical marijuana dispensary at a tax rate of 300 percent of the sales price.
- Specifies that for manufactured buildings used in the state but purchased outside Arizona, the tax rate is a percentage of 65 percent of the sales price.
- Makes technical and conforming changes.
Watch the video of the portion of the February 8, 2011, Ways & Means committee hearing dealing with HB 2557. Click on the last link on the bottom left.
On January 26, 2011, a group of legislators who want to overturn the will of the majority of the Arizona people who voted for Arizona Proposition 203 (legalization of medical marijuana) and who know what is best for the masses introduced a proposed law that would kill Arizona’s medical marijuana industry before it begins and allow all 160,000 future medical marijuana patients to grow their own marijuana. House Bill 2557 will, if enacted unchanged, impose a sales tax of 300% on all medical marijuana. That means a $10 THC laden candy bar would cost the patient $40 and an ounce of marijuana that retails for $250 would cost the patient $1,000.
I googled “HB 2557” and marijuana today and found only one story in the first 5 pages of Google results in Arizona’s main stream media about HB 2557. The Tucson Citizen published a story on January 26, 2011, entitled “Drug Cartel Empowerment Act: Arizona Legislature proposes 300% sales tax on medical marijuana,” which stated:
“All I can say is WTF are you thinking?“
On January 27, 2011, the Arizona Daily Star published “Medical marijuana sales taxable, Horne says” in which HB 2557 is discussed. Apparently the paper interviewed one of the bill’s sponsors, Rep. Steve Farley, D-Tucson (phone (602) 926-3022; email address: [email protected]), about HB 2557. Farley said the tax could bring in as much as $1.8 billion a year and solve Arizona’s deficit problem. He also claimed that patients would not have a problem paying a total of $160 to buy an ounce of medical marijuana for $40. This guy appears to be out of touch with reality. Taxing anything 300% does not generate more sales tax revenue it generates ZERO sales tax revenue. Is there any item in the U.S. that must be purchased for 4 times its actual value?
My clients who operate dispensaries in Colorado tell me that an ounce of medical marijuana in Colorado sells between $250 – $400 depending on the strain and quality. For the benefit of the we know what is best for the people of Arizona legislators who think a 300% sales tax will generate revenue, I will do the math and show my work.
Example: Patient goes to local dispensary to purchase 1 ounce of medical marijuana and decides to buy the cheapest ounce for $250. Clerk rings up the sale and says “that will be $1,000 please.” Let’s analyze this sale from the perspective of the Arizona legislators who live in a different world and the perspective of the average guy on the street who may not be as smart as our legislators.
How the legislators think: 160,000 patients will happily fork over $1,000 to buy one $250 ounce of medical marijuana as just a small part of the patient’s grand plan to purchase 5 ounces per month and 60 ounces a year. Total cost to patient to purchase 60 ounces a year = (60 ounces x $250) $15,000 plus 300% tax of $45,000 = $60,000. Total sales tax revenue collected annually on medical marijuana purchases by 160,000 patients = 160,000 x $45,000 = $7,200,000,000. Budget deficit solved with the additional bonus that Arizona will have so much new revenue it can cancel all other types of sales taxes.
How the patients and citizens think: Are you kidding? Nobody is going to pay $40 for a $10 candy bar or $1,000 for a $250 ounce of medical marijuana. All 160,000 patients will grow their own marijuana. Total sales tax revenue collected by Arizona = 160,000 patients x $0 plus $0 sales tax = $0. There will not be medical marijuana dispensaries in Arizona.
Some years ago the brains in Congress who also are unaware of the laws of economics passed a luxury tax on yachts. The idiots actually thought that the rich would be happy to pay the tax and the federal government would collect more revenue. What actually happened was the rich (who are not stupid) stopped buying luxury yachts, the luxury yacht manufacturing industry died and the federal government collected less money from yacht sales.
Main Stream Media Not Reporting for Duty
Why isn’t the main stream media reporting this story? Does the main stream media oppose Proposition 203 and want to suppress news of HB 2557 to minimize public opposition to the bill? Early on the morning of January 27, 2011, I called and emailed an Arizona Republic reporter who has written a lot of stories about Prop 203 and medical marijuana in Arizona. The reporter responded that he/she would check out my January 27, 2011, article called “Arizona Legislators Introduce HB 2557 to Overturn Voters Approval of Proposition 203.” No Republic story on the 27th, 28th or 29th, but it did have two “who cares” stories on the front page of the Saturday, January 29, 2011, online version of the paper called “Valley cities fight unwanted garage-sale signs” and “Economy has 3 Valley chefs down, not out.”
What gives? Why aren’t the big Arizona papers and TV channels covering this story?
Arizona Republic: “Attorney General Tom Horne opposed a ballot measure to legalize medical marijuana but now he’s calling for it to be taxed. State tax collectors say that’s exactly what they plan to do.”
The Republic missed the big story on taxing medical marijuana. On January 26, 2011, a group of legislators introduced House Bill 2557 (aka the “Don’t Divert Money from the Drug Cartels Act”) that would tax the sale of medical marijuana at the rate of 300 percent. See “Arizona Legislators Introduce HB 2557 to Overturn Voters Approval of Proposition 203.”