This blog post will be in two parts. The first part will provide the reader with an understanding of the laws and concepts associated with the taxation of the marijuana business. The second part will take these ideas and concepts and attempt to provide some practical operational guidance.
The First Part
The income taxation of a marijuana business, whether it be a producer, processor, wholesaler or retail establishment, is very different from a non-marijuana business. Everyone entering into the business will want to talk with a tax expert experienced in the taxation of a marijuana business in order to maximize the return on their investment.
There are several sections of the Internal Revenue Code (“IRC”) that impact the taxation of the marijuana business. Businesses, in general, in which the sale of merchandise is an income producing factor, calculate their taxable income in accordance with three primary sections of the IRC. Those are code sections IRC § 162(a), IRC § 471 and IRC § 263A.
Come tax time, taxpayers in the marijuana industry in Oregon may want to proceed with caution. Since Oregon is tied to the Internal Revenue Code—specifically IRC § 280E—for purposes of income taxation, deductions relating to the trade or business of selling medical or recreational marijuana will be disallowed, and therefore taxpayers in this industry seeking to capitalize expenses and add them to the cost of goods should keep in mind that the taxing authorities will likely be monitoring this area closely. For more information on this issue, please read the latest post on our firm's sister blog Larry's Tax Law.
Under Section 162(a) of the Internal Revenue Code, a business can deduct from its gross income “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” According to the United States Court of Appeals for the Ninth Circuit, however, this deduction is not extended to marijuana related businesses. Olive v. Commissioner of Internal Revenue, No. 13-70510 (9th Cir. July 9, 2015).
In 2012, the United States Tax Court assessed penalties and interest against Vapor Room Herbal Center, a California medical marijuana dispensary owned by Martin Olive, for its deduction of $654,071 as business expenses on its 2004 and 2005 income tax returns. Although IRC Section 162(a) allows businesses to deduct “ordinary and necessary expenses,” IRC Section 280E prohibits a business from deducting for any “trade or business [that] consists of trafficking in controlled substances … prohibited by Federal law.” Citing Section 280E, the Tax Court held that operating a medical marijuana dispensary constituted trafficking in controlled substances in violation of federal law, even though it was legal under California law.
Olive appealed the Tax Court’s decision to the Ninth Circuit Court of Appeals. His first claim was that for a “trade or business” to “consist of trafficking in controlled substances,” the business must consist solely of trafficking in controlled substances. Olive argued that in addition to dispensing medical marijuana, the Vapor Room also offered free caregiving services such as yoga, massage therapy, discussion of illnesses, counselling on various personal, legal or political matters related to medical marijuana and education on how to consume medical marijuana responsibly. The Ninth Circuit agreed with the Tax Court that the Vapor Room’s only “trade or business” was the sale of marijuana. It noted that the test for determining if an activity is “trade or business” is whether the activity was entered into with the intent of making a profit. As the Vapor Room’s other services were offered for free, the only activity that could raise a profit was the sale of marijuana.
Olive’s second claim was that IRC Section 280E should not apply to him because it was enacted before medical marijuana dispensaries existed, therefore Congress could not have intended for medical marijuana dispensaries to fall within the category of “items not deductible.” The Ninth Circuit stated that this argument had no bearing on its analysis.
Olive’s last claim was that Section 538 of the Consolidated and Further Continuing Appropriations Act 2015, PL 113-235 prohibits the IRS from defending his appeal as it provides that federal funds may not be used to prevent states that at the time of the Act had legalized medical marijuana, from implementing their state laws authorizing the use, distribution, possession or cultivation of medical marijuana. The Ninth Circuit held that Section 538 does not apply because the IRS is not preventing California from implementing its laws that authorize the use, distribution, possession or cultivation of marijuana. Instead, the IRS is simply enforcing a tax, which does not prevent people from using, distributing, possessing or cultivating marijuana in California.
This ruling is an obvious and a troubling set-back for the marijuana business community. It is just another example of how the inconsistencies between federal and state laws can be challenging for marijuana users, growers, processors and regulators. This problem could be resolved by revising the Internal Revenue Code to provide a further exception under 280E to allow state-sanctioned marijuana enterprises. Until then, marijuana business owners should caution taking business deductions or – alternately, consider whether other business activities are entered into with the intent of making a profit for the business.
Foster Garvey’s Cannabis practice group comprises a premier legal counsel team who provides a full range of legal services such as regulatory compliance, marijuana licensing, business finance, contracts, labor and employment, health care, real estate, intellectual property, litigation and dispute resolution, technology and tax. Our team possesses deep and diverse industry experience and has counseled clients across virtually all industry sectors. We understand the inherent challenges that licensed marijuana and ancillary businesses in Washington state, Oregon and Alaska are burdened with in this highly regulated industry as they deal with onerous state and local regulations as well as uncertainty resulting from federal law.
We are committed to helping our clients achieve their business goals while navigating the intricacies in this rapidly changing area of law. We prize innovation and entrepreneurship, and closely monitoring industry trends.