Currently, 29 states and the District of Columbia allow legal use of marijuana in some form. Several more will join in 2018, while advocates in other states are pushing to add marijuana initiatives to upcoming ballots. Marijuana sales are big business and generate needed tax revenue for the states. Although state law legalizes activities related to its production and sale, marijuana is considered a Schedule I drug under the Controlled Substances Act of 1970. As such, this activity continues to be illegal under federal law. This dichotomy of state and federal laws on the use and sale of marijuana presents unique challenges to the industry.
As far as the IRS is concerned, all income is taxable, even illegal income. IRS publications state that “illegal activities, such as money from dealing illegal drugs, must be included in your income on Form 1040, line 21, or on Schedule C or Schedule C-EZ (Form 1040) if from your self-employment activity.” When no other crimes could be pinned to Al Capone, the Internal Revenue Service obtained a conviction for tax evasion. As the astonished Capone left the courthouse he said, “This is preposterous. You can’t tax illegal income!” But the fact is income from whatever source derived (legal or illegal) is taxable income.
State legalization often comes with heavy regulation and oversight. In addition, growers, distributors and dispensaries incur costs like any other business. They hire employees and pay overhead costs. For federal tax purposes a legitimate business is allowed to deduct all “ordinary and necessary” costs from revenue in order to compute their taxable income. This is not the case for the trafficking of controlled substances such as marijuana. Although all illegal income is taxable, not all expenses are deductible.
Code Sec. 280E specifically denies tax credits or deductions to businesses trafficking in controlled substances. However, the legislative history does not indicate that Congress intended to deny all of a taxpayer’s business expense deductions simply because the taxpayer was involved in trafficking in a controlled substance. Code Sec. 280E applies to deductions or credits that are taken against gross income. Therefore, the adjustment for cost of goods sold, which is subtracted from gross receipts to arrive at gross income, is allowed by Code Sec. 280E.
Subsequent to Code Sec. 280E, Congress amended Code Sec. 263A and added the UNICAP rules. The IRS has taken the position that costs that are not deductible under Code Sec. 280E are not capitalized under the UNICAP rules. On the other hand, excise tax is neither a deduction from gross income nor a tax credit and the IRS notes that Code Sec. 280E does not apply and is therefore included in the adjustment for cost of goods sold. Obviously the exclusion of credits and deductions results in a material distortion of taxable income and a higher effective rate of taxation.
There is little chance that Congress will act to exempt state-licensed marijuana suppliers from the rules under Code Sec. 280E anytime in the near future. One partial solution to this problem is to allocate appropriate expenses between two separate businesses. For example, a dispensary may also sell paraphernalia or provide counseling services. By segregating business activities, and isolating the sale of marijuana, businesses can use the benefit of the necessary and ordinary business expenses to their other operations. This approach has had mixed reaction from the IRS. Taxpayers should be cautious with this strategy and be diligent in recordkeeping and operations procedures, making certain that the expenses allocated to the legitimate operations cannot be expenses of the marijuana business. Any allocation must be supported in an IRS audit.
Because dealing in marijuana is illegal at the federal level, banks are prohibited from working with any marijuana business. Banks must adhere to FDIC regulations and refuse to accept money directly related to the sale of a controlled substance. There are some exceptions to this rule in Colorado, where some banks have found ways to work with the marijuana industry. But in general, these business have no access to bank accounts, and therefore, no check writing privileges.
While some businesses in the marijuana industry have begun accepting credit cards, it is still largely a cash-based industry. Where retailers must deal exclusively in cash, their customers cannot use credit or debit cards for payment. All payments to suppliers, landlords, and employees are in cash. This not only presents a security issue, with large amounts of cash on site, but there is the practical issue of how to make payroll tax deposits and pay the tax on income.
The IRS recognized this problem and now offers a way to pay taxes at participating retail stores using PayNearMe. There is a small fee for the cash payment option. It usually takes two business days to post to the account so a taxpayer should plan ahead to avoid interest and penalties. Payment limits are up to $1,000 per day. This cash option is only available at participating 7-Eleven locations in 34 states. In Colorado, payments can be made in cash at local IRS offices by appointment. In addition, the IRS has also offered cash counting rooms during the recent tax filing season in Denver and Seattle.
Finally, there are tax implications for the medical user. Although patients, many with serious or life threatening illness, may derive benefit from the use of marijuana and have the full endorsement of their doctor, they cannot take a deduction for the cost of the cannabis treatment. Payments for illegal treatments are not deductible as a medical expense.
If you have any questions or concerns related to the marijuana industry, please call our office. We are here to assist you.