Deductions Up in Smoke?
The Impact of Section 280E on the Marijuana Industry
By Brandon N. Mourges
In 2014, Maryland followed the path of many other states and passed legislation to legalize the sale of marijuana for medical use. Aside from the Maryland Medical Cannabis Program, some speculate that this action may usher in the legalization of marijuana for recreational use in the near future in Maryland. Given that monthly marijuana sales in Colorado now exceed $100 million and the industry employs approximately 175,000 individuals in 13 states, it is not a stretch to think that this could soon be a billion dollar a year industry for Maryland. Related industries, such as those involving the manufacturing of hemp-based products, will likely expand along with the marijuana industry. While burgeoning opportunities for entrepreneurs may be hard to pass on, continuing conflict between federal and state law may cause an unexpected marijuana hangover for the unwary.
Despite changes to state laws regarding its use and sale, marijuana continues to be classified for federal purposes as a Schedule I drug under the Controlled Substances Act (21 U.S.C. § 801 et seq.). Though the United States Department of Justice (“Department of Justice”) has issued guidance regarding marijuana enforcement in states where the use and sale of marijuana is legal (e.g., the Cole Memorandum and subsequent updates), this guidance is subject to change and has no impact on the Department of Justice’s ability to enforce existing federal laws to their full extent. Therefore, even if a marijuana dispensary is in compliance with all relevant state laws and regulations, there is no certainty that federal enforcement actions will not occur, even if none of the eight criteria specified in the Cole Memorandum are found to exist. For example, the Department of Justice will continue to focus its enforcement efforts to prevent distribution of marijuana to minors, prevent the generation of revenue from criminal enterprises and cartels, and to prevent marijuana use on federal property, even if the sale or use of marijuana is legal within a given state. Advisers need to be aware that their assistance of dispensaries could, under certain circumstances, be viewed as a violation of federal or state law or could subject them to scrutiny from an ethical perspective. Some state accounting and legal associations have already published guidance regarding the ethical and legal concerns for those assisting these businesses.
Though the aforementioned legal issues are significant, businesses and advisors in the marijuana industry must also consider a potentially ruinous tax issue: the application of Internal Revenue Code section 280E (“Section 280E”). That section provides:
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 essence, for federal tax purposes, any expenses incurred in the business of selling marijuana – even if permitted under state law – are not deductible. Absent a legislative change, since the computation of Maryland taxable income tracks its federal counterpart, Section 280E effectively disallows a substantial amount of deductions from a state income tax perspective as well.
While this may sound like a death knell to profitability in the industry, there are ways to mitigate the potential damage of Section 280E and its elimination of otherwise deductible expenses. First, the cost of goods sold are not excluded by Section 280E. While Section 280E impairs the ability to claim deductions from gross income, the cost of goods sold are used to arrive at the gross income. That is, Internal Revenue Code (“I.R.C.”) § 61(a)(3), consistent with the Sixteenth Amendment, provides that “[g]ains derived from dealings in property,” such as sales of marijuana, means gross receipts less the cost of goods sold. Treas. Reg. § 1.61-3(a). This is further explained in IRS CCA 201504011, “[t]he ‘cost of goods sold’ concept embraces expenditures necessary to acquire, construct or extract a physical product which is to be sold; the seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold.” Citing Reading v. Commissioner, 70 T.C. 730, 733 (1978). So, to the extent a business incurs direct costs associated with the acquisition, manufacturing, or sale of marijuana, those costs may be properly considered the cost of goods sold and used to reduce gross income. At least on the issue of state excise taxes, the Internal Revenue Service has indicated that these costs are also properly included as the cost of goods sold. See IRS CCA 201531016 (Washington marijuana excise tax paid considered a reduction of gross income). As the industry continues to grow, the Internal Revenue Service will likely continue to challenge the scope of cost of goods for marijuana businesses.
While many items may avoid the coverage of Section 280E because they constitute cost of goods sold, there are a number of other indirect costs that do not fit within that definition. For example, are payroll costs for salespeople still deductible? What about rental costs associated with the retail space? And what about professional fees incurred in forming and advising the business? Although these would normally be deductible as business expenses under I.R.C. § 162, as explained in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173 (2007) (“CHAMP”), the analysis for marijuana businesses is not so simple.
While the Tax Court in CHAMP confirmed that the cost of goods sold could not be disallowed for a marijuana business, the Tax Court noted that any indirect expenses allocable to the business of selling marijuana were not deductible as a result of Section 280E. However, the Tax Court went a step further. Since the sale of marijuana was only part of the trade or business in CHAMP, expenses that were allocable to another line of business, e.g., provision of medical support, consultations regarding medical issues, and providing household products, could still be properly deducted if the allocation of expenses could be substantiated and was attributable to another activity. In this regard, the Tax Court allowed deductions of payroll costs and rental payments, which could be attributed to multiple profit-motivated activities, to be applied and deducted on the basis of pro-rata allocations. In making this determination, the Tax Court relied upon Commissioner v. Heininger, 320 U.S. 467, 474 (1943), which provided that “[i]t has never been thought…that the mere fact that an expenditure bears a remote relation to an illegal act makes it non-deductible.” For a marijuana dispensary, this holding illustrates the importance of properly planning and documenting expenses that may be related to a supplemental line of business.
In addition, if costs associated with a marijuana business cannot be considered in the cost of goods sold or allocable to a separate business activity, some have suggested an election under I.R.C. § 263A in order to alleviate the effects of the non-deductibility provisions of Section 280E. In general, this election permits certain items to be capitalized as inventory costs. Although most businesses prefer to immediately expense costs, rather than capitalize them, if an expense may be disallowed under Section 280E (i.e., for marijuana sales), this could be an effective workaround to recognize the benefit of the cost when inventory is sold – even if it must be claimed in the more distant future. While tax regulations are undeveloped in this area, relevant authority indicates that expenses that would not otherwise be deductible cannot be capitalized pursuant to I.R.C. § 263A. See Treas. Reg. § 1.263A-1(c)(2)(i) (explaining that a business meal deduction limited by I.R.C. § 274(n) to 80 percent of the cost of the meal is limited to 80 percent for purposes of I.R.C. § 263A). The Internal Revenue Service also takes the position that Section 263A cannot be used to transform non-deductible expenses from a marijuana business into costs that can be capitalized. IRS CCA 201504011. While the guidance of the Service is not controlling on this issue, businesses need to carefully consider the potential issues that may result if the approach is later challenged in an examination by the Internal Revenue Service.
As the marijuana industry gains mainstream acceptance nationwide, tax practitioners need to be increasingly aware of Section 280E and the profound impact it will have on such businesses. As time passes, it is likely that regulatory and administrative tax guidance will play a key role in determining whether profitability lights up or burns out.