Matters Column

Keeping the cash and the grass from going up in smoke

September 24, 2012
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The old saying “The grass is always greener on the other side” has taken on some additional meaning. In recent years, an increasing number of states (including Michigan) permit the medical use of marijuana. The trend has occurred as a result of state legislatures or statewide referendums approving, in some fashion, the sale and distribution of marijuana for limited medical purposes.

This change in state law created some debate on the operating rules of the storefronts that distribute the marijuana, as well as the process to approve which individuals can acquire marijuana for medical use. We have seen these issues arise in Michigan since the passage of Proposal 1 in November 2008.

Many entrepreneurs have seen the business opportunity to open up a dispensary for marijuana. Though I have not yet seen the late night infomercials on this opportunity, there seem to be fair number popping up. There are legal issues to contend with operating this type of business. The Controlled Substances Act of 1970 is a federal statute that provides that the possession of marijuana is illegal.

The U.S. is also a signatory to other international agreements that also result in marijuana being illegal in many countries that are parties to these international agreements. And in 2005, the Supreme Court decision held that the federal government has the right to criminalize the production and use of the drug even when states have laws that allow for limited legal use of it.

There are definitely federal tax consequences for the medical marijuana industry. There are a few tax code sections to quickly review in the analysis. Section 61 of the Internal Revenue Code provides that gross income is taxable from whatever source derived except for certain exclusions of certain income or the allowance of certain deductions that are described in other code sections. Section 162 allows ordinary and necessary business expenses incurred in the production of income.

And then there is the little known section 280E, which 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.” 

Section 280E was added to the Code in 1982 during the Reagan Administration as one more weapon in the arsenal to crack down on drug trafficking. This change allowed federal prosecutors to use the tax code in their pursuit of the dealers in a manner similar to their pursuit of Al Capone in the days of prohibition.

On Aug. 2, 2012, the U.S. Tax Court held that a taxpayer who operated a retail medical marijuana dispensary in California is barred by section 280E from the deduction of the expenses incurred related to its business because the business activity was the trafficking in a controlled substance.

In some ways, the decision shouldn’t come as a surprise to many since there is a Code section that is quite specific and on point. Some have expressed dismay at the decision, though I wonder what they may are smoking.

The Tax Court decision, which is more than 40 pages long, deals with a business called the “Vapor Room.” The Tax Court took issue with some of the recordkeeping with respect to the deductions claimed on the taxpayer’s tax return, as well as determining that gross receipts that were reported by the taxpayer were understated. There was some disagreement between the IRS and the taxpayer with respect to the cost of goods sold, primarily related to the cost of the marijuana.

The Tax Court determined that the taxpayer gave away 6.5 percent of the Vapor Room’s purchases as samples to customers. The taxpayer also indicated some inventory was withdrawn for personal use. Footnote 17 in the case reads: “Both staff members (including petitioner) and other patrons received medical marijuana for free. The record does not disclose how much of the free marijuana went to “needy” individuals.” That portion of the inventory apparently went up in smoke.

Query: Is this a de minimis or working condition fringe benefit, or should this be included in the employees’ Forms W-2? The Tax Court didn’t comment.

In reading the Tax Court’s decision, it appears the overall documentation and substantiation of the purchases and expenses was lacking. The latter part of the opinion rebuts the taxpayer’s arguments that state law permitted the sales activity and that the Code section (280E) only limits illegal trafficking in a controlled substance. The taxpayer’s argument continued that, since the state law allowed the sale of the marijuana,  the deductions should be allowed in determining taxable income.

The Tax Court noted the word “illegal” isn’t included in Code section 280E and cited an earlier decision that determined the dispensing of marijuana under the California law was trafficking of a controlled substance within the meaning of section 280E.

The taxpayer also tried to argue that it offered care-giving and other services in addition to the sale of the marijuana, and therefore some of the expenses should be allowed as deductions. Thus, there were two businesses being conducted and the expenses were mainly incurred for care-giving and not the trafficking of a controlled substance.

The Tax Court didn’t give much weight to this argument and disallowed all expenses.

In the end, the taxpayer was required to pay federal income tax on the gross receipts (no deductions) of the business and, in addition, the taxpayer was penalized at 20 percent of the tax liability for an accuracy related penalty for a tax underpayment of tax attributable to negligence or disregard of rules or regulations or any substantial understatement of tax.

The total federal income tax liability was determined to be more than $1.5M and the 20 percent penalty will add another $300K to this amount. These are large amounts, given that the taxpayer originally reported net income of approximately $100K (total) for the two tax years at issue (2004 and 2005). The business plan for this operation didn’t likely contemplate this size of a tax expense. What can we all take away from this real life story?

Recordkeeping, documentation and substantiation of tax deductions are necessary in ultimately sustaining the deductions. And most importantly, make sure the deductions are allowed under the Internal Revenue Code in the first place. Otherwise, the cash, and the grass, may go up in smoke.

Bill Roth is tax partner with the local office of BDO LLP. The views expressed are those of the author and not necessarily of BDO. The comments are general in nature and not to be considered as specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties.

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