Medical marijuana is now legal in 23 states and recreational marijuana is legal in four plus the District of Columbia. It is decriminalized in a few more states and low-THC medical marijuana is legal in still others. Marijuana is only illegal in 10 states. In 1991, 78% of Americans believed marijuana should be illegal. Attitudes have dramatically changed, and a 2014 Pew survey showed that 54% support legalization. Business appears to be booming, but for tax purposes those in the marijuana industry are not treated like ordinary businesses. Despite state laws allowing marijuana, it remains illegal on a federal level but is obligated to pay federal income tax on its taxable income because I.R.C. §61(a) does not differentiate between income derived from legal sources and income derived from illegal sources.
Generally, businesses can deduct ordinary and necessary business expenses under I.R.C. §162. This includes wages, rent, supplies, etc. In 1982, however, in response to a defeat in Edmondson v. Commission, Congress added I.R.C. §280E. Under §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. Marijuana, including medical marijuana, is a controlled substance. Dispensaries and other businesses trafficking in marijuana have to report all of their income, yet cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most.
All is not lost, as a marijuana business can deduct its cost of goods sold (COGS). Costs of goods sold are the direct costs attributable to the production of goods. For a marijuana reseller this includes the cost of marijuana itself and transportation used in acquiring marijuana to give two examples. As such, income in the context of a reseller or producer means gross income, not gross receipts. In general, the taxpayer first determines gross income by subtracting COGS from gross receipts, and then determines taxable income by subtracting all ordinary and necessary business expenses [e.g., I.R.C. §162] from gross income.
In January, the IRS issued guidance clarifying how marijuana businesses determine COGS. The take away is that although the cost of marijuana might be included, the inventory rules under I.R.C. §263A force the capitalization of certain costs such as purchasing, handling and storage. Throwing all types of expenses in costs of goods sold may raise caution in an audit, where the IRS is also likely to question gross receipts given the significant amounts of cash received and reluctance of banks to do business with many in the marijuana industry.
It is important to note that dispensaries that operate a separate wellness business can likely deduct the ordinary and necessary expenses related to the wellness operation. In the seminal CHAMP case, the taxpayer, aside from operating a dispensary, had a separate business providing caregiving services. The dispensary operation was not-for-profit and over 70% of the employees worked exclusively in caregiving. Contrast that case with Olive v. Commissioner, where the taxpayer’s deductions were disallowed because the Court held that its dispensing of marijuana and its providing of services and activities shared a close and inseparable organizational and economic relationship.
Those who choose to proceed, should do so with caution since the existence or non-existence of specific facts can significantly impact the ultimate tax-related determination . . .
JONATHAN KALINISKI – For more information please contact Jonathan Kalinski at email@example.com. Mr. Kalinski is a former trial attorney with the IRS Office of Chief Counsel litigating Tax Court cases and advising IRS Revenue Agents and Revenue Officers on a variety of complex tax matters. Jonathan received his LL.M. in taxation from New York University and served as an Attorney-Adviser to the United States Tax Court. He is a tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com.
 Edmonson v. Commissioner, T.C. Memo. 1981-623.
 Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173 (2007).
 Olive v. Commissioner, 139 T.C. 19, 41-42 (2012).