Thursday, July 16, 2015

Magic Dragon, Pain Management and Taxation


I had lunch recently with a friend who has been diagnosed with Multiple Sclerosis.  I learned about MS primarily through him, and the disease is frightening. He went on to explain the neural degeneration and the pain that it can – and does – cause. His doctors have prescribed any number of pain medicines, but sometimes - many times - he does not need the full power of those prescriptions. He needs more than an aspirin but much less than an opioid.

It appears that marijuana does work for pain management.


Granted, this can be a problem where we live, as marijuana is not legal in either Kentucky or Ohio.

Over twenty states permit the medical use of marijuana, and four permit its recreational use. The problem arises from its status as a Schedule I controlled substance, meaning that it is illegal under federal law. I doubt too many tax CPAs get involved with businesses selling illegal products, and those that do are probably not in public practice.

The White House has encouraged the Justice Department not to prosecute marijuana distributors who comply with state law.  Granted, the next White House may change course on this matter, but for the moment there is temporary stability.

I have no idea how a state Board of Accountancy would react.

Remember that the tax Code is federal tax law. It also contains Code section 280E, which was passed in 1982, 14 years before California became the first state to legalize medical marijuana.

Let’s look at this polished pearl of prose.

Sec 280E Expenditures in connection with the illegal sale of drugs
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 the trade or business is conducted.

This section was created in response to the 1981 Edmonson case, in which the Tax Court allowed a seller of amphetamines, cocaine and marijuana to deduct expenses. The decision did not go over well.

So Congress responded with “no deduction or credit shall be allowed” on public policy grounds.

However that language does not mean what it first appears to say.  

Section 280E does allow a cost-of-goods-sold deduction. The reason goes back to accounting theory. Let’s say that you sell Supreme Court clown hats. You sell a million of them for $5 each. You have to have them manufactured, which you outsource and pay $3 each.  Let’s step into a tax accounting class and the professor asks you: what is your income?


·        Is it 1 million times $5 = $5 million
·        Or is it 1 million times ($5 - $3) = $2 million

The answer is $2 million, as you get to deduct the cost of a product when your business involves selling a product.

And the Tax Court agreed in the Olive case.

Following Olive, we know that we can deduct the cost of the marijuana from the revenues received from selling marijuana. What about everything else: payroll, rent, lights, cell phone, computers and software, stationary, and so forth?

Now we run full-face into Section 280E. There is no deduction.

That has to hurt come April 15th.

Surely the tax accountants can do something, right?

Yes, up to a point.

Remember that we said that you are allowed to deduct the cost of a product when your business involves selling a product? Another word for product is inventory, and there are things an accountant can do to tack some of those otherwise nondeductible expenses onto the inventory. You would then deduct those expenses as cost of goods sold when the product sells. I suspect you will still be leaving most of those expenses on the floor, but it is something.

More useful is to have another line of business that does not involve the sale of marijuana. Let’s say that one sets up a caregiving activity involving marijuana, providing support groups, lunches, counseling, social events and so on. As long as the primary business is not the sale of marijuana, the accountant could shift expenses (within reason; be fair) to that activity and sidestep the Section 280E disallowance. This was the Californians Helping to Alleviate Medical Problems (CHAMP) case, and it received the Tax Court’s approval. Introduce creative minds and I am certain there are a thousand variations on the theme.

There is a San Francisco marijuana business (Canna Care) that has taken Section 280E to Tax Court.  In their case it means a $2.6 million deduction. They do not have a CHAMP fact pattern but are instead arguing that the disallowance is punitive and hence unconstitutional.

There has been no decision as of this writing, but I would not be optimistic.

Why? The Ninth Circuit very recently decided on the appeal of Olive mentioned above. Martin Olive operates the Vapor Room, a medical marijuana dispensary in California. In addition to selling marijuana, it offers a number of services as well as food – both for free. It made a CHAMP argument, wanting to allocate expenses between the two lines of business.

The Ninth Circuit said no, basing its decision primarily on the “free” part of the food and services. To allocate expenses to two or more trades or businesses, one must in fact be in business. There is no hope of a profit when the activity is giving things away for free, so that activity cannot rise to the level of a trade or business.

But the Ninth Circuit also slapped down Olive’s direct challenge to Section 280E, saying the tax disallowance is not based on marijuana being legal or illegal. Rather the disallowance is based on marijuana being a controlled substance, which it is and continues to be.

And there you have the federal taxation of marijuana in a nutshell.

My thoughts?

It appears that the 1982 Section 280E addition to the tax Code is a bit out-of-step with contemporary society. Perhaps Congress could change one word: 

which is prohibited by Federal law AND the law of any State in which such trade or business is conducted”.

And no, I don’t want any credit for the suggestion. I am more of a bourbon fan myself.


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