How A Drug Dealer Then Affects Marijuana Taxation Today

 

I spent substantial time last week reviewing and researching issues related to the marijuana industry. There is one Code section – Section 280E – that overpowers almost all tax planning in this area.

That section came into the Code in 1982.

It came in response to a Tax Court decision.

Let’s talk about it.

Here is the Court setting the table:

During …, petitioner Jeffrey Edmonson was self-employed in the trade or business of selling amphetamines, cocaine, and marijuana. His primary source of controlled substances was one Jerome Caby, who delivered the goods to petitioner in Minneapolis on consignment. Petitioner paid Caby after the drugs were sold. Petitioner received on consignment 1,100,000 amphetamine tablets, 100 pounds of marijuana, and 13 ounces of cocaine during the taxable year 1974. He had no beginning inventory of any of these goods and had an ending inventory of only 8 ounces of cocaine.

What got this bus in motion was a 1961 Supreme Court decision holding that everyone who made money – whether through legal or illegal activities – had to pay taxes on that money.

Edmonson got busted.

The IRS came in with a jeopardy assessment.

The IRS was concerned about Edmonson skipping, hence the jeopardy. This assessment causes all taxes, penalties, and interest to become immediately due. This allows to IRS to exercise its Collections powers (liens, levies, not answering phone calls for extreme durations) on an expedited basis.

Edmonson might not have been too concerned about po-po, but he wasn’t about to mess with the IRS. Although he did not keep books and records (obviously), he came up with a bunch of expenses to reduce his taxable income.

The IRS said: are you kidding me?

Off they went to Tax Court.

Edmonson went green eyeshade.

·      He calculated cost of goods sold for the amphetamines, marijuana, and cocaine

·      He calculated his business mileage

·      He had business trips and meals

·      He paid packing expenses

·      He had bought a small scale

·      He used a phone

·      He even deducted an office-in-home

The IRS, on the other hand, reduced his cost of goods sold and simply disallowed all other expenses.

The Court reduced or disallowed some expenses (it reduced his office in home, for example), but it allowed many others, including his cost of goods sold.

Here is the Court:

Petitioner asserts by his testimony that he had a cost of goods sold of $106,200. The nature of petitioner’s role in the drug market, together with his appearance and candor at trial, cause us to believe that he was honest, forthright, and candid in his reconstruction of the income and expenses from his illegal activities in the taxable year 1974.

The Edmonson decision revealed an unanticipated quirk in the tax Code. This did not go over well with Congress, which closed the Edmonson loophole by passing Code section 280E in 1982:

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.

This Code section pretty much disallows all business deductions (marijuana is classified as a controlled substance), except for cost of goods sold. Cost of goods sold is not considered a deduction in the tax Code; rather it is a subtraction from gross receipts to arrive at gross income. Think about a business where you could not deduct (most or all) your salaries, rent, utilities, taxes, insurance and so on. That is the headwind a marijuana business faces.

Meanwhile, things around us have changed greatly since 1982. Marijuana is legal in 21 states, and medical marijuana is legal in almost twice that number. Colorado by itself has collected over $2 billion in taxes since legalizing marijuana. There are publicly traded companies in the marijuana industry. There are even ETFs should you want to invest in this sector.

And that is how we have business activity that may be legal under state law but is illegal under federal law. The federal tax Code taps into federal law – that is, the Controlled Substances Act – and that tap activates Section 280E and its harsh tax result. 

Our case this time was Edmonson v Commissioner, T.C. Memo 1981-623.