A Cannabis Business Offer In Compromise

 

Let’s talk reasonable collection potential (RCP).

If the conversation turns to RCP, chances are good that you owe the IRS and are hoping to settle for less than the full amount. A couple of programs come immediately to mind:

• Offer in Compromise

• Partial Payment Installment Agreement

 As you might guess, the IRS requires paperwork before agreeing to this. The IRS wants to look at your:

• Income

• Expenses

• Assets

• Liabilities

• Future Income Potential

Yes, the process is intrusive. I have had clients balk at the amount of disclosure involved, but in truth it is not much different from what a bank would request. I rarely work with OICs or partial pays these days. Some of it is the client base, but some also reflects past frustration. I have started this process too many times with a client and the first wave of documentation comes in quickly enough; the second wave takes longer. The last wave may take long enough that we must start the first wave over again, and sometimes we never even receive the last wave. It has happened enough that I am now reluctant to get involved, unless it is a client I have known for a while and am confident will follow instructions. The IRS is going reject a partially completed application anyway, so there is no upside to submitting one.

COMMENT: This is a repetitive tactic of the reduce-your-tax-debt mills. They will assemble and file whatever, knowing (or at least should know) that the application will be rejected. That does not matter to them, as they are paid in advance.

The IRS is trying to pin down how much you can pay: the RCP.

And it is not what you may think.

Assets are relatively easy: you must list and value all your assets. You may not want to disclose that restored Corvette or gun collection, but you really should.

Liabilities are tricky. You will submit all your liabilities, but the IRS may not allow them. Credit card debt comes to mind. Let’s just say that the IRS is not overly concerned whether you fail to repay your credit card balances.

Income again is easy, unless you have unusual sources of income. In practice, I have found that the IRS also has difficulty with erratic (think gig) income, sometimes to the point that one cannot get a plan in place.

Expenses can break your heart. Just because you have an expense does not mean that the IRS will allow it. Examples? Think an expensive car lease, private school tuition, even veterinary expenses for an aging dog. For some expense categories, the IRS will look to tables listing normalized allowances for your region of the country. You supposedly can persuade the IRS that your situation is different and requires a larger number than the table. I wish you the best of luck with that.

Future income potential has disqualified many. Let me give an example:

·      A retiree has substantial health issues. It is unlikely that the retiree will (or can) return to work, meaning that current income (sources and amount) is likely all there is into the foreseeable future.

·      A young(er) nurse practitioner is bending under the weight of credit cards, car loan, day care, and aging parents.

The IRS is not going to view the retiree and nurse practitioner the same. One’s earning power is behind him/her, whereas the other likely has many years of above-average earning power remaining. Granted, both may be in difficult straits and both may receive relief, but it is unlikely that the relief will be the same. The retiree may receive an OIC, for example, whereas the nurse practitioner may receive a temporary partial-pay with a two-year revisit. Even then, I anticipate that getting a partial pay for the nurse practitioner is going to be … challenging.

Let’s talk about a recent RCP situation that irritates me. It involves a business.

Mission Organic Center (Mission) is a state legal marijuana dispensary in California.

COMMENT: Two things come into play here. The first is the federal Controlled Substances Act, which classifies cannabis as a Schedule 1 substance. The second is a Code section (Sec 280E) that prohibits businesses from deducting ordinary business expenses from their gross income if the business consists of trafficking in controlled substances. This gives us the odd result of a state-legal business that cannot deduct all its expenses on its federal tax return. Perhaps the state will allow those expenses on its return, but there is no federal equivalent. An accounting firm can deduct its payroll, rent and utilities, by contrast, but a cannabis business cannot (there is an exception for cost of goods sold, but let’s skip that for now).

This raises the question: what is the reasonable collection potential of that cannabis business?

Did you know that there are different accounting methods for different purposes?

Let’s say that you are auditing a Fortune 500 company.  You probably want to keep the accounting on the pavement, something the accounting profession refers to as “generally accepted accounting principles.” Leave the pavement too long or too far and you might have liability issues.

Switch this to the tax return for the Fortune 500, and it is a different matter. The IRS is likely telling you which bad debt – or inventory, or asset capitalization, or depreciation, or deferred compensation, or (on and on) - accounting method to use. The profession calls it “tax accounting,” and that is what I do. I am a tax CPA.

Here is the Supreme Court in Thor Power Tool distinguishing generally accepted accounting income from taxable income:

The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the Internal Revenue Service is to protect the public fisc. Consistently with its goals and responsibilities, financial accounting has as its foundation the principle of conservatism, with its corollary that "possible errors in measurement [should] be in the direction of understatement rather than overstatement of net income and net assets." In view of the Treasury's markedly different goals and responsibilities understatement of income is not destined to be its guiding light. Given this diversity, even contrariety, of objectives, any presumptive equivalency between tax and financial accounting would be unacceptable.”

Got it: financial accounting provides useful information to stakeholders and tax accounting funds the fisc. Both use the word “accounting,” but they are not the same thing.

Question: what does a business pay bills with?

With cash. Unless somebody is throwing in equity or loaning money, profit is the sole remaining source of cash.

Mission owed a lot of taxes. It submitted an OIC. An IRS Settlement Officer reviewed the OIC and disallowed the Section 280E expenses. The reasoning? The IRS has a policy of disregarding for RCP purposes those business expenses nondeductible under Code Sec. 280E.

I do not see this is an issue of discretion. I see it as a matter of economic reality. Mission needed cash to pay the IRS, and merely making something nondeductible does not create cash. The IRS missed a step here by conflating RCP (an economic measurement of cash) with taxable income (which might mirror cash by luck or accident but then only rarely).

Mission however had a history of filing tax returns without paying. We are not making friends and influencing people here, Mission.

The Tax Court looked at this and decided that the policy was within IRS discretion, and the Settlement Officer did not abuse her discretion by following that policy.

I disagree.

We now have a precedential case that Congressional tax-writing caprice will override an economic evaluation of a business’ ability to generate and retain the cash necessary to pay its tax obligations to the IRS. Let me restate this: Congress - via tax law - can bankrupt you.

Bad facts.

Bad law.

Our case this time was Mission Organic Center v Commissioner, 165 T.C. 13 (2025).

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.

Marijuana And Tax-Exempt Status

I am not surprised.

I am looking at a Private Letter Ruling on a tax -exempt application for an entity involved with marijuana and CBD.

I doubt the CBD plays any role here. It is all about marijuana.

I have become sensitive to the issue as I have two friends who are dealing with chronic pain. The pain has risen to the level that it is injuring both their careers. The two have chosen different ways to manage: one does so through prescriptions and the other through marijuana.

Through one I have seen the debilitating effect of prescription painkillers.

The other friend wants me to establish a marijuana specialization here at Command Center.

I am not. I am looking to reduce, not expand, my work load.

What sets up the tax issue?

Federal tax law. More specifically, this Code section:

        § 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 such trade or business is conducted.

Marijuana is a Schedule I substance, so it runs full-face into Section 280E. There is “no deduction or credit” allowed on that tax return.

There is one exception, and that has to do with the cost of the marijuana itself. Accountants refer to this as “cost of sales,” and it would include more than just the cost of the product. It would include costs associated with buying the product or storing it, for example. Still, the big bucks would be with the cost of the product itself.

There is a Court decision which defines taxable revenues as revenues after deduction for cost of goods sold. The decision applies to all businesses, not just marijuana.

What it leaves out is everything other than cost of sales, such as rent, utilities or the wages required to staff and run the business.

That gets expensive. One is paying taxes on business profit, without being allowed to deduct all the costs and expenses normally allowed in calculating business profit. That is not really “profit” in the common usage of the word.

I am reading that someone applied for tax exempt status. They argued that their exempt purpose was:

·      To aid financially disadvantaged patients and families affected by the cost of THC and CBD medical treatment

·      To educate health providers about THC and CBD medical treatments

·      To support research into said THC and CBD medical treatments

The entity anticipated the usual stuff:

·      It will be supported by contributions and gifts

·      It will develop a website, which will give it another venue to educate about its mission as well as fundraise

·      It will develop relevant medical and treatment literature

·      It will conduct relevant seminars and classes

·      It will organize support groups for patients and their families

·      It will track and publish relevant medical data

The IRS led with:

You were formed to aid financially disadvantaged patients and patient’s families who are affected by the costs of THC and CBD medical treatment by providing financial support to cover costs of living and other expenses that the patients may incur.”

It continued:

… you are providing funding to the users of these substances who may be struggling to pay living and/or travel expenses because of their use of these illegal substances. Furthermore, your financial assistance is only available to users of these substances.”

In response the entity argued that it did not directly provide THC or CBD to individuals nor did it provide direct funding for the same.

The IRS was unmoved:

You were formed for the purpose of providing financial assistance to individuals who are engaged [in] an illegal activity which is contrary to public policy.”

The IRS rejected the tax-exempt application.

There are numerous tax-exempts throughout the nation that counsel, research, educate and proselytize concerning their mission. A substance abuse clinic can provide methadone, for example. What it cannot do is provide the heroin.

The entity could, I suppose, withdraw the financial support platform from its mission statement, greatly increasing the likelihood for tax-exempt status.

If its core mission was to provide such financial support, however, this alternative might be unacceptable.

If I were advising, I might consider qualifying the entity as a supporting organization for a pain clinic. The clinic would likely address more than marijuana therapy (it would have to, otherwise we are just circling the block), which represents a dilution of the original mission. In addition, a supporting organization transfers some of its governance and authority to the supported organization. It may be that either or both of these factors could be deal-breakers.

It has been interesting to see the continuing push on this area of tax law.