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.

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 15^th.

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.