In 1982 Congress enacted IRC § 280E largely in response to Jeffrey Edmondson v. Commissioner, a case in which the Tax Court allowed an illegal business engaged in the sale of amphetamines, cocaine, and marijuana to recover the cost of the controlled substances and claim certain business deductions. Congress stated that:
There is a sharply defined public policy against drug dealing. To allow drug dealers the benefit of business expense deductions at the same time that the U.S. and its citizens are losing billions of dollars per year to such persons is not compelled by the fact that such deductions are allowed to other, legal, enterprises. Such deductions must be disallowed on public policy grounds.
IRC §280E reads:
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.
The result of 280E is an effective tax rate on marijuana-related businesses that can reach between 60-90 percent. Business expenses scrutinized by the IRS include employee salaries, utilities, health insurance premiums, marketing and advertising costs, rent, and independent contractor payments. This treatment by the IRS has made it very difficult for these businesses to remain profitable and has resulted many closing their doors after only a few years.
While deducting ordinary and necessary businesses expenses is prohibited under 280E, marijuana-related business are allowed to deduct cost of goods sold (“COGS”). If employed correctly, categorizing certain expenses as below the line deductions can mitigate the detrimental impact of 280E. A marijuana-related business must carefully examine each business expense to determine if that expense directly contributes to the costs associated with the production of marijuana. Supply costs (such as printed labels placed on medical marijuana bottles), material costs (such as seeds), and labor costs (such as planting, harvesting, sorting, and cultivating) may all potentially be included in COGS.
Another option to mitigate the impact of 280E is to diversify the services offered by a marijuana-related business. In Californians Helping to Alleviate Medical Problems, Inc. v. CIR (“CHAMP”), the tax court held that a taxpayer’s caregiving services and its provision of medical marijuana were separate trades or businesses for purposes of 280E, and does not preclude taxpayer from deducting the expenses attributable to the caregiving service. In CHAMP a business that offered caregiving services and medical marijuana to its members with debilitating diseases was able to attribute nearly 90 percent of certain expenses to the caregiving services portion of the business. If executed properly, offering supplemental services, such as selling clothing, accessories, and smoking devices can be an effective technique to thwart 280E. Using different cash registers for marijuana and non-marijuana products, selling marijuana and non-marijuana products in separate areas of a retail store, and allocating employee hours to marijuana or non-marijuana activities are a few methods to ensure favorable tax treatment. As later court decisions evidence, failure to keep meticulous financial records and clearly delineate between services offered may result in less than favorable treatment under 280E.
In Olive v. CIR, the court found that a medical marijuana dispensary was precluded from deducting ordinary and necessary business expenses under 280E because selling medical marijuana was the only income generating activity it was engaged in. The provision of vaporizers, food and drink, yoga, games, movies, and counseling services offered by the dispensary at no costs to its patrons did not qualify as a separate trade or business. The court distinguishes this case from CHAMP by comparing two hypothetical bookstores. Store A sells books and provides complimentary amenities to its patrons. Store B sells books AND sells coffee and pastries. The book and food sales by store B qualify as a separate trade or business while the book sales and complimentary amenities offered by store A do not.
In Canna Care v. CIR, a medical marijuana dispensary was found to owe more than $800,000 in federal taxes after the court determined the sale of medical marijuana was the primary source of income and the sale of books and t-shirts did not qualify as a separate trade or business. The court was not able to determine the percentage of income derived from the sale of medical marijuana from the income derived from sale of books, t-shirts, and other items.
Both Olive and Canna Care illustrate marijuana-related businesses will be held to a strict standard when trying to establish different revenue sources as a separate trade or business. To mitigate the full force of 280E it is imperative that these businesses clearly delineate between different services, charge for non-marijuana products and services, keep service specific financial records, and establish protocols to ensure all employees properly allocate their time.