In 1982, Congress enacted Internal Revenue Code Section 280E, which states that anyone in the business of “trafficking controlled substances,” specifically those listed in schedules I and II of the Controlled Substances Act, is not allowed to deduct any ordinary business expenses on their tax return. This law was created to be used as an additional penalty against criminal drug smugglers after they had been convicted. Unfortunately for state-licensed “legal” marijuana businesses, the IRS has taken the position that this law also applies to them. And no distinction is made between medical and recreational businesses, it applies to them all.
That means items like rent, wages, utilities, and more are not allowed to be deducted against gross income on the tax returns of state-licensed marijuana businesses. Oddly enough, you are allowed to deduct Cost of Goods Sold, and that has been upheld in tax court. So you can deduct the wholesale cost of all the marijuana you sell, or the costs for growing it if you’re a wholesaler. But despite that loophole, the effect of complying with this law can result in federal income tax rates of 70% or higher for some of these businesses. In many cases, this makes it impossible for the business to survive.
To make matters worse, the IRS appears to be actively seeking these businesses out for audits. The normal IRS audit rate of the general business population is around 1%. Anecdotal evidence from attorneys and accountants who service the industry suggests the rate of marijuana businesses currently under audit could be 20% or higher. Not surprisingly, many in the industry are fighting back. There are several ongoing tax court cases that could set precedent in determining whether or not 280E should apply to state-legal marijuana businesses or not.
The most relevant case to date was Californians Helping to Alleviate Medical Problems (CHAMP) vs IRS, in which a California cooperative challenged the IRS on Section 280E. The court decided that CHAMP was allowed to separate out “non-trafficking” expenses, for things like their counseling offices, from “trafficking” expenses directly related to their storefront. It was decided that only about 20% of their expenses were directly related to “trafficking,” and so only those amounts were disallowed under 280E.
Although this case did not set a precedent and only applied to that one business, the court’s decision opened up a new strategy for tax preparers to think about: the separation of trafficking vs non-trafficking expenses. This has resulted in a variety of different tactics, whether that’s limiting patient-accessible areas to minimal amounts of space, opening up secondary businesses under the same roof, or other strategies. However, the IRS is still taking a rigid stance and applying 280E aggressively during audits, regardless of how creative the strategies are.
Some businesses choose not to comply with 280E when preparing their tax returns, and they deduct everything. Whether it’s because they simply can’t stay in business if they do, because they want higher profits, or as a form of protest, they roll the dice and hope they don’t get audited. And then there are a small number of businesses who don’t comply because they were not even aware of it.
Still, there are reasons to be hopeful that things could change in the near future. As mentioned earlier, there are a number of ongoing tax court cases, any of which could set a precedent. One of the more compelling arguments being made in the courts is that 280E cannot be applied to a person or entity that has not been convicted of “trafficking controlled substances,” as that was clearly the original intent of the law. Additionally, they argue that the burden of proof is on the IRS to prove that a business is “trafficking,” and many experts feel that determination clearly falls outside the jurisdiction of the IRS.
Support for the industry in Congress also continues to grow, and they are aware of 280E and the negative impact it’s having. So the battle is being fought on multiple fronts. It’s likely just a matter of time before this obstacle is removed and the legal marijuana industry will have a clearer road to success.