Blog : Tax Planning For MJ Sellers

by Ed Zwirn on March 12th, 2014

Participants in the MJ business - whether legal or illegal - are at a distinct disadvantage when it comes to the tax man. As I pointed out in my penny stock blog last month, marijuana sellers, although subject to income tax, are not allowed to deduct ordinary business expenses.

This was apparently a political no-brainer when Congress changed the tax code to accomplish this in 1982. The passage then of IRS Code Section 280E, which disallowed the deductions, was an outraged knee-jerk reaction to an earlier Tax Court ruling that allowed a busted drug dealer to deduct expenses like travel, scales and baggies after he had been audited by the IRS following his bust.

Bear in mind that other types of illegal entrepreneurs, such as pimps and numbers runners, are not subject to this provision. Also bear in mind that 32 years ago, when Congress made this call, there was little outrage on behalf of the wronged dealers. America, after all, was engaged in fighting a War on Drugs.

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Flash forward to the present: The growing trend toward legalization of marijuana for recreational and/or medicinal purposes (I'll take some of each) has fostered the creation of a community of legitimate businesses that, unlike the illegal dealers, has no reason to hide and every reason to concern itself with the vagaries of federal law.

Into this fray come the lawyers and tax experts.

One of these, Benjamin Leff of American University's Washington College of Law, proposes a novel solution to this problem. Writing in the Iowa Law Review, he argues that MJ entrepreneurs, the legal ones, anyway, should sidestep this problem by declaring themselves to be non-profit entities.

"In recent years, many states have legalized marijuana while the federal government has not," he writes. "But marijuana industry insiders consider not federal criminal law but federal tax law to be the biggest impediment to the development of a legitimate marijuana industry."

What Leff proposes is that MJ businesses declare themselves tax-exempt under IRS Section 501(c)(4) and avoid the whole tax problem and allow the country to sidestep the thorny federalism issues that develop when a state legalizes an activity but the feds do not.

"This Article proposes for the first time that the public policy doctrine [which bars charitable status for organizations engaging in illegal activities] does not apply to 501(c)(4) organizations, which opens the door for marijuana sellers to qualify as tax-exempt."

It is important to throw in a caveat here: The IRS has already stated that MJ businesses cannot be exempt under another tax provision, 501(c)(3), because of the "public policy doctrine." Any attempt to allow tax-exempt status for MJ sellers under 501(c)(4), as Leff proposes, would therefore probably have to survive court challenges before becoming a matter of settled law.

"It is unlikely that the IRS will approve an application for section 501(c)(4) status from a marijuana seller who applied," Leff writes. "Even though the law permits it, it is uncharted legal terrain, and the IRS is not required to go out on a limb for a 501(c)(4) applicant - especially in the current political environment."

Leff sees his proposal, which is probably being considered by tax lawyers as I write, as "more than just a 'tax loophole.'"

The organization in question, he writes, "would have to be operated to improve the social and economic conditions of a neighborhood blighted by crime or poverty by providing job training, employment opportunities and improved business conditions for commercial development in the neighborhood, just like many existing community economic development corporations that run businesses." They would also be prohibited from attempting to influence legislation and restricted from engaging in campaign activities.

In addition to the possible societal benefits of such an approach to MJ taxation policy, Leff maintains that there are basic fairness issues involved. Current IRS enforcement, as he points out "dramatically raises the cost of legitimacy for a marijuana seller."

"Black-market operators avoid paying taxes by hiding their operations and avoiding detection by the authorities," he says. "State-sanctioned operators do not have that luxury, and the IRS is currently punishing them with an unsustainable income-tax regime."

While political considerations probably represent a huge hurdle toward recognition of tax-exempt MJ organizations, Leff argues that politics are irrelevant to the legal question involved. "If the IRS denies a properly operated organization's application, a court can decide that," he says, predicting that the courts will concur with his opinion.

Beyond that, Leff sees tax-exempt status for MJ sellers to be a possible way out of the legal impasse that has resulted between jurisdictions which like Colorado, have legalized their activities, and the feds, who have not done so. In addition, incentivizing MJ sellers become, non-profit, neighborhood-based organizations would in effect tie "federal approval to local support."

"Interjurisdictional conflicts between the federal government, states and localities are likely to recur," he concludes. "And creative solutions may be necessary to mitigate the harmful effects of such conflicts."