Blog : Reefer Madness: Cannabis and the Tax Man
by Ed Zwirn on February 22nd, 2014
One of a series of updates we will be providing on the challenges and rewards of the MJ industry.
Imagine three companies: The first is a penny stock company which develops and sells software apps and is in complete conformity with all federal and state laws. The second, a gambling establishment, is in violation of the laws of its state. The third dispenses marijuana, but is legal under the laws of its state.
It is obvious that MJ vendors face risks and hurdles in their quest to make a living. For one thing, their activity, whether for medical or "recreational" purposes, is illegal throughout most of the U.S., and under federal law itself. For another, as we have earlier pointed out in this penny stock blog, even legal cannabis sellers have to face huge hurdles in trying to obtain financing, leases or even checking accounts. This usually means that they have large amounts of cash lying around (or at least the successful ones do), which is also a sloppy way for a company with accounting and shareholders to operate.
But, as tax preparation time gets into high gear, many Colorado entrepreneurs find they are getting the roach end of the federal tax joint. Getting back to the three companies in paragraph 1: As Joel Newman of the Wake Forest University School of Law points out in a recently published paper, company number one is entitled to deduct both cost of goods sold and ordinary business expenses. The same is true for the illegal gambling operation, which is subject to criminal prosecution but able to enjoy the full range of deductions all the same.
Company three is treated the worst by the IRS. Under IRS Code Section 280E, companies "trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substance Act)" are unable to deduct business expenses.
Congress made that choice in 1982. Apparently reacting to an earlier Tax Court ruling that allowed a busted drug dealer to deduct expenses (e.g., travel and the purchase of scales and baggies) after he had been audited by the IRS and taxed on his ill-gotten gains, our legislators enacted IRC 280E, which prohibits the deductions.
"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" the Senate Finance Committee report commented. "Such deductions must be disallowed on public policy grounds."
Some 32 years later, MJ is still on the controlled substance list and even medical dispensaries are not allowed to deduct business expenses, something that both the software app vendor and the illegal gambling establishment owner can do. To cite the hypothetical figures used in Newman's paper, let's say all three companies have identical income and expenses:
Gross sales $100,000
-Cost of goods sold -80,000
Gross profit $20,000
-Other operating expenses - 8,000
Operating income $12,000
In this case, both the software app developer and the illegal numbers runner would need to pay taxes on $12,000 of income, while the MJ vendor, being unable to deduct items like rent and utilities, would be taxed on the $20,000, meaning that a legal MJ entrepreneur would pay higher taxes than his illegal gambling counterpart.
"IRC Section 280E makes no sense," Newman argues. "Those in the drug industry should be treated no worse than those in other illegal industries. If caught breaking the law, they should suffer the appropriate consequence. However, they should not be taxed on gross income. They should be allowed business deductions, just like everybody else."
"Arguably, those dispensing medical marijuana or recreational marijuana, in states where such dispensation is legal, should be treated better than other lawbreakers," he adds.
There are to ways to end this anomaly. Either Congress votes to repeal IRC 280E or it removes marijuana from the controlled substances list.
All three of the companies mention in his example "should be treated the same" under federal tax law, Newman writes. "If they earn income, they should report it, and be taxed on it. If they incur ordinary and necessary expenses in producing that income, they should be allowed to deduct them."
Both the IRS and the DOJ "should spend their enforcement resources in other ways," he concludes. "There are, indeed, bigger fish to fry."
You are reading this old blog entry because we still like to reference it. :-)
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