When operating a cannabis business as a “ganjapreneurs” from a taxation standpoint there are a few tax court cases you have to become intimately aware of.
On June 13, the U.S. Tax Court issued an opinion regarding the application of IRC §280E. In Alterman v Commissioner of Internal Revenue (“Alterman“) the Court held, yet again, that IRC §280E operates to disallow a cannabis businesses’ tax deductions. A few days later, the Court also issued Loughman vs. Commissioner of Internal Revenue (“Loughman“). In that case, the Court held that IRC §280E disallowed the deduction of wages paid to S Corporation shareholders. Olive vs. Commissioner of Internal Revenue (“Olive”) In that case, Olive tried to argue, unsuccessfully, since his business offered other services IRC IRC §280E did not apply.
The disappointing but predictable outcomes in these cases highlight the need for Congress to repeal or modify IRC §280E.
By now, the destructive force of IRC §280E is well known. IRC §280E disallowing deductions and credits to a business trafficking in a controlled substance. One exception is cost of goods sold (“COGS”). Other than a 2015 IRS General Counsel memorandum, the IRS has not offered much guidance regarding the application of IRC §280E. With this gap in IRS guidance, it is the courts that have outlined the (fairly narrow) parameters of IRC §280E.
From a reading of the IRS guidance and court rulings together, it is clear that selling or growing cannabis is always considered trafficking and expenses related to such activity are disallowed. A cannabis business can deduct all expenses related to a separate trade or business. A court is more likely to accept a separate business activity if that business can operate independently of a cannabis business.
IRS Code Section 280E
When it comes to marijuana and taxes, there is no bigger buzzword than “280E.” However, there is still a lot of confusion about what exactly 280E is and does. Section 280E is a single sentence of the Internal Revenue Code. It states:
“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.”
Section 280E was passed by Congress in 1982 in response to a case where the Tax Court ruled that a taxpayer could deduct expenses relating to his sales of cocaine, amphetamine, and marijuana. Deductible expenses included the costs of packaging, travel, and even scales used to weigh the illegal substances. However, this is no longer possible in the world of 280E.
Since cannabis is a Schedule I controlled substance, the IRS has used section 280E to disallow marijuana businesses from deducting their ordinary and necessary business expenses. The result is that marijuana companies face much higher federal tax rates than similar companies in other industries. There are differing opinions on the level of tax rates imposed on marijuana companies, all of which are higher than the 21% corporate tax rate paid by most other businesses in the United States.
So what does this mean for those currently operating or looking to form a marijuana company? Normal business expenses such as rent, advertising, and employee salaries won’t reduce your taxable income unless they can be allocated to Costs of Goods Sold (COGS). For marijuana growers, COGS include expenses directly related to production of the plants, such as the seeds, electricity, and labor that went into growing and preparing the flowers for sale. For marijuana dispensaries, COGS is much more restrictive, and generally includes only the amount they paid for the cannabis products they sell plus a few additional allocations.
Much like the rest of the industry, marijuana tax laws and policies are constantly changing. For a while, many tax accountants and attorneys advised their clients to include a generous amount of expenses in COGS to reduce taxable income. However, in January of 2015, the IRS released Memo. 201504011 that clarified what types of costs could be allocated to COGS, further limiting the ability of marijuana businesses to reduce their federal tax rates.
For now, this single sentence is still largely up to interpretation and is even causing headaches for the IRS themselves. As more and more states legalize cannabis for medical and recreational use, more and more companies are being subject to the 280E bite. Some free advice for all you ganjapreneurs – get your books in order, keep good records, and remember that the IRS is years behind in audits, so just because you haven’t been audited for your last year’s return does not mean you won’t be hit with a large tax bill a few years from now.
Alterman
Alterman does not offer broad guidance regarding IRC §280E. In part, this is because the Court issued a Memoranda opinion. A Memoranda opinion does not set a precedent for taxpayers; however, they are useful to illustrate how the Court may analyze the law.
Laurel Alterman and William Gibson operated a Colorado medical marijuana grow and dispensary. These taxpayers also sold cannabis paraphernalia, hats and shirts. The Court held that the sale of paraphernalia, hats and shirts was not a separate trade or business primarily due to the lack of records. Accordingly, costs associated with these activities were not deductible under IRC §280E.
In addition, the Court determined that certain costs were not allowable as COGS because of insufficient records, which should be a lesson to any cannabis business owner: It’s not enough to have potentially deductible costs, if you don’t keep records! Interestingly, the opinion uncharacteristically discusses, in detail, the records available, only to hold that those records were insufficient. (Court cases that disallow deductions because of poor recordkeeping typically do not discuss in detail, the records examined.)
Because of the fact-specific nature of this case, Alterman offers little guidance to cannabis businesses other than recordkeeping must be sufficient to support deductions.
Loughman
In Loughman, the Court did not address the issue of record keeping or substantiation. Instead, the Court addressed the issue of double taxation of income because of IRC §280E. And the Court concluded that double taxation is allowed.
Jesse and Desa Loughman were licensed in Colorado to grow and sell cannabis through a Colorado corporation, Colorado Alternative Health Care (“CAHC”). The Loughmans were the sole shareholders of CAHC and elected to be treated as an S Corporation for federal tax purposes.
An S corporation is not subject to tax; instead shareholders are taxed on S Corporation income at the individual level. Special rules treat S Corporation shareholder/officers as employees and require the S Corporation to pay them a reasonable wage. Under ordinary circumstances, an S Corporation deducts shareholder/officer wages; the shareholder/officer then pays income tax on the wages. The S Corporation’s deduction of wages prevents double taxation.
In this case, the IRS applied IRC §280E and disallowed CAHC’s deduction for wages paid to the Loughmans. Consequently, the amount of S Corporation income passed through to the Loughmans increased. The result is that the Loughmans wages are taxed twice — first as an employee and then as S Corporation shareholders.
The Court rejected the argument that IRC§280E discriminates against S Corporation shareholders operating a cannabis business. The Court reasoned that wage payments to a third-party performing the same services as the Loughmans would not be deductible under IRC §280E. Accordingly, the amount of pass through income to the Loughmans would not change: IRC §280E applies equally to increase S Corporation income, regardless of who receives wages. Furthermore, the Court noted that the taxpayer did not have to, but chose to, elect S Corporation status for their cannabis business.
As in Alterman, the Court issued a memorandum opinion. Accordingly, the Court’s determination only applies to the Loughmans and does not set precedent. Nonetheless, the Court highlighted a serious disadvantage to operating a cannabis business through an S Corporation– namely, double taxation.
The STATES Act
So where does that leave us? These cases highlight the dire need for a legislative fix of IRC §280E. On June 7, 2018, Senators Gardner and Warren introduced the Strengthening the Tenth Amendment Through Entrusting States Act (The “STATES Act”). The STATES Act exempts persons from the Controlled Substances Act, so long as they are acting in compliance with a state’s cannabis law. Specifically, under the STATES Act, the production or sale of cannabis in a cannabis legal state “shall not constitute trafficking”. Because IRC §280E applies to a trade or business that consists of trafficking, the STATES Act would effectively eliminate the impact of IRC §280E.
As more cannabis businesses are audited, expect more cases like Loughman and Alterman to move through the system. In addition, expect similar results on similar facts, unless Congress finally takes action. The STATES Act would do a lot of good for the industry and eliminating the oppressive impact of IRC §280E is high on the list.
Olive
Olive is a notable case, not because of its entirely predictable outcome, but because of the arguments Olive tried to make to escape 280e and because it tells us what to expect from the IRS (and federal courts) going forward. Most importantly, it reaffirms that most tax cases, including 280e cases, tend to be fact specific.
The relevant facts in the Olive case are as follows. Martin Olive manages the Vapor Room Herbal Center, a medical marijuana dispensary in San Francisco. The Vapor Room is set up like “a community center,” with an alleged variety of activities offered to patrons, like yoga, free of charge. The Vapor Room also sells cannabis for medical use to qualifying patients.
Olive sought to take ordinary and necessary business expense deductions associated with the operation of the Vapor Room and this landed him in front of the Tax Court. The Tax Court ruled that because Olive traffics in a federally controlled substance (marijuana) the Vapor Room could not claim any ordinary and necessary business deductions pursuant to IRC 280e. Olive then appealed that decision to the Ninth Circuit Court of Appeals.
First, Olive tried to argue that 280e should not apply to the Vapor Room at all because the Vapor Room’s sole “business or trade” was not just the sale of cannabis. He argued that it was the sale of cannabis along with various “caregiving services.” Olive argued that these different lines of business put the Vapor Room beyond 280e, similar to the business in the 2007 CHAMP case. The Court disagreed with Olive based strictly on the facts, noting that Olive’s primary business was indeed the sale of cannabis, not the other caregiving services which in the Court’s opinion were akin to “complimentary amenities,” rather than distinct lines of separate businesses that would otherwise warrant regular business deductions.
Second, Olive pursued arguments around “congressional intent and public policy,” which the Court found “similarly unavailing.” Specifically, Olive argued that §280E “should not be construed to apply to medical marijuana dispensaries because those dispensaries did not exist when Congress enacted §280E,” and that “Congress could not have intended for medical marijuana dispensaries (now legal in many states) to fall within the ambit of “items not deductible” under the Internal Revenue Code.” The Court concluded that this line of argument was irrelevant, that “application of [280e] does not depend on the illegality of marijuana sales under state law; the only question Congress allows us [a federal court tasked with enforcing federal law] to ask is whether marijuana is a controlled substance ‘prohibited by Federal law.’” The Court concluded that Congress is free to change 280e if it thinks that law to be “unwise” and left it at that.
Lastly, Olive asserted that the 2014 Cromnibus should prevent the IRS from spending any government dollars to prosecute its case against the Vapor Room. The Court ruled that section 538 of the Cromnibus did not apply to Olive’s case:
The government is enforcing only a tax, which does not prevent people from using, distributing, possessing, or cultivating marijuana in California. Enforcing these laws might make it costlier to run a dispensary, but it does not change whether these activities are authorized in the state.
What comes from Olive, loud and clear, is that we should not expect the courts to give the marijuana industry any tax relief: that is going to have to come from Congress. With Congress not expected to do anything much on marijuana until 2016 it seems the marijuana industry will need to put up with the IRS and its antiquated and unfair marijuana taxation regime for at least a while longer.