Conflicting Federal and State Laws Lead to Higher Taxes for the Legal Marijuana Market

Lesley D. Lawson, KLJ Staff Editor[1]

State law is slowly becoming more open to not only to legalizing medical marijuana, but also to legalizing recreational marijuana.[2] Even though states are becoming increasingly liberal with regards to marijuana legalization, the federal tax code remains conservative in its ideas of taxing the businesses that sell marijuana. This makes a great barrier for sellers wanting to enter into the legal marijuana market.

The Internal Revenue Code (“IRC”), at § 280E, reduces the amount of deductions that persons trafficking in controlled substances can claim.[3] I.R.C. § 280E states that no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if the trade or business consists of trafficking in controlled substances, regardless whether if it is legal distribution under state law.[4] The Controlled Substance Act schedule I and II defines what is a controlled substance, and marijuana is included the schedule I list.[5]

I.R.C. § 280E was enacted after the tax court decision in Jeffrey Edmondson v. Commissioner in 1981. This case ruled that a taxpayer could deduct expenses relating to the taxpayers business that pertained to selling cocaine, amphetamine, and marijuana.[6] § 280E was passed in response to this tax court decision in 1982.[7] § 280E reversed the holding that was in Edmondson as it relates to the deductions for those selling illegal substances.[8] There is also an idea that § 280E was passed in relation to increase cost for those involved in illegal activity.[9] § 280E affects and applies to all business that engage in the cultivation, sale, or processing of the cannabis plant, which includes cultivators, medical dispensaries, retail stores, infused product manufactures, and oil manufacturers.[10]

A highly simplified version of the federal income tax formula is gross income minus business expenses (above-the line deductions); this equals adjusted gross income.[11] Next, if the taxpayer is an individual or partnership in which revenues flow through to the partners, the entity can make one of two choices: (1) itemize its deductions or (2) take the standard deduction. With either of these choices, the taxpayer will then subtract their personal exemptions. Lastly, the sum of this equation is taxable income, which is the amount that the taxpayer will actually pay taxes on.[12] This simple formula is sometimes referred to as the “tax ladder.”

  • 280E, in simple terms, does not allow the business to take any business deductions (above-the line deductions), which reduces their adjusted gross income.[13] § 280E does allow a deduction for cost of goods sold, however.[14] Cost of goods sold is determined by using the inventory costing regulations under § 471, unless the taxpayer is properly using non-inventory method of accounting.[15] However, this is a more complex issue that extends far beyond the ideas set forth in this blog.

Below is a simplified mathematical comparison of the tax liability of a business that sells non-controlled substances, compared to a legal business that sells marijuana.

Non- Marijuana Business Marijuana Business
Gross Revenue $1,000,000 $1,000,000
LESS: Cost of Goods Sold $300,000 $300,000
EQUALS: Gross Income $700,000 $700,000
LESS: Business Expenses $200,000 $0
EQUALS: Taxable Income $500,000 $700,000
Assuming 30% Flat Tax

Tax Liability

$150,000 $210,000
Effective Tax Rate:

(Tax Liability/ Gross Income)

21.42% 30%

From the table above, it is clear that businesses that legally sell marijuana are taxed as though they make more money than businesses that do not sell marijuana. In reality, the non-marijuana business and the marijuana business are identical in all other aspects besides what they are selling. § 280E creates an issue in the federal income tax law because it is taxing people suited similarly in different ways. This is a failure of what is referred to as horizontal equity.

  • 280E eliminates the possibility of businesses taking business expenses.[16] Examples of business expenses are employee salaries, utility costs, health insurance premiums, marketing and advertising costs, repairs and maintenance, rental fees for facilities, and payments to contractors.[17]

The tax court has somehow tried to ease this harsh rule by separating a business into a marijuana selling division and a division that does not sell marijuana.[18] In the CHAMP case, the business Californians Helping to Alleviate Medical Problems (“CHAMP”) provided multiple types of help to those in need of medical help including marijuana distributions and counseling.[19] The tax court allowed for an allocation for each different division of the business and allowed the counseling services to take business expense deductions.[20] This allocation of income and expenses helped the business by reducing their overall tax liability.

In conclusion, some may view § 280E as a good policy to increase taxes on those performing federal illegal activities, while others may view this as a conflict between what is “illegal” for state and federal law. Some people view § 280E as disincentivizing people from filing tax returns, and it penalizes people who are trying to operate within the law.[21] Despite our views of marijuana, it has been legalized for various uses in many states. The conflict between how the IRS views taxing these legal business entities and how states have legalized these businesses is something that needs to be reconsidered.

One way to resolve this issue is for businesses that cultivate medical marijuana to organize as a non-profit § 503(c)(3) organization. This would allow the business to avoid paying tax in its totality. Another way to fix this problem is for marijuana to be removed from the Controlled Substances Act or for the IRS to state that § 280E does not apply to state legal marijuana businesses. Another conservative fix would be for federal law to apply this harsh tax rule to all drugs, whether legal or not, to eliminate discrimination among sellers. It will be interesting to see how these conflicting laws will be evaluated by the new administration, and how the current law will effect new businesses as more states begin to legalize the selling and distributing of marijuana.

[1] J.D. expected May 2018.
[2] Tony Nitti, Ninth Circuit: Legal Or Not, Marijuana Facility Cannot Deduct Its Expenses, Forbes (July 10, 2015), http://www.forbes.com/sites/anthonynitti/2015/07/10/ninth-circuit-legal-or-not-marijuana-facility-cannot-deduct-its-expenses/#495e3b684303.
[3] I.R.C § 280E (1998).
[4] Id.
[5] Controlled Substances Act, 21 U.S.C. §§ 801-904 (2012).
[6] Edmondson v. Commissioner, T.C. Memo. 1981-623 (1981).
[7] Memorandum from W. Thomas McElroy, Jr. Senior Technician Reviewer to Matthew A. Houtsma (Jan. 23, 2015), https://www.irs.gov/pub/irs-wd/201504011.pdf; Tiffany Wu, The Trouble with § 280E and Marijuana Businesses, Canna Law Group (Jan. 20, 2016), http://www.cannalawblog.com/the-trouble-with-§-280e-and-marijuana-businesses/.
[8] S. REP. NO. 97-494 (Vol. I), at 309 (1982). The Senate bill was adopted in conference. CONF. REP. NO. 97-760, at 598 (1982), 1982-2 C.B. 661; Memorandum from W. Thomas McElroy, Jr. Senior Technician Reviewer to Matthew A. Houtsma (Jan. 23, 2015), https://www.irs.gov/pub/irs-wd/201504011.pdf.
[9] Tiffany Wu, The Trouble with § 280E and Marijuana Businesses, Canna Law Group (Jan. 20, 2016), http://www.cannalawblog.com/the-trouble-with-§-280e-and-marijuana-businesses/.
[10] Internal Revenue Code § 280E: Creating an Impossible Situation for Legitimate Businesses, National Cannabis Industry Association (April 2015), https://thecannabisindustry.org/uploads/2015-280E-White-Paper.pdf.
[11] I.R.C. § 162(a) (2012), (“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. . . .”).
[12] IRC § 61 (1984); I.R.C. § 62 (2015); I.R.C. § 63 (2014).
[13] I.R.C. § 280E (1998).
[14] Tony Nitti, Ninth Circuit: Legal or Not, Marijuana Facility Cannot Deduct Its Expenses, Forbes (July 10, 2015), http://www.forbes.com/sites/anthonynitti/2015/07/10/ninth-circuit-legal-or-not-marijuana-facility-cannot-deduct-its-expenses/#495e3b684303.
[15] Memorandum from W. Thomas McElroy, Jr. Senior Technician Reviewer to Matthew A. Houtsma (Jan. 23, 2015), https://www.irs.gov/pub/irs-wd/201504011.pdf.
[16] I.R.C. § 280E (1998).
[17] Internal Revenue Code § 280E: Creating an Impossible Situation for Legitimate Businesses, National Cannabis Industry Association (April 2015), https://thecannabisindustry.org/uploads/2015-280E-White-Paper.pdf.
[18] Californians Helping to Alleviate Medical Problems Inc. v. Commissioner, 128 T.C. 173 (2007).
[19] Id.
[20] Id.
[21] Internal Revenue Code § 280E: Creating an Impossible Situation for Legitimate Businesses, National Cannabis Industry Association (April 2015), https://thecannabisindustry.org/uploads/2015-280E-White-Paper.pdf.
*Featured image by Thomas Cizauskas, licensed under CC BY-NC-ND 2.0.