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Last November, Amendment 2 was passed by the voters of Florida, expanding the use of medical marijuana, with an overwhelming 71% margin of victory. Twenty-six states and the District of Columbia have legalized marijuana in some form, and the trend seems to be toward an expansion of allowed use.
What we have now is a unique situation where marijuana can be legal for state purposes but still considered an illegal drug for federal purposes. Under the federal Controlled Substances Act, marijuana is considered a Schedule I drug. States can write laws to legitimize the consumption of marijuana within the borders of the state, but sometimes federal law can rear its head with unexpected consequences.
One of these ways is with federal income tax.
Back in 1982, Jeffrey Edmondson was engaged in the illegal dealing of drugs. He was audited by the IRS and all deductions against his drug income were denied. The Tax Court ruled in his favor and allowed him to deduct expenses. Congress did not like this result and enacted Section 280E to overturn the result of the Tax Court.
Section 280E, in a nutshell, denies all deductions from gross income with the exception of the cost of goods sold. The reason for letting a drug dealer deduct the cost of goods can be found in the tax code definition of gross income. For manufacturing and merchandising businesses, gross income is defined as sales less cost of goods sold. The Tax Court has also taken the position that an item used to compute gross income is not a deduction.
For a marijuana business, this is huge.
Consider a retail business with gross sales of $3 million. Cost of goods sold is $1.5 million and expenses such as payroll, rent, utilities, and other expenses amount to $500,000. Net income for the business is $1 million.
If this business sells trinkets, and these trinkets happen to be legal, at a tax rate of 35%, the business will pay $350,000 in federal income tax.
Contrast that to the marijuana business. With identical expenses, net income will be $1 million but taxable income will be $1.5 million, because deductions from gross income are disallowed. At a tax rate of 35%, federal income tax on the business will be $525,000. An effective tax rate of 52.5%.
Cannabis retailers, in states such as Colorado, have devised methods to help mitigate the federal tax bite. These methods can be broadly put into two types:
• Limit deductions
• Maximize cost of goods sold.
To limit deductions, businesses structure retail marijuana operations as part of another legitimate business, allocating a portion of the expenses to the legal business. This has been done with some success in California, where a cannabis retail facility provided medical cannabis to patients and also provided non-cannabis related counseling and caregiving services. Expenses related to the non-cannabis activity were deductible.
Other attempts to use this strategy have been less successful. In Olive v. Commissioner, the Tax Court found that free yoga classes, board games, movies with popcorn and drinks, chair massages, use of vaporizers, education on medical marijuana, tea, water, snacks and other light food did not constitute a business separate from the taxpayer's trafficking business. All expenses were disallowed.
The second strategy to minimize taxes is counter to normal tax practice, and that is to capitalize as much expense as possible into inventory, thereby allowing a deduction as cost of goods sold. Cost of goods sold can include the actual cost of the product as well as expenses of purchase, storage and inventory management.
For example, Jane Doe has a retail marijuana dispensary where 90% is retail and 10% is devoted to inventory storage. She can deduct 10% of her costs related to rent and utilities because 10% of the space is related to inventory storage.
To maximize deductions, a cannabis business should be structured to minimize retail space. This could be accomplished by a small retail shop attached to a warehouse facility.
A word of caution, the 2014 IRS audit rate for cannabis retailers was 8.1%, as compared to a 1.4% audit rate for regular U.S. businesses. One of the keys to successfully defending a tax position under audit is adequate records and documentation. If you are running a marijuana business, you will want to have tax and legal representation, as well as top notch bookkeeping and recordkeeping systems, to take advantage of favorable tax treatment and minimize the stiff federal tax burden.
Pamela Schuneman, CPA, is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected]
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