What is a Legitimate Seller of Marijuana To Do?

William Delaney, EA
Westwood, MA

Revisiting an Earlier Article Published on www.massrinatp.org

Jason R. Beck operated medical marijuana businesses in California, where it is legal (see below) to do so.  On January 11, 2007, Beck’s West Hollywood, CA business location was raided by the federal Drug Enforcement Administration (DEA).  While Mr. Beck’s operation was permitted under state law, it operated in violation of federal law.  Among other things, the DEA allegedly seized $600,000 of what would be classified in that industry as inventory, plus cash.

On his 2007 Schedule C, Mr. Beck reported $1,700,000 in gross receipts; $1,429,614 in cost of goods sold (COGS); and $194,094 in expenses.  His COGS total included the $600,000 seized by DEA.  All income and expense amounts were provided to the preparer by the taxpayer, through his attorney.  The tax preparer neither prepared any books and records nor questioned any of the taxpayer provided information.  Upon audit, it was determined that the taxpayer “…routinely destroyed most documents pertaining to the operation of both dispensaries.”  So, on the issue of substantiation, three strikes against the taxpayer.

However, the larger issue was whether anything could be deducted if documentation had been provided and someone did a decent job with the books and records.  The federal determination was that the taxpayer’s trade or business “…consists of trafficking in controlled substances…which is prohibited by Federal law.”  IRC Sec. 280E disallows deductions and/or credits “…if such trade or business…consists of trafficking in controlled substances…”  So, on the issue of allowable deductions, three strikes against the taxpayer regardless of whether or not he maintained adequate business records.

Does that mean report all of your income but don’t try to take any deductions?  What about COGS?  According to the Court in Jason R. Beck v. Comm., TC Memo 2015-149 (8/10/2015), “COGS is an offset to gross receipts in determining business income,” therefore the Court would allow COGS to the extent that it could be documented.  The Court determined that the $600,000 included in COGS as an adjustment for the value of seized inventory could not be documented, so it was disallowed.  Does that mean it would have been allowed if documented?  Well, not really.  To quote once again from the Beck decision:  “Actually, if petitioner (Beck) had provided substantiation, the seized marijuana would still not be allowable as COGS BECAUSE THE MARIJUANA WAS CONFISCATED and not sold.” (emphasis added)  Heads we win; tails you lose!

The case is silent as to what would happen if the DEA “disposed” of the marijuana by some legal means.  Would that mean that taxpayer Beck now has a $600,000 COGS deduction?  Somehow, I doubt it but I would not blame him for trying.

Now that MA has ‘legalized’ the sale and use of marijuana, what does that really mean?  Marijuana is still an illegal controlled substance under federal law.  A state law permitting its use and sale in MA does not make it legal to do so.  Federal law is supreme.  Federally chartered banks and credit unions in MA cannot do business with dealers in an illegal controlled substance; most state chartered banks will shy away for the same reason.  If Oregon is any guideline, marijuana sellers often must deal almost entirely in cash and pay their bills (including taxes) in cash.  A few state chartered financial institutions provide payroll related services, including the deposit of taxes, but cannot offer a full range of financial services (such as credit cards) without running into federal prohibitions, such as being denied federal wire transfer services.

Transmitting and/or transporting funds derived from the distribution of a controlled substance, such as marijuana, is illegal under federal law according to a statement made in court by a representative of the Federal Reserve Bank of Kansas City, citing 18 U.S.C. Sec. 1960 – See The Fourth Corner Credit Union (CO) v. Federal Reserve Bank of Kansas City, Civil Action No. 1:15-cv-01633-RBJ-NYW (9/10/2015).

Now comes the IRS Office of Chief Counsel in a memo dealing with an excise tax levied on medical marijuana by the State of Washington.  (CCM 201531016 – 7/31/15).  The memorandum cites IRC Sec. 280E and its disallowal of either a deduction or a credit when the trade or business involves “trafficking in controlled substances.”  So, what is the taxpayer to do---pay the excise tax (not an insignificant amount) and shut up---no deduction or credit allowed?  The memorandum also cites IRC Sec.164(a) which sets forth the general rule for allowing taxes as a deduction.  This would appear to offer no hope, given the wording of Sec. 280E.  However, Sec. 164(a) does state that “…any tax (not described in the first sentence of this section) which is paid or accrued by the taxpayer in connection with an acquisition or disposition of property shall be treated as part of the cost of the acquired property or, in the case of a disposition, as a reduction in the amount realized on the disposition.”  Does this provide the taxpayer with a ray of hope?  Read on…

The memo then states that “We interpret the State of Washington marijuana excise tax to be a tax paid or accrued in connection with the disposition of property by a trade or business.  Accordingly, pursuant to Sec. 164(a), a taxpayer who paid the marijuana excise tax should treat the expenditure as a reduction in the amount realized on the sale of the property…this excise tax is neither a deduction from gross income nor a tax credit.  Consequently, Sec. 280E does not preclude a taxpayer from accounting for this excise tax as a reduction in the amount realized on the sale of the property.”

So, it’s a reduction of the gross sales price and the taxpayer would report the net amount as gross income.  A win for the taxpayer.  One would presume that if MA were to enact a similar tax (as provided for in the new “legal” MA statute), it could be treated in a similar manner on the federal income tax return.