An obscure provision of the Internal Revenue Code that bans business tax deductions for sellers of legal marijuana is shutting down many dispensary businesses throughout the U.S., but tax experts say diversification and cost allocation are the keys to escaping current draconian federal tax policy.

Although the sale of marijuana is legal in several states, it remains illegal under federal law, and Revenue Code 280E bans most deductions and tax credits given to businesses selling Schedule I and II controlled substances, which includes marijuana, under the Controlled Substance Act.

“When potential marijuana dispensary business owners figure out that their effective federal tax rate will be 60 to 90 percent, it turns them off,” Jordan Cornelius, a CPA with Hawkway CPAs LLC in Denver, told Law360.

“But some businesses are now using smart tactics to push the envelope with the IRS to include some business expenses in their tax returns, despite Section 280E.” Revenue Code Section 280E arose after the U.S. Tax Court in 1982 allowed a convicted felon to deduct expenses he incurred when selling amphetamines, cocaine, and marijuana.

Under current law, Section 280E allows marijuana dispensaries to deduct only their cost of goods sold – all other normal and ordinary business expenses are rejected by the IRS, including marketing, training, transportation, meals and entertainment, and a host of other big-ticket expenses.

“You have a lot of organizations that end up failing and closing after two to three years because of the tax burden imposed by 280E,” Abraham Finberg, a CPA assisting dispensaries across California, told Law360.

“But now it’s impressive – I’m seeing a lot of CPAs tackling these tough tax issues, and the industry’s tax outlook is becoming a little more clear.” One popular technique involves the diversification of services offered by marijuana dispensaries.

A 2007 court case opened the door for the current business diversification trend, when the U.S. Tax Court in Californians Helping to Alleviate Medical Problems Inc v. Commissioner of Internal Revenue – called the CHAMP case – allowed a California medical marijuana dispensary to allocate almost 90 percent of certain expenses to the nonmarijuana aspects of its business.

In the CHAMP case, the U.S. Tax Court rejected the IRS’s argument that once a business begins selling marijuana, all of its business deductions and credits are barred.

“Harborside and others are choosing to offer things like acupuncture and yoga, and this gives them the option to allocate business expenses to these items.” Another popular technique to reduce a dispensary’s tax burden is to use the IRS’ own regulations against it when capitalizing indirect costs and allocating them to deductions for the cost of goods sold.

On one hand, the IRS disallows the deduction of ordinary business expenses for marijuana businesses, but on the other hand, related IRS rules and regulations mandate certain uniformed capitalization practices toward the cost of goods sold.

Luigi Zamarra, CPA and former chief financial officer at Harborside, says the use of certain tax deduction tactics will sometimes lead to an IRS appeals conference, but he says this is not always a bad situation for marijuana businesses.

“My clients walk into appeals conferences with the IRS and tell the agents that they are applying 280E incorrectly, and the IRS usually settles on the issue,” Zamarra told Law360.

“And that’s great for my clients because they get 280E disallowance rulings that allow them to continue business without a bankruptcy.” According to Zamarra, the IRS typically settles tax disputes over 280E issues with marijuana dispensaries because it’s in the federal government’s best interest to continue collecting money from the industry.

Despite the clarification of tax rules for the marijuana industry, many tax professionals feel that without a complete overhaul of Section 280E, the industry will continue to be plagued by unequal treatment by the IRS. “280E treats marijuana businesses like second class citizens, in a way,” Finberg told Law360.

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