Ed Roche: Federal Income Taxation of Medical Marijuana Businesses

8/21/2019 Ed Roche: Federal Income Taxation of Medical Marijuana Businesses

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Federal Income Taxation of

Medical Marijuana Businesses

Professor Edward J. Roche, Jr.

University of Denver Sturm College of Lawand Graduate Tax Program


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Federal Income Taxation of Medicaland Recreational Marijuana

Businesses

Professor Edward J. Roche, Jr.

University of Denver Sturm College of Lawand Graduate Tax Program


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Catch 22

Eighteen states have enacted laws permitting

the sale and use of medical marijuana.

Marijuana is listed as a controlled substance

under the Controlled Substance Act. 21 U.S.C. §

812 sched. 1(c)(10) (2006).

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Catch 22

Because these state laws have no effect on federallaws which continue to outlaw the production, sale,or possession of marijuana, those who engage in

this business, as well as their customers, are in adifficult legal position: their activities are legalunder state law but illegal under federal law. Underthe Supremacy Clause, any state law that conflicts

with a federal law is preempted.U.S. CONST. art. VI, cl. 2; see also Gibbons v. Ogden, 22U.S. 1, 42 (1824).

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Catch 22

The Supreme Court has twice ruled that the

federal government has a right to regulate and

criminalize marijuana sales and use, even when

a state’s laws permit marijuana to be used for

medical purposes.

Gonzales v. Raich, 545 U.S. 1 (2005); United States v.

Oakland Cannabis Buyers’ Coop., 532 U.S. 483 (2001).

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The Ogden Memorandum

On October 19, 2009, Deputy United States Attorney David W.

Ogden issued a memorandum (Ogden Memorandum)

announcing that the Justice Department would no longer make it

an enforcement priority to pursue those who are in “clear and

unambiguous compliance” with state medical marijuana laws inthe then 14 states that had passed legislation legalizing medical

marijuana.

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Not so fast…

In a July 29, 2011 memorandum, however, Deputy Attorney General James M.Cole repeated the position taken in the 2009 Ogden Memorandum, but notedthe “increase in the scope of commercial cultivation, sale, distribution anduse of marijuana for purported medical purposes,” including “multiple large-scale, privately-operated industrial marijuana cultivation centers.” Mr. Colethen stated:

The Ogden Memorandum was never intended to shield such activities fromfederal enforcement action and prosecution, even where those activities purportto comply with state law. Persons who are in the business of cultivating, selling ordistributing marijuana, and those who knowingly facilitate such activities, are inviolation of the Controlled Substances Act, regardless of state law. Consistent withresource constraints and the discretion you may exercise in your district, such

persons are subject to federal enforcement action, including potentialprosecution. State laws or local ordinances are not a defense to civil or criminalenforcement of federal law with respect to such conduct, including enforcementof the CSA.

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Disallowance of Ordinary and

Necessary Business Deductions

Under Section 280E


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Section 280E

(in its entirety)

No deduction or credit shall be allowed for anyamount paid or incurred during the taxable yearin carrying on any trade or business if such trade

or business (or the activities which comprisesuch trade or business) consists of trafficking incontrolled substances (within the meaning ofschedule I and II of the Controlled Substances

Act) which is prohibited by Federal law or thelaw of any State in which such trade or businessis conducted.

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Section 280E

No deduction or credit shall be allowed for anyamount paid or incurred during the taxable yearin carrying on any trade or business if such trade

or business (or the activities which comprisesuch trade or business) consists of trafficking incontrolled substances (within the meaning ofschedule I and II of the Controlled Substances

Act) which is prohibited by Federal law or thelaw of any State in which such trade or businessis conducted.

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Typical Taxation of Illegal Businesses

As a general rule, an illegal business is subject to

tax on its income in the same manner as any

legal business would be, and is entitled to the

same business deductions as are available to alegal business.

See, e.g., Commissioner v. Tellier, 383 U.S. 687, 691

(1966).

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Example

Edmonson v. Commissioner , 42 T.C.M. (CCH) 1533 (1981).

Business: Selling amphetamines, cocaine and marijuana

Deductions allowed: COGS, shipping, phone, car, homeoffice (!)

Deductions disallowed: T&E (for lack of substantiation)

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Treatment of Illegal Payments

Illegal payments, on the other hand, cannot be

deducted by either a legal or illegal business.

I.R.C. § 162(c). See Tank Truck Rentals, Inc. v.

Commissioner, 356 U.S. 30, 31, 35 (1958); see also

Hoover Motor Express Co. v. United States, 356 U.S. 38,

39 (1958).

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Operation of Section 280E

Section 280E denies a taxpayer any deduction for anyamount paid or incurred during the taxable year incarrying on any trade or business if such trade or businessconsists of trafficking in controlled substances.

Marijuana is listed as a Schedule I controlled substanceunder 21 USC § 812(c)(10).

Thus, a taxpayer operating a medical marijuana businessis subject to tax on its gross income rather than its netincome. It may not deduct what are clearly businessexpenses, such as rent and employee salaries.

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Allowance of Cost of Goods Sold


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Cost of Goods Sold

While § 280E disallows any deduction for a medicalmarijuana seller’s ordinary and necessary businessexpenses, the legislative history excepts the cost ofgoods sold from this rule. Constitutional concerns

are the stated reason in the legislative history forthis exception.

S. REP. NO. 97 –494 (Vol. I), at 309 (1982), reprinted in

1982 U.S.C.C.A.N. 1050, 1050 –51; See CaliforniansHelping to Alleviate Med. Problems, Inc. v.Commissioner , 128 T.C. 173, at 182.

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Paradigm Shift

Allowing the adjustment for the cost of goods

sold while denying a deduction for business

expenses under § 280E puts the medical

marijuana business in an unusual position -- itwould prefer to capitalize expenditures to the

cost of inventory rather than claim a current

deduction.

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Paradigm Shift

Medical marijuana businesses may benefit from

decades of legislation, cases, and IRS rulings,

and arguments calling for an expanded

interpretation of the capitalization rules andadopt an expansive interpretation of the

inventory capitalization rules to increase the

stated cost of their inventory, thereby reducingtaxable income.

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Full Absorption Inventory Cost Method

Section 471

A taxpayer must include as inventoriable costs alldirect (e.g., the cost of inventory and delivery, andthe cost of materials and labor for manufactured

inventory) and indirect production costs (e.g., rentand utilities related to inventory).

Farmers are allowed to elect to use an inventorymethod of accounting rather than the generally

applicable cash receipts and disbursementsmethod.

Reg. § 1.471 –11, 6(a).

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Uniform Capitalization Rules Under

Section 263A

The uniform capitalization rules (UNICAP rules)

require a producer of inventory to include in the

cost of its inventory the direct costs of such

property, and such property's proper share ofthose indirect costs (including taxes) part or all

of which are allocable to such property.

§ 263A(a)(2); Reg. § 1.263A –1(a)(3)(ii).

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Uniform Capitalization Rules Under

Section 263A

The UNICAP rules, as a general rule, require

more indirect costs to be allocated to inventory

than the full absorption rules require under §

471, and which also in some cases go beyondthe requirements of generally accepted

accounting principles (GAAP).

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Good News!

I will not be discussing the full absorption and

UNICAP rules in any detail.

(Call an accountant)

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Using the UNICAP Rules

The UNICAP rules must be followed by allmanufacturers and most resellers, but a smallbusiness exception is provided for resellers with lessthan $10 million in gross receipts on a three-year

rolling average basis. Thus, most medical marijuanabusinesses that do not produce marijuana ormarijuana-based products will not be required tocomply with the UNICAP rules, because their gross

receipts are typically less than $10 million.

I.R.C. § 263A(b)(2)(B).

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A reseller which is not subject to the UNICAP

rules is usually required to include only direct

costs in the cost of its inventory.

See Reg. § 1.471 –1, –3(b).

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A medical marijuana business would be well

advised to comply with the UNICAP rules,

whether or not it is required to do so, in order to

maximize the costs allocated to cost of goodssold and to minimize the amount of disallowed

business expenses. There is nothing that says

that taxpayers cannot voluntarily follow theserules.

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Using the Full Absorption Rules

A medical marijuana business that producesmarijuana or marijuana-based products must, andshould want to, comply with the full absorptioninventory rules. In addition to direct costs, these

businesses should include all Category I costs intheir inventory costs and should adopt financialaccounting treatments which would allow themaximum amount of Category III costs to be

included. They should also comply with the UNICAPrules and maximize the indirect costs included ininventory.

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Examples

A medical marijuana business should capitalize

otherwise deductible insurance costs and taxes

relating to inventory (such as personal property

taxes) for financial accounting purposes, causingthese “Category III” expenses to be capitalized

under the full absorption rules.

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A more interesting question is whether a medicalmarijuana business could go beyond the rulesunder § 471 and the UNICAP rules and include in itsinventory cost costs that both sections excuse fromrequired inclusion, such as Category II costs underthe full absorption rules or expenses that are notrequired to be included under the UNICAP rules.

The answer appears to be that some, but not all, ofthese costs can possibly be included in the cost ofinventory.

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The § 1.263A regulations provide that certaincosts are not required to be capitalized adds,including on-site storage, certain deductible

service costs, and property expensed under §179. An argument can be made, however, thatan allocable portion of these costs can beincluded in the cost of inventory.

See Reg. § 1.263A –1(e)(3)(iii).

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The regulations clearly contemplate a taxpayer goingbeyond the requirements and adding additional “non-required” costs to inventory costs. The UNICAPregulations provide:

A taxpayer may . . . elect to capitalize certain period costs [costs which arenot required to be added to the cost of inventory and which can beexpensed currently] if: The method is consistently applied; is used incomputing beginning inventories, ending inventories, and cost of goodssold; and does not result in a material distortion of the taxpayer's income.A material distortion relates to the source, character, amount, or timing ofthe cost capitalized or any other item affected by the capitalization of thecost.

Reg. § 1.263A –1(j)(2)(i).

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Similarly, the full absorption method regulationsstate: Notwithstanding the preceding sentence,[which describes the Category II Costs which do nothave to be capitalized], if a taxpayer consistently

includes in its computation of the amount ofinventoriable costs any of the costs described in thepreceding sentence, a change in such method ofinclusion shall be considered a change in method of

accounting.

Reg. § 1.471 –11(c)(2)(ii).

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Examples

A medical marijuana business should include thecosts attributable to on-site inventory storage ininventory costs, even though the regulations do

not require its inclusion.

A medical marijuana business should also

consider making the § 179 election for eligibleproperty and including the deductible amount ininventory.

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Example

Example: A medical marijuana business growsmarijuana at a facility away from its retail saleslocation. It also has a secure storage room forinventory at its retail sales location, which uses 25%

of the space at that location. This business shouldinclude in inventory 25% of its rent (or depreciationon the building and real property taxes, if it ownsthe building). In addition, it should allocate a

portion of its utilities and security costs toinventory, based on the same percentage. It shouldalso include any additional costs specificallyincurred to secure the inventory storage area.

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Optional Capitalization of Indirect

Costs

The regulations permit a taxpayer to elect tocapitalize certain indirect costs that do notdirectly benefit or are not incurred by reason of

the production of property or acquisition ofproperty for resale if the method: (1) isconsistently applied; (2) is used in computingbeginning inventories, ending inventories, and

cost of goods sold; and (3) does not result in amaterial distortion of the taxpayer's income.

Reg. § 1.263A –1(j)(2)(i).

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Under this optional capitalization rule, a medicalmarijuana business could capitalize all of the costs in anyindirect cost category so long as some portion of theexpenses in that category is otherwise properly allocableto inventory under the § 263A regulations. Thus, forexample, if an employee of a medical marijuana businessspent some of her time working in the inventoryoperations, all of her employee compensation costs couldbe included in inventory costs. Similarly, if the marijuana

is grown on site, all of the rent could be included ininventory. This would be of obvious benefit to themedical marijuana business (and would relieve it of theburden of allocating costs between operations as well).

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The types of indirect costs eligible for capitalizationunder this rule include only the types of indirectcosts for which some portion of the costs incurredis properly allocable to inventory. Thus, forexample, marketing or advertising costs, no portionof which are properly allocable to propertyproduced or property acquired for resale, do not

qualify for elective capitalization under this rule.

Reg. § 1.263A –1(j)(2)(ii).

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The difficulty with this argument is the requirement that theuse of the optional capitalization rule not result in a materialdistortion of the taxpayer's income. The regulations provide:

A material distortion relates to the source, character, amount,or timing of the cost capitalized or any other item affected bythe capitalization of the cost. Thus, for example, a taxpayermay not capitalize a period cost under § 263A if capitalizationwould result in a material change in the computation of theforeign tax credit limitation.

Reg. § 1.263A –1(j)(2)(i).

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Indirect Costs that Cannot Be Included

in Inventory

The arguments above will not permit all indirect costs to beincluded in inventory costs. Both the § 471 full absorptionrules and the UNICAP rules provide that selling, marketing,distribution, and advertising expenses are not required to beincluded in inventory costs. Unlike the indirect costs discussed

above, these costs are excluded because they are not in anycase attributable to the cost of goods sold -- they representthe costs of selling the products, not acquiring or producingthem. In this light, the UNICAP optional capitalization rulesspecifically provide that marketing or advertising costs cannot

be capitalized under that rule.

Reg. §§ 1.263A –1(j)(2)(ii), 1.471 –11(c)(2)(ii).

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Disallowance of “Nondeductible”

ExpensesThe UNICAP rules provide that any cost that may not be taken intoaccount in computing taxable income (e.g., fines and penalties and50% of meals) cannot be capitalized as part of the cost of inventoryunder the UNICAP rules. At first blush, this would appear to prevent amedical marijuana business from capitalizing any of its expenses,because under § 280E, none of its business expenses are deductible.

This is not the case, however. Section 280E disallows a deduction forbusiness expenses but permits the taxpayer to reduce its sales by thecost of goods sold. The inventory capitalization rules in effect draw theline between these two categories of costs; they define the cost of

inventory and thus the cost of goods sold. Any cost included ininventory under these rules is not an otherwise deductible businessexpense and thus is not subject to disallowance under § 280E.

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Two Lines of Business


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Section 280E Is Limited to the

Marijuana Business

A taxpayer which sells medical marijuana and is

also engaged in another business is not subject

to § 280E with respect to the other business.

Californians Helping to Alleviate Med. Problems,

Inc. v. Commissioner, 128 T.C. 173, 182 (2007).

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The Two-Business Rule

It is well established that a taxpayer can havemore than one trade or business.

Alverson v. Commissioner, 25 B.T.A. 482, 488 (1937).

This principle is reflected in the regulations,which provide standards to determine whethera taxpayer’s activities constitute separate

businesses.

Reg. § 1.183 –1(d)(1).

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The Two-Business Rule

1.183(d)(1) states, in relevant part:

[W]here the taxpayer is engaged in several

undertakings, each of these may be a separateactivity, or several undertakings may constituteone activity. In ascertaining the activity oractivities of the taxpayer, all the facts andcircumstances of the case must be taken intoaccount.

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Facts and Circumstances Test

“Generally, the most significant facts andcircumstances in making this determination are thedegree of organizational and economicinterrelationship of various undertakings, the

business purpose which is (or might be) served bycarrying on the various undertakings separately ortogether in a trade or business or in an investmentsetting, and the similarity of various undertakings.

Generally, the Commissioner will accept thecharacterization by the taxpayer of severalundertakings either as a single activity or asseparate activities . . . . ”

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Caveat

“The taxpayer's characterization will not be

accepted, however, when it appears that his

characterization is artificial and cannot be

reasonably supported under the facts andcircumstances of the case.”

Reg. § 1.183 –1(d)(1).

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Factors

(1) whether the undertakings are conducted at the same place;(2) whether the undertakings were part of a taxpayer's efforts to findsources of revenue from his or her land;

(3) whether the undertakings were formed as separate activities;

(4) whether one undertaking benefited from the other;

(5) whether the taxpayer used one undertaking to advertise the other;(6) the degree to which the undertakings shared management;

(7) the degree to which one caretaker oversaw the assets of bothundertakings;

(8) whether the taxpayers used the same accountant for the

undertakings, and(9) the degree to which the undertakings shared books and records.

Rupp v. Commissioner, 103 T.C.M. (CCH) 1594, 1598, 2012 T.C.M. (RIA)2012-108.

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CHAMP v. Commissioner

In Californians Helping to Alleviate Med. Problems, Inc. v.Commissioner , the director of the dispensary was well experienced inhealth services, and he operated the dispensary with caregiving as theprimary feature and the dispensing of medical marijuana as asecondary feature. Sixty-eight percent of the CHAMP dispensary'semployees—17 out of 25—worked exclusively in its caregivingbusiness, and the dispensary provided its caregiving services regularly,extensively, and substantially independent of its providing of medicalmarijuana. It rented space at a church for peer group meetings andyoga classes, but the church did not allow marijuana on the church'spremises. It provided its low-income members with daily lunchesconsisting of salads, fruit, water, soda, and hot food. Its members,approximately 47% of whom suffered from AIDS, paid a singlemembership fee “for the right to receive caregiving services andmedical marijuana from” the taxpayer.

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CHAMP v. Commissioner

In CHAMP, the Tax Court held that the taxpayer’sprovision of caregiving services and its provision ofmedical marijuana were separate business activitiesbecause the taxpayer “was regularly and

extensively involved in the provision of caregivingservices, and those services are substantiallydifferent from the [taxpayer’s] provision of medical

marijuana.”

Californians Helping to Alleviate Med. Problems,Inc. v. Commissioner , 128 T.C. 173, 183 (2007).

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Olive v. Commissioner

The Tax Court applied the factors in Olive v.

Commissioner to deny the taxpayer’s attempt to

treat its medical marijuana dispensary, the

Vapor Room, as two activities—the secondbeing a caregiving activity, as in CHAMP.

Olive v. Commissioner , 139 T.C. No. 2 (2012).

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In Olive, the taxpayer established the Vapor Room so thatits patrons, including some suffering from AIDS and HIV,cancer, and other maladies, “could socialize and consumemarijuana there.” The taxpayer “designed the VaporRoom with a comfortable lounge-like community centeratmosphere, placing couches, chairs and tablesthroughout the premises. He placed vaporizers, games,books and art supplies on the premises for patrons to useat their desire.”

The taxpayer claimed that he trafficked marijuana onlywhen actually selling it “and [that] the rest of the VaporRoom’s business was providing caregiving services” byproviding the lounge and recreational supplies.

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The Court distinguished CHAMP and applied the Rupp factors toconclude that the Vapor Room had only one trade or business,stating:

The facts here persuade us that the Vapor Room's dispensing of

medical marijuana and its providing of services and activities sharea close and inseparable organizational and economic relationship.They are one and the same business. Petitioner formed andoperated the Vapor Room to sell medical marijuana to the patronsand to advise them on what he considered to be the bestmarijuana to consume and the best way to consume it. Petitioner

provided the additional services and activities incident to, and aspart of, the Vapor Room's dispensing of medical marijuana.

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Practitioner Concerns


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Legal Concerns

Whoever commits an offense against the UnitedStates or aids, abets, counsels, commands,induces or procures its commission, is

punishable as a principal. 18 U.S.C. § 2(a) (2006).-- Preparing a lease

-- Preparing financial statements

-- Tax advice or preparing tax returns (?)-- Lecturing on the tax treatment of medicalmarijuana businesses (?)

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Ethical Concerns

“A lawyer shall not counsel a client to engage, or

assist a client in conduct that the lawyer knows

is criminal or fraudulent.”

MODEL RULES OF PROF’L CONDUCT R. 1.2(d) (2011).

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State Ethics Rulings--Maine

A lawyer cannot assist a client to engage in the

medical marijuana business.

Maine Prof’l Ethics Comm’n, Op. 199 (2010).

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State Ethics Rulings--Arizona

A lawyer can ethically perform such legal acts asare necessary or desirable to assist the client toengage in the conduct that is expressly

permissible under the Arizona MedicalMarijuana Act so long as the lawyer advises theclient with respect to the potential federal lawimplications and consequences thereof.

State Bar of Ariz. Comm. on the Rules of Prof’l Conduct, Opinion 11 –01 (2011).

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The End

Thank you for attending.

Ed Roche: Federal Income Taxation of Medical Marijuana Businesses

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