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I will supplement this post in an ongoing effort to synthesize the ongoing development of taxation of Marijuana. The legalization of marijuana in Colorado poses fascinating federal tax challenges. I will help the industry manage this challenge.
The problem lies in a short provision in the United States Tax Code. As States, such as Colorado, legalize substances that are illegal under federal law, this section in the tax code provides a formidable barrier to business operations. This section was enacted in 1982 when Ronald Reagan declared the “War on Drugs”. As unambiguous as that war was so to it is this section of the internal revenue code.
Sidebar: I have always taken interest in the Tenth Amendment to the United States Constitution. The Tenth Amendment is beyond the scope of this post. In general, the Tenth Amendment is used by States as a legal mechanism to exert legal authority in its own right and thereby limit legal authority of the federal government. The argument would go that if a State, such as Colorado, chooses to legalize a substance that is illegal under federal law, Colorado law prevails and preempts federal law.
Sidebar to the Sidebar: As a Coloradoan for the past 20 years, having first hand witness of the evolution of this business, it is headed in the right direction. I base this solely on observation. It has helped commercial real estate. It does seem that it stimulated the commercial real estate market during the great recession. Now that Colorado is regulating the industry, especially the City & County Denver, the industry appears more reasoned and is in its second stage. I would say it is very much in the growth cycle. My personal belief is that store-front advertising such as displays should be scaled down a bit although they are already somewhat modest. Perhaps this is because I have small children. Perhaps borrowing the advertising approach from merchants in the State of Vermont would fit my bill. I do believe that the Denver Council and the State of Colorado deserve acknowledgement for spearheading successful regulation with courage in unknown territory. I am proud to be a Coloradoan.
Putting our political and personal passions aside, let’s talk math and tax.
I focus on the taxation of profits and business models. A business model would not be sustainable if it were taxed 100% on revenue without the ability to take deductions. Internal Revenue Code §280E does just that.
IRC §280E is a subsection to Part IX of the internal revenue code entitled Items Not Deductible .
IRC §280E provides:
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
Marijuana is a schedule I controlled substance under federal law. As such no deductions or credits are allowed pursuant to IRC §280E. Article XVIII, Section 16 of the Colorado Constitution legalizes marijuana for recreational use for individuals over 21 and regulation thereof. Article XVIII, Section 14 of the Colorado Constitution legalizes marijuana for medicinal use. Therein lies the rub.
Tax Court to the Rescue
Thank goodness for the separation of powers and level-headed judges.
Federal Taxation of Medical Marijuana / Caregiver Business Model
In a caregiver tax case, pursuant to IRC §280E the IRS disallowed all of Taxpayers deductions related to the provisioning of marijuana and deductions related to caregiving services. The Tax Court disagreed.
The tax court allowed for Taxpayer to classify its business as two separate business models: provisioning of marijuana, and caregiver. In the end, the tax court permitted most of taxpayer’s deductions. The court permitted deductions related to caregiving such as rent, salaries, and so on. The court allocated 10% of rent to provisioning of marijuana, which was disallowed.
What is interesting to note about this case is the IRS position of business-model pollution, as I describe it. The IRS took the position that because Taxpayer was in a business concerning a controlled substance that business polluted the deductions of the legitimate business. This concept of business-model pollution must be heeded as it applies to recreational marijuana.
Cost of Goods Sold
In a more recent tax court case, the court permitted the cost of good sold (COGS) deduction. This is a huge win for the marijuana industry.
Gross income, as defined in IRC §61, does not include COGS. Historically, accountants perform separate measurements of income. At the very outset a measurement is calculated to determine gross revenues less COGS. Tax law inherited this practice. Tax law considers COGS an exclusion. When one studies accounting, as I have, he undertakes the study of Cost Accounting, which is in itself the science of COGS.
In this more recent case, the tax court implemented the notion of business-model pollution against Taxpayer that had the affect of disallowing deductions that otherwise would have been allowed.
COGS provides a considerable tax planning strategy especially as it relates to the recreational industry. Minimizing business-model pollution is critical to fortify the profit models of separate businesses as it possibly relates to grow and retail.
Published: July 16, 2014.
By: Philip Falco, CPA, Juris Doctor – Honors