The Federal Controlled Substances Act (“CSA”) 21 U.S.C. § 812 classifies marijuana as a Schedule 1 substance with a high potential for abuse, no currently accepted medical use in treatment, and lack of accepted safety for use under medical supervision.
Generally, businesses can deduct ordinary and necessary business expenses under I.R.C. §162. This includes wages, rent, supplies, etc. However, in 1982 Congress added I.R.C. §280E. Under §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law.
Under IRC §280E, businesses that are engaged in trafficking controlled substances cannot take regular business deductions, so they end up paying taxes on their gross receipts less their allowed cost of goods sold (COGS). If an expense doesn’t fit into the category of COGS, a company that is considered to be “trafficking” would have to pay taxes as if the expense hadn’t been incurred in the first place. This is why cannabis businesses can end up paying a lot more in taxes than non-cannabis businesses.
One strategy that has been used for cannabis business is to set up operations using multiple companies with one of those companies being a “management company”. Most of the value of having a management company comes from the ability of the management company to get banking and enter into regular electronic transactions with third parties. Also, it was an untested way to avoid the harsh realities of IRC §280E – at least until now…
Alternative Health Care Advocates, et al v. Commissioner Of Internal Revenue
In the case of Alternative Health Care Advocates, et al v. Commissioner Of Internal Revenue, 151 T.C. 13 (Click here for the opinion), Alternative Health Care Advocates, Inc. (“Alternative Health”) operates a medical marijuana dispensary in West Hollywood, California. Related to this corporation is another company, Wellness Management Group, Inc. (“Wellness Management”), which provided management services to Alternative Health. These services included hiring employees and managing HR for those employees, paying wages for those employees, paying advertising expenses, paying rent, etc. Wellness Management did not provide services of that nature or any nature to any other business entity. Wellness Management made money by collecting fees for its services from Alternative Health.
Wellness Management recognized as income the management fees it charged to Alternative Health and Wellness Management deducted its expenses incurred in generating the management fees on the basis that Wellness Management was not engaged in the sale and purchase of marijuana but that it is a management services company that can engage in a separate line of business from the entity it manages.
While Tax Court recognized that Wellness Management and Alternative Health were legally separate entities, it was clear to the Court that Wellness Management’s employees were engaged in the purchase and sale of marijuana (albeit on behalf of Alternative Health); that was Wellness Management’s primary business. The Court did not read the term “trafficking” to require Wellness Management to have had title to the marijuana its employees were purchasing and selling going on further to state that neither IRC §280E nor the nontax statute on trafficking limits application to sales on one’s own behalf rather than on behalf of another. Therefore, the Court concluded that the management service company, Wellness Management, was engaged in the business of “trafficking in controlled substances” during the taxable years at issue and since Wellness Health was unable to identify any portion of its activities being non-related to marijuana activities, none of its expenses would be deductible.
Risk Of Getting A Big Tax Bill From IRS That You Cannot Pay
As long as marijuana remains a Schedule 1 controlled substance under Federal law, dispensaries and other businesses trafficking in marijuana have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses. A cannabis business that has not properly reported its income and expenses and not engaged in the planning to minimize income taxes can face a large liability proposed by IRS reflected on a Notice Of Deficiency or tax bill.
This risk should be risk posing the greatest challenge to any cannabis business as the Federal taxation of cannabis businesses is consistent in all states and not dependent on whether local Federal prosecutors are aggressive in enforcing the illegality of cannabis or the banks unwilling to do business with the cannabis industry. This unexpected liability can put you out of business so it is important to secure qualified tax counsel to be proactive with tax planning to minimize taxes and to defend you in any tax examinations, appeals or litigation with the IRS.
What Should You Do?
While more States are legalizing cannabis, risks to the cannabis industry still exist. Considering this risks of cannabis you need to protect yourself and your investment. Level the playing field and gain the upper hand by engaging the cannabis tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), San Diego County (Carlsbad) and other California locations. We can come up with solutions and strategies to these risks and protect you and your business to maximize your net profits.