In a recent decision, the Tax Court illustrated the importance of good record-keeping, as well as the continuing barrier the Tax Code poses for the full deductibility of expenses related to marijuana facilities, in Alterman v. Commissioner, T.C. Memo 2018-83.
While marijuana is legal for medicinal purposes in 30 states and the District of Columbia, and for recreational purposes in another nine states, would-be retailers are faced with an impediment. Code Section 280E, in effect since 1982, states that “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 schedules 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.”
Because marijuana is still listed as a Schedule I controlled substance, retailers are limited in the deductibility of business expenses to the cost of goods sold, which can present an insurmountable hurdle to the profit-making ability of their business.
Laurel Alterman and her husband, William Gibson, filed joint returns for 2010 and 2011. They resided in Colorado, where Alterman operated a medical marijuana business, Altermeds LLC. She was its sole owner during the years at issue. Altermeds was a separate entity under Colorado law. For federal tax purposes, it is a disregarded entity, meaning it is treated as a sole proprietorship of Alterman.
Initially the business operated simply as a retail store, selling smokable marijuana, either as pre-rolled marijuana cigarettes, referred to by the Tax Court as “joints,” or as dried marijuana buds. It also sold marijuana in edible form such as brownies and cakes, and orally consumed tinctures. It also sold non-marijuana merchandise such as pipes, papers, and other items used to consume marijuana. In September 2010, Colorado began requiring medical marijuana businesses to grow as least 70 percent of the marijuana they sold, at which point Altermeds rented a warehouse to grow its own marijuana.
The service denied all of Altermed’s claimed administrative expenses, and reduced its cost of goods sold. It determined deficiencies and accuracy-related penalties for 2010 of $157,821 and $31,564, and for 2011 of $233,421 and $46,684.
Alterman argued that the sale of non-marijuana merchandise constituted a second line of business that could separately deduct business expenses. She also argued that Altermed’s deductible cost of goods sold was greater than the amounts conceded by the service.
The Tax Court said that whether selling non-marijuana merchandise was a separate business from selling marijuana is an issue of fact that depends on the degree of economic interrelationship between the two activities. In her testimony, Alterman said that the dispensary also sold hats and T-shirts with the name and business logo of Altermeds, magazines about marijuana, and chicken soup. However, no documentary evidence was presented, and the court found on a preponderance of evidence that no such items were sold. The court held that selling non-marijuana merchandise in this case was not a separate line of business from selling marijuana. Most of its revenue was derived from selling marijuana merchandise, and the types of non-marijuana products that it sold complemented its efforts to sell marijuana. Moreover, even if it were a separate business, Alterman failed to properly support its alleged deductions. It simply attributed a percent of expenses of the marijuana facility as attributable to the non-marijuana business.
And Alterman and Gibson failed in their attempt to have the court accept her higher estimate for cost of goods sold. Their method assumed that cost of goods sold equals purchase costs plus production costs, and leaves out beginning inventory and ending inventory. Therefore, the court accepted the IRS estimate of cost of goods sold.
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