As more and more states legalize either the recreational use of marijuana or the medical use of marijuana, more tax advisors will be encountering issues with respect to the representation of these businesses and recreational or medical marijuana users. The main issues stem from the fact that, even though states are legalizing these businesses and activities, at the federal level marijuana remains a Schedule I drug under the Controlled Substances Act of 1970. These legal businesses and activities under state law remain illegal businesses and activities under federal law. The Supreme Court has ruled that federal law takes precedence over state law.
The Justice Department under the current administration is taking a generally hands-off approach to these state law experiments, but the Obama administration has expressed no strong desire to change the legal status of marijuana at the federal level and has warned of possible enforcement activity if the marijuana activities involve criminal elements, sales to minors, sales across state lines, other illegal drugs, or use of public lands or federal property.
The Internal Revenue Service follows the federal law in viewing these businesses as illegal businesses for tax purposes. This creates a number of tax issues for representing these clients, as well as criminal exposure and possible ethical issues with respect to the professional licenses that a particular tax advisor may hold.
THE SCOPE OF STATE LEGALIZATION
Currently 27 states and the District of Columbia have legalized some form of marijuana use, from decriminalizing possession to legalizing marijuana sale, production and use for medical purposes, to legalizing marijuana sale, production and use for recreational purposes. Several additional states are looking at the issue.
For most of these states, the changes are relatively new and procedures and rules are still being created, and problems and solutions are still being identified. These states include some of the largest states in terms of population: California, Illinois, Massachusetts, Michigan and New York.
Code Sec. 280E specifically denies tax credits or deductions to businesses trafficking in controlled substances. Marijuana remains a Schedule I controlled substance under federal law. The result is to effectively make the income tax on a marijuana business a tax on gross income rather than net income, a considerable burden to a marijuana business.
There is an exception under the legislative history of Code Sec. 280E for cost of goods sold. Some marijuana businesses could try to allocate as much expense as possible to inventory to preserve their deduction. For example, the expenses related to producing and storing marijuana could be allocated to inventory. Since for most businesses there is an interest in deducting expenses, rather than allocating them to inventory, most of the IRS guidance is focused on restricting expenses. There are relatively few restrictions on voluntarily allocating more expenses to inventory than are required.
The direct costs are relatively easy to allocate to inventory. With respect to indirect costs, the full absorption rules under Code Sec. 471 and the uniform capitalization (UNICAP) rules under Code Sec. 263A come into play. Voluntarily complying with these rules, even if not required to do so, would generally be beneficial for a marijuana business that cannot otherwise claim deductions and credits.
There would still be some limits on the ability to allocate indirect costs to cost of goods sold. There is a general requirement in the regulations that the allocations not result in a material distortion of income. Some costs, such as selling, marketing and advertising costs, would generally not be allocable to cost of goods sold. There are indications that the IRS is taking a fairly strict look at what expenses can be properly allocated to cost of goods sold by marijuana businesses.
There is also litigation in Colorado with respect to the disallowance of deductions that could go to trial in the summer of 2015.
Another approach might be to try to segregate businesses to isolate the marijuana business from other activities and therefore protect the deduction of expenses related to the other activities. Whether the IRS will recognize the separate businesses will depend on a facts and circumstances analysis. Factors taken into account include whether the businesses had separate origins, whether they are conducted in the same location, to what extent each business supports the other, whether there are shared management and employees, and whether there are shared books and records.
The IRS requires certain taxes to be paid electronically. However, because of the federal view of marijuana and money laundering regulations, it is difficult for marijuana businesses to get bank accounts or utilize credit cards. They are usually run on a cash basis. The IRS has sought to impose substantial penalties on marijuana businesses that tried to pay their taxes in cash, the businesses contending that they could not file electronically.
Allgreens LLC had sued the IRS in Tax Court challenging the IRS’s determination that the inability to get a bank account did not excuse the failure to pay employee withholding taxes electronically. In a settlement of the case, the IRS agreed to abate the penalties, but stated that the settlement should not be viewed as precedent for future cases. The settlement may give the IRS an opportunity, however, to come up with a system to resolve the problem.
MEDICAL EXPENSE DEDUCTION
For the individual utilizing marijuana for medical purposes, the federal law treatment of marijuana also creates problems for the medical expense deduction. Revenue Ruling 97-9 determined that amounts paid for marijuana for medicinal use are not deductible, even if permitted under state law, since they were not legally procured under federal law. A similar analysis would probably apply to health flexible spending accounts, health savings accounts, health reimbursement accounts, and Archer Medical Savings Accounts.
AN ILLEGAL ACTIVITY
Under federal law, a person who aids, abets, counsels, commands, induces or procures the commission of a federal offense is punishable as a principal. The issue is whether rendering tax advice or preparing tax returns qualifies as aiding or abetting an illegal activity. Preparing a tax return may be safer than rendering tax advice since the tax return preparation would be generally focused on past activity, while rendering tax advice would generally be more associated with future activity, and therefore more likely be viewed as contributing to that activity. If the Justice Department is taking a generally hands-off approach to state experiments with marijuana businesses as long as they do not start to interfere with other federal priorities, the Justice Department is also likely to take a similar hands-off approach to anyone who could possibly be viewed as aiding or abetting that activity.
A number of national and state professional organizations have issued guidance with respect to the role that a licensed accountant or lawyer can play with marijuana businesses.
Tax advisors would be well advised to consult with the professional organizations with which they are affiliated or by which they are licensed to review those guidelines on professional conduct or ethics rulings to see how they apply in your particular state. The rulings seem to have relatively little consistency from state to state.
As more and more states start to adopt marijuana legalization statutes, the conflicts with federal law will continue to expand. Federal legislation has been proposed to remove marijuana from the list of Category I or II controlled substances.
Such a step would go a long way to resolving the issues discussed herein. The administration has not at this point been pushing the legislation, and there is considerable opposition in Congress.
Over time, either through regulatory changes or court decisions, the tax issues involved with representing marijuana businesses and users should eventually start to be resolved. In the meantime, however, tax advisors should tread carefully through the legal minefield in representing marijuana businesses and users.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA is principal analyst at Wolters Kluwer Tax & Accounting US.