Tax Implications of Government Regulation In The Marijuana Business

Rex Halverson

How Does the Federal Government Regulate Drugs?

Under the federal Controlled Substances Act (CSA) drugs are classified into 5 schedules. Drugs are placed into a schedule based on their acceptable medical use and their potential for abuse or dependency. Schedule I, which includes marijuana, is reserved for drugs that currently have no acceptable medical use according to the Drug Enforcement Administration. The sale and use of marijuana for medical and recreational purposes is now legal in California. However, according to the Supremacy Clause of the United States Constitution, federal laws take precedence over state laws, which means the Federal Government can prosecute violations of the Controlled Substances Act even in states where marijuana is legalized.

In August of 2013, under President Obama, the Federal Department of Justice issued the Cole Memorandum, which stated that the Justice Department would not enforce federal marijuana prohibition in states that have legalized marijuana and implemented their own regulatory scheme. In January of 2018, however, Attorney General Jeff Sessions rescinded the Cole Memorandum, opting to allow individual prosecutors to decide whether to enforce the federal law. But, on June 8, President Trump surprised many of us and announced his view that the states, not the federal government, should decide how to regulate marijuana.

What is Trump Suggesting and What Power Does the President Have?

President Trump voiced his support for S.3032, the Strengthening the Tenth Amendment Entrusting States (STATES) Act, a bill introduced by Senator Cory Gardner (R-CO) and Senator Elizabeth Warren (D-MD) which would exempt marijuana from the CSA in states that have legalized it. It would allow individual states to determine how they want to regulate marijuana and keep the federal government from interfering if a state meets some minimal requirements. The Act would also clarify that banks which accept money from marijuana dispensaries or marijuana growers are not ‘trafficking’ in illicit substances according to the CSA. This would encourage banks to begin to facilitate the marijuana industry, which they have avoided so far because of the threat of prosecution under federal law. The Act would also remove hemp from the CSA entirely.

President Trump said “I support Senator Gardner. I know exactly what he’s doing.” The President’s support means that Congress will not need to gather the two-thirds majority required to overturn a presidential veto. It could also help to shift the views of members of Congress.

There is another way in which the President can influence the scheduling of drugs. According to 21 USCS § 811 (a) the Attorney General may alter the schedule with the recommendation of the U.S. Department of Health and Human Services. This method is unlikely to be successful in the near future while Jeff Sessions continues as the Attorney General. While the Attorney General can be fired by the President at any time for any reason, President Trump has so far not shown any proclivity to remove Jeff Sessions and it is unclear how important the marijuana issue is to the President. Furthermore, 21 USCS § 811 (d) requires the Attorney General to schedule drugs in accordance with United States obligations under international agreements, regardless of subsection (a). The United States is a signatory to the Single Convention on Narcotic Drugs that classifies marijuana in its most restrictive schedule.

What are the Tax Implications of the STATES Act?

Under Section 280E of the Internal Revenue Code, businesses are barred from deducting business expenses from gross income related to the ‘trafficking’ of schedule I or II drugs. The effect of this law is that marijuana businesses pay a much higher effective income tax rate than all other types of businesses which are allowed to deduct business expenses. The STATES Act will not change this because the Act will only exempt federal enforcement in the states in which marijuana is legal, instead of removing marijuana from schedule I.

Section 280E was enacted in response to the tax court decision in Edmondson v. Commissioner 42 T.C.M. 1533 (1981). The Court in Edmondson held that a taxpayer could deduct expenses related to the sale of cocaine and marijuana, including the cost of goods sold and even a portion of the rent he paid for his apartment that he used to conduct business. Section 280E was passed one year later and was meant to increase the financial burden of dealing in illicit substances. Now that the legal status of marijuana is changing, there is some movement within Congress towards a more equitable tax system. The Small Business Tax Equity Act would exempt marijuana businesses that are in compliance with state law from Section 280E and allow them to take the business deductions that other businesses routinely do.

The Small Business Tax Equity Act was introduced in the House of Representatives (H.R. 1810) and the Senate (S.777) in March of 2017 and was sent to the Committee on Finance in the Senate and the Committee on Ways and Means in the House. Since then, there has been no action on either bill and it seems likely that both bills have died in committee.

There are a few ways that marijuana businesses have tried to circumvent 280E, with varying degrees of success. In the United States Tax Court decision Californians Helping to Alleviate Medical Problems (CHAMP) v. Commissioner 75 T.C.M. 1849 (1998), CHAMP was allowed to apportion its business between the caregiving services and medical marijuana that it supplied. This significantly reduced the amount of taxes assessed against CHAMP because they could take regular business deductions from the portion of their business that was not affiliated with marijuana. In Olive v. Commissioner 792 F.3d 1146 (2015), however, the CHAMP case was limited. In Olive, the business sold marijuana and provided complimentary games, books, and refreshments. The Ninth Circuit Court of Appeals held that the business was only hoping to realize a profit on the sale of marijuana and was therefore not entitled to avoid the application of Section 280E to any of its business expenses. Some businesses have opted to give away marijuana for free after receiving ‘donations’. However, in June of 2017 the California Business and Professional Code section 26153 was amended to prohibit giving away any cannabis, cannabis products or accessories as part of a business promotion or other commercial activity.

Preparation Now Can Save You From Facing Serious Tax Trouble Later

If the legal or taxable status of growing and/or selling marijuana changes, your marijuana business may benefit greatly so stay alert to all that is going on in Washington and Sacramento.

Over the years we have noticed that many marijuana businesses have failed to keep detailed records, e.g., resale certificates and sales receipts. Failure to keep such records can be very costly as the IRS, Franchise Tax Board and California Department of Tax and Fee Administration will require such records in order to perform their audits. Don’t let the possibility of federal prosecution prevent you from preparing for these inevitable audits. Seek advice from your attorney as to whether he or she will store copies of your records and receipts.