Dear Dick

Massachusetts is one of the 46 states in the US that has legalized marijuana.  So, I decided to petition my City of Cambridge to open a medical marijuana dispensary.  Medical marijuana can effectively treat pain, headache, muscle spasms, eye disease, and many other medical problems.

I received a good deal of support locally and from the Commonwealth of Massachusetts in forming my cannabis business.

That is, until I heard that the federal government still has not legalized marijuana.

Marijuana remains classified as a Schedule 1 substance with a high potential for abuse, and ranks high on the list of controlled substance along with heroin and LSD

Am I going to be faced with not only bank financial issues but also IRS federal tax problems too?  Do I have to keep looking over my shoulder for US Treasury agents and IRS auditors chasing me?

“Reefer Madness”

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Dear “Reefer Madness”

Despite Operating Legally in Many States, Marijuana-Related Businesses Face Significant Federal Income Tax Law Challenges.

Let me shed some light on the frustrations encountered by a growing segment of the business taxpayer population – the growers, distributors, and retailers of marijuana-related products – and educate you on federal tax law.

All but four states have legalized marijuana use in some form (i.e., for recreational or medicinal use).

Per the Chief Economist for the National Cannabis Industry Association, there were 35,329 adult-use or medical licenses issued in the U.S. as of October 2021, up from 29,604 such licenses at the start of 2021. Revenue from the licensed marijuana industry is projected to grow to nearly $30 billion annually by 2025.

Erin Collins, IRS National Taxpayer Advocate and head of the Taxpayer Advocate Service (TAS), tells us that despite being able to operate legally under state law, in the U.S., trafficking of marijuana remains a federal offense.

Specifically, the Controlled Substances Act (CSA) makes it illegal under federal law to manufacture, distribute, or dispense marijuana, which is classified as a “Schedule 1” controlled substance.

Schedule 1 controlled substances are those drugs with a high potential for abuse, no currently accepted medical use in treatment in the United States, and for which there is a lack of accepted safety for use of the drug or other substance under medical supervision.

Schedule 1 controlled substances include drugs such as heroin and LSD. Because marijuana is classified under this category of controlled substances under the CSA, the sale of marijuana remains a violation of federal law, even if permitted in a growing number of states.

Several bills (including the Marijuana Opportunity, Reinvestment, and Expungement Act of 2020, which passed the House in December 2020 by a vote of 228 to 164, and the Cannabis Administration & Opportunity Act, a bill introduced by Senators Booker, Schumer, and Wyden in July 2021) have been introduced seeking to remove marijuana from the definition of a Schedule 1 controlled substance under the CSA.

On April 1, 2022, the House passed legislation to decriminalize marijuana at the federal level. While the Department of Justice has not made it a priority to prosecute businesses that comply with state law, the mere possibility of federal prosecution, no matter how slim, may deter businesses from entering into and/or engaging with the marijuana industry.

There are significant federal tax-related consequences for businesses engaged in the “trafficking” of marijuana, even in states that have legalized (or de-criminalized) the use of it.

Section 61(a)(2) of the Internal Revenue Code provides that, for the purpose of computing taxable income, an individual’s or a business’s “gross income” includes “all income from whatever source derived,” including “income derived from business.” This includes income from illegal sources.

Federal courts have consistently upheld Internal Revenue Service determinations that marijuana-related business, including state compliant marijuana dispensaries, have taxable income. These businesses must also pay employment taxes.

While businesses can generally deduct from their gross income “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on [the] trade or business” pursuant to section 162(a), there are exceptions.

Section 280E, enacted in 1982, forbids businesses from deducting expenses from their gross income if the business consists of illegally “trafficking” in Schedule I or II controlled substances. Because marijuana is still classified as a Schedule I controlled substance under federal law, all cannabis businesses fall into the category of drug trafficking and remain prohibited from writing off otherwise legitimate business expenses.

Similarly, because marijuana is not a federally recognized course of medical treatment, individual taxpayers are prohibited from claiming associated expenses as itemized deductions on Schedule A of their Form 1040 tax return.

There is an exception for the cost of goods sold (COGS); marijuana businesses can offset their gross receipts by their COGS, even for products considered controlled substances under federal law. Even so, marijuana-related businesses end up paying federal taxes on gross profit rather than net income.

Let’s Consider an Example.

A marijuana retailer has gross revenue of $1,000,000.

It spent $750,000 on COGS and incurred another $200,000 in business expenses (which are nondeductible per Section 280E (Expenditures in connection with the illegal sale of drugs).

Assuming a 30 percent effective tax rate, the marijuana retailer has a federal tax burden of $75,000 ($250,000 taxable income x 30%).

Had the business been allowed to deduct the other $200,000 in business expenses, its tax burden would have been reduced to $15,000 ($50,000 taxable income x 30%).

In the example above, the marijuana retailer incurred a tax burden five times as large as its non-marijuana-related business counterpart due to Section 280E.

Not only is the marijuana retailer effectively taxed at a higher rate, it may take longer for a marijuana-related business to recoup its start-up expenses and turn a profit than other businesses.

Because federal laws significantly limit access to financial institutions for marijuana-related businesses, many such businesses operate on a cash-only basis.

With cash payments over $10,000, the business must file a Form 8300 “Report of Cash Payments Over $10,000 Received in a Trade or Business” with the IRS.

Such businesses need to pay federal taxes in cash, and this can only be accomplished at designated offices where the IRS can accept it.

Legislation designed to give marijuana-related businesses more direct access to banking services would make it easier for the IRS to collect the taxes those businesses owe, as acknowledged by Treasury Secretary Janet Yellen during a December 1, 2021, congressional hearing.

Conclusion

Regardless of your personal or political views, or whether this disparate treatment is fair or not, taxpayers involved in the production, distribution, or sale of marijuana should be aware that there are significant federal income tax challenges that apply to this industry and understand the federal tax consequences.

To its credit, the IRS recently posted guidance on IRS.gov/marijuana, educating and informing marijuana-related business owners of the specific challenges they may face.

Until Congress changes the law removing marijuana from the definition of a Schedule I controlled substance under the CSA, these businesses are not entitled to claim deductions and expenses like other businesses and need to understand the federal tax consequences in conducting its business.

If you have other questions, call us at the AACA LITC (Asian American Civic Association Low Income Taxpayer Clinic).

Our Qualified Tax Experts provide representation, education and advocacy for individual taxpayers who who are low-income or speak English as a second language (ESL).

We can help you with your tax problems. 

Please contact AACA Low Income Taxpayer Clinic (AACA LITC) for an appointment at

(617) 426-9492 Ext. 285 or litc@aaca-boston.org

Dick

Richard Soo Hoo CPA, AACA LITC

SAMPAN, published by the nonprofit Asian American Civic Association, is the only bilingual Chinese-English newspaper in New England, acting as a bridge between Asian American community organizations and individuals in the Greater Boston area. It is published biweekly and distributed free-of-charge throughout metro Boston; it is also delivered to as far away as Hawaii.