Taxpayer in the Weeds

IRS wins a victory against marijuana dispensariesSelling illegal drugs may be a little less profitable than you thought.

While I don’t think this blog will apply to many, if any, of my clients, it is an interesting case of conflicts between state laws and the Internal Revenue Code (IRC).  Here’s a little background.  In 2004, Martin Olive left college to pursue his lifelong dream (one would imagine) of opening a medical marijuana dispensary in California.  The dispensary, named the Vapor Room, quickly grew from $1 million in gross sales in his first year, to $3 million in his second year of business.  As all good business-people do, Olive filed his taxes, taking full advantage of all the business deductions he could.  That was the problem.

Under IRC Section 280E, a taxpayer may NOT deduct any amounts, other than cost of goods sold, for a trade or business where the trade or business consists of selling controlled substances prohibited by federal law.  But medical marijuana is legal in California (and many other states).  Doesn’t matter said the IRS.  The IRS disallowed all his deductions, other than his cost of goods sold, increased his tax liability, and hit him with penalties and interest.

Olive took the IRS to Tax Court (yes, there is such a thing).  Olive argued that his business did not consist of illegal trafficking of a controlled substance because medical marijuana, and therefore his business, are legal under California law.  Doesn’t matter said the Tax Court.  Marijuana is a controlled substance under federal law, and that means he doesn’t get the deductions.

Olive appealed to the Ninth Circuit.  On appeal, Olive made some semantical arguments that his business does not “consists of” trafficking in a controlled substance because he also offers caregiving services and a place for patients to socialize with other patients.  Because he offered these services, argued Olive, his business did not “consist of” either business alone and therefore did not fall within the domain of Code Sec. 280E.  The Ninth Circuit didn’t accept the argument and upheld the Tax Court’s original ruling.

So what does this mean?  Well, if you are trafficking in a controlled substance, your business deductions, except for cost of goods sold, will be disallowed.  No deductions for mileage, home office, travel, meals, utilities, etc…  Something to be aware of when you are thinking about starting a business selling controlled substances.  There are also other non-tax issues you should consider, but that’s for another time.