The complications caused by the conflict between state and federal law continues as dispensaries that are legal in their state of business attempt to file federal tax returns. Since the selling of marijuana is still a federal criminal act, filing a tax return admits illegal activity, but that is not the only problem. The tax law has code dealing with filing of illegal income. However, don’t think that you’re off the hook – the tax code limits the deductibility of expenses when it comes to illegal businesses.
According to the IRS Comprehensive Drug Abuse Prevention and Control Act of 1970 (CSA), taxes are due on the sale of controlled substances, such as heroin, opiates, and marijuana (including medical). As Al Capone’s case proves, tax evasion can turn out to be a larger problem than confessing to an illegal activity on your income tax return. As long as dispensaries are operating under state law, they do not need to fear federal prosecution of their business, but they may be in for a shock when they calculate their taxable income under the CSA code.
Section 61 of IRS Tax Code identifies gross income for business purposes and the business expenses that can be deducted to calculate taxable income. Though costs of doing business were originally allowed as deductions, Section 280E, enacted in 1982, specifically disallows the deduction of any expenses beyond costs of goods sold. Costs of goods sold (COGS) is defined as the inventoried costs of the substance sold (in our instance this would be cost of producing medical marijuana or reimbursement). As counterintuitive as this may seem, you get to deduct the “illegal” part but nothing else. Other related business expenses, such as office, admin or storefront costs, are disallowed.
The end result is that the taxpayer pays federal income tax on a much larger portion of their income than they would if they were operating a federally legal business. Classification of expenses as costs of goods sold is vitally important to businesses of this sort, and it makes sense to minimize other expenses until federal tax code catches up with business reality.
The other method to help reduce 280E disallowances is to offer other non-marijuana products and services. For example, if a medical dispensary provides other forms of caregiving, rent and wages can be deducted from that legal business income even when under a 280E audit.
Proposed bills, such as the Marijuana Tax Equity Act attempt to resolve these issues. However, the conflict between state and federal law is likely to continue raising issues when the two collide.