Given the recent enactment of the Arizona Medical Marijuana Act, we anticipate a number of new business enterprises in the Arizona market attempting to comply with its “dispensary” provisions. Thoughtful entrepreneurs engaged in this fledgling industry will be wondering whether they will be permitted to deduct the expenses incurred in their business operations. This article will consider relevant tax provisions and attempt to provide a meaningful “rule of thumb” that these businesspersons, or their tax preparers, may find useful.
The Arizona Medical Marijuana Act authorizes the establishment of nonprofit medical marijuana dispensaries (“dispensaries”). These dispensaries are to be licensed, tightly regulated, and inspected and are intended to provide medical marijuana to qualified patients, with their doctor’s approval, or their designated caregivers. Although, under Arizona Revised Statutes Section 36-2806, these dispensaries are to be nonprofit entities (but they need not be tax-exempt organizations for IRS purposes), they are clearly authorized by Arizona Revised Statutes Section 36-2801 to receive payment for all expenses incurred in their operations. As a result of receiving such revenue, they will undoubtedly be required to file income tax returns. Before considering these tax returns, however, an important legal issue must be dealt with. Is this business legal or illegal?
Although this may seem like a strange question to be asking, given that we are able to review specific Arizona statutes that authorize the business and provide detailed rules on numerous aspects of the creation and operation of such dispensaries, we would be remiss if we failed to do so. Since, however, the focus of this article is not the legality of a dispensary, we will rely on existing analysis of the issue as it has arisen in connection with California statutes, which have been around for the past decade and a half.
Since the passage of the Compassionate Use Act of 1996 and the California Medical Marijuana Program Act, California businesses have been wrestling with a number of legal issues and have had the opportunity to create a growing base of case law that will undoubtedly provide precedence as these same issues arise under Arizona law. The most important issue is whether the creation of these state statutes that authorize the possession and use of marijuana for medical purposes provides some protection, some defense, from Federal prosecution for the possession or use of illegal drugs.
A number of cases make it clear that the possession and use of marijuana, even for medical purposes, is still illegal under Federal law. See, for example, Footnote 10 of the California Supreme Court case, People v. Kelly (2010). According to the Controlled Substances Act, marijuana remains a Schedule I drug and, state statutes authorizing medical use to the contrary, Federal law does not contain any exception for “medical use”. Furthermore, Federal law still supersedes state law (Gonzalez v. Raich US Sup. Ct (2005)). In short, except perhaps for certain, specific research purposes, no use of marijuana is legal.
Thus, it would appear that any person or business possessing marijuana, even if in compliance with state medical use laws, is involved in an illegal business activity. This fact explains the many legal conundrums arising in advice given in the industry. Should a doctor merely “approve” of a patient’s medical use of marijuana or may she “recommend” it? May the product be “sold” or must it be given away (in exchange for a donation)? What is the difference between distribution by a “dispensary” and a “collective”? It should be noted that these issues arise, not necessarily as a result of any ambiguity in the state statutes, but because of concern over exposure to legal liability at the Federal level.
One may find some comfort (but, perhaps, not much) in statements issued by/on behalf of the Department of Justice (DOJ). In 2009, the Attorney General indicated that even though the DOJ does not condone any possession or use of marijuana, in an effort to use its resources efficiently, it would limit its prosecution efforts and target only dispensaries being used as a front for dealers of illegal drugs. However, in the DOJ guidelines issued in October 2009, I believe it expressed its intention more broadly, that is, it intended to prosecute “for profit” enterprises. Its statements have also indicated that it will not require its agents to prove any violation of specific state (Medical Use) statutes during such prosecutions (that is, such statutes do not matter and, even if followed precisely, offer no defense).
Thus, although AS 36-2811(B) clearly states that those complying with the provisions of the Arizona Medical Marijuana Act are not subject to arrest, prosecution or penalty for their possession or use of marijuana, this statute should not provide much comfort for anyone using or possessing marijuana for medical purposes. It may serve to give guidance to state police on the proper use of their resources but will apparently not affect Federal law enforcement officials. For further analysis of this issue, and others, you may wish to consider the White Paper on Marijuana Dispensaries, issued by the California Police Chief Association’s Task Force in April 2009 (www.counties.org. , under the CSAC Advocacy tab), as a possible starting point.
We will leave the resolution of this issue to the interested lawyers among you. For the remainder of this article, we will assume that a medical marijuana dispensary is an “illegal” business activity for Federal tax purposes.
The starting point for determining “deductibility” of a business’s expenses is Internal Revenue Code Section 162. In general, the primary “rule of thumb” is that a business may deduct all expenses that are “ordinary and necessary” as long as they are “reasonable”. While these are often-used words in the English language, a couple of perhaps unusual implications (both of which are taxpayer friendly) should be noted before one thinks they understand this requirement. First, “ordinary” does not mean that the expense need be frequently encountered in the taxpayer’s industry. The law is not intended to penalize the innovator. A creative businessperson who attempts a new way of conducting business should not automatically be precluded from claiming a deduction for the “new” expenses.
Secondly, “necessary” does not mean that an expense must be incurred in order to be deductible. Only that the businessperson believes that the expense will be appropriate and helpful in conducting business. It may turn out that the expenditure was not actually helpful, but it still may have been believed “necessary”. Finally, even an “ordinary and necessary” expenditure must be “reasonable” when alternatives are considered. As one might guess, these requirements are not often used to actually limit the deductibility of expenses incurred in business operations when the owner honestly believes that such expenditures were actually business related.
A more frequently seen limiting factor is also found in Section 162. Specifically, payments that are illegal or against public policy are defined as not deductible. Sec. 162(c)(2) states that to be nondeductible the “illegal” payment must subject the payor to criminal penalty or to the loss of its business license. IRS regulations clarify that the important test is being “subject to” the criminal penalty – not that the criminal penalty actually be imposed in a given situation. Of course, this distinction may offer a bit of room for argument about whether the payment would have actually subjected the payor to the penalty (since none was actually imposed).
Revenue Ruling 62-194 is an early explanation of the public policy doctrine. It holds that a payment, even if not actually illegal, will not be deductible if it is against public policy. A number of court cases have “explained” this concept over the years and provided examples of expenditures that were found to have been against public policy. However, this limitation has not often been cited as the sole reason to disallow the deductibility of an expense and is now (since 1969) seldom seen as an actual threat in and of itself. In fact, Regulation 1.162-1(a) now states that a deduction (of “ordinary and necessary” business expenses) will not be disallowed solely because it is a violation of public policy. It should be noted, however, that the IRS will still use the “public policy” argument to disallow Sec. 165 losses (ie. confiscation of property) – see Revenue Ruling 77-126 and Technical Advice Memorandum 200629030.
Against this backdrop, we have a number of cases that have analyzed the operations of an “illegal” business and concluded that such business was, in fact, entitled to deduct its “ordinary and necessary” expenses. For example, see the 1958 Supreme Court case, Comr. V. Sullivan 356 US 27. The way to think about this issue is that one must examine the nature of the expenditure itself (is it legal ?) vs. the nature of the business – which may, in fact, be illegal. An expenditure that is itself illegal (and would subject the payor to criminal penalties) is not deductible.
Thus, in general, an illegal business would be permitted to deduct “ordinary and necessary” expenses incurred, which were not in themselves “illegal” expenditures, but would not be able to deduct any expenditure that was itself illegal.
Ability to Deduct Expenses
Given the way case law had developed in this area, and the still pervasive “public policy” issues surrounding the use of drugs in our culture, Congress passed a new law that was to be applied specifically to an “illegal drug business”. In 1982, Section 280E became effective and states that no deduction for any amount incurred in carrying on any illegal drug sale or business would be allowed. Thus, it would appear that Congress effectively overturned the existing “illegal business” case law as it pertains to dispensary operations. Their intentions seemed to be that public policy mandated that a severe penalty be imposed for those engaging in illegal drug activities and while they were probably not thinking of dispensaries when the law was passed, the statute has certainly ensnared the industry.
As is so often the case, what seems to have evolved is a bit different than one might have expected just from a superficial reading of the law. As this law began to be enforced, it was determined that a “deduction” was different from a “reduction to gross income” (ie. cost of goods sold). Thus, under Section 280E, although the drug dealers are no longer permitted any deductions incurred in connection with their illegal trade, it has been decided that they are permitted to offset their revenue with the cost of their inventory (Sundel v. Comr 75 TCM 1853).
Since Section 280E had been enacted specifically to deal with an “illegal drug business”, the previous tax concepts related to other illegal businesses were no longer considered applicable to an illegal drug business. Thus, under this new statute, the rules have been, in effect, turned upside down for the drug industry. While the drug dealers can no longer deduct otherwise legal “ordinary and necessary” expenses, they may, in effect, deduct the cost of their illegal purchases, the drugs. Rather ironic, given the apparent purpose of the Section.
The cases to date that have dealt with Section 280E have, for the most part, seen the deduction limitations imposed on taxpayers that have had rather poor accounting systems (based upon the facts evident in the published records). The courts have ended up permitting the cost of goods deduction frequently based solely upon estimates provided by the government. I predict that this will change as the dispensary industry grows and becomes more sophisticated.
Over the past decades, businesses in general have experienced increasing efforts by the IRS to capitalize additional costs as part of their recorded inventory (this will result in higher taxable income). They have modified their accounting systems to accommodate “full absorption” accounting, Section 263A accounting and court cases that have refined the definition of “inventory”. A cost accountant should be able to assist the business in identifying and capitalizing numerous otherwise “ordinary and necessary” expenses as inventory in order to comply with these concepts. That is, hopefully, convert disallowed deductions to permitted cost of goods sold.
It should be noted that this ability for an illegal drug business to capitalize otherwise “ordinary and necessary” expenses should be expected to come under attack by the IRS. Although it is certainly a requirement that most businesses capitalize such expenses, various regulations (see, for example, Regs. 1.471-3(d) and 1.263A-1(c)(2)) prohibit the capitalization of expenses “not otherwise deductible” and may, arguably, be considered applicable in these cases. Here, the interplay between the “new”, Section 280E and its developing case law, and the “old” will become severely contested in the courts. Although the outcome of this conflict is uncertain, I believe that the importance of a good cost accountant should become obvious to dispensary owners very quickly.
Another accounting concept that may come into play is the idea that a business entity can easily encompass more than one line of business. Although the expenses of the illegal drug business are nondeductible, the deductions of other business activities will remain deductible. Thus, the business owner will want to install a good accounting system and ensure that all deductions are properly allocated among the various businesses.
This appears to be the state of the law today. It is already being applied to dispensaries created under the medical use statutes (see Californians Helping to Alleviate Medical Problems, Inc. v. Comr 128 TC 173 (2007)).
It should be noted that although the above analysis is believed to have arrived at the correct conclusion, this writer finds that the level of uncertainty seems slightly higher than usual after the given amount of research. Given the politically charged nature of the topic, it feels as though it is more likely than not that some future judicial decision will shed new light on this question of deductibility and may certainly have the potential to surprise us. The answer to the question of what a dispensary will ultimately be permitted to deduct still remains a bit uncertain. However, I suspect that, for an entrepreneur willing to enter this business, with its numerous legal questions that have yet to be answered, this question will probably not be the one that causes him/her to lie awake at night.
About the Author
Lance Meilech is a Certified Public Accountant practicing with the firm of AddingMachine.com in Phoenix. He has earned a Masters in Taxation and has been licensed as a CPA in Arizona since 2004. As a licensed professional, he provides a full range of accounting and tax services, including accounting and tax services for Arizona medical marijuana dispensaries. However, neither this article nor the author purport hereby to offer legal, tax or accounting advice in any form. This article is not a comprehensive assessment of issues that might be experienced in a particular business operation. Each reader’s situation is dependent on his/her facts and circumstances. As a result, each reader should consult his or her own advisor for information concerning his or her specific situation or may contact the author at [email protected]. Call Lance at 602-943-2060.