Question: Does a medical marijuana dispensary that is legal under state law have anything to fear from the Internal Revenue Service?
Answer: Yes. In 2007 the United States Tax Court issued its opinion in the case of Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner of Internal Revenue. The issue in this case was what business expenses could a California medical marijuana dispensary deduct on its federal income tax return in light of Internal Revenue Code Section 280E, which states:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
In the CHAMPS case, the IRS conceded that the taxpayer could deduct its cost of goods sold, which included $575,317 for marijuana. Based on news reports about recent IRS audits of big California medical marijuana collectives, it appears that the IRS wants to revisit Section 280E and how it applies to medical marijuana dispensaries.
Warning to All Would-Be and Existing Medical Marijuana Dispensaries about Federal Income Taxes
The IRS is auditing a number of high dollar revenue medical marijuana dispensaries in California. See for example “IRS tells California Medical Marijuana Dispensary it Owes Millions in Unpaid Taxes” and “Millions at Stake in IRS Audit of Oakland Medical Marijuana Dispensary.” I believe that the ultimate goal of the IRS is to change the result in the CHAMPS case, which will have the practical affect of putting almost all state legal medical marijuana dispensaries out of business. If a dispensary spends $1,000,000 to grow its marijuana in 2011 and none of that expense is deductible because of Section 280E, then the dispensary will pay federal income taxes of $340,000 that it would not pay if the expense were deductible. This means it actually will cost the dispensary $1,340,000 to grow $1,000,000 of marijuana.
I do not know why the IRS conceded in CHAMPS that the taxpayer could deduct the cost of goods sold. COGS was the taxpayer’s biggest expense. I believe the IRS regrets conceding in CHAMPS that the COGS was deductible. I predict the IRS will disallow the COGS of the medical marijuana dispensaries it audits. I believe the IRS wants to litigate this issue in federal district court rather than in Tax Court with the ultimate goal of having the 9th Circuit Court of Appeals rule that COGS is not deductible by a state legal medical marijuana dispensary. If the IRS can get one or more appellate courts to agree that the COGS is not deductible, the practical result may be to kill the medical marijuana industry in every state that has legalized it.
Tax Court vs. Federal District Court & Circuit Courts of Appeal
The CHAMPS case was a U.S. Tax Court case that had a good result for the medical marijuana dispensaries in states that have legalized the growing and sale of medical marijuana. Neither federal district courts nor Circuit Courts of Appeal are required to follow the decisions of the Tax Court. That is why the IRS wants to relitigate Section 280E in the federal district courts and then the appropriate Circuit Court of Appeals. The IRS wants to reverse the CHAMPS case by winning at the Circuit Court of Appeals level.
When the IRS conducts an audit and demands more taxes from a taxpayer, the taxpayer who wants to dispute the results of the audit has two choices:
- Pay the entire amount of taxes in dispute and ask the U.S. Tax Court to determine how much additional taxes, if any, the taxpayer owes, or
- Pay none or less than all of the amount of taxes demanded by the IRS and ask the U.S. district court to determine how much additional taxes, if any, the taxpayer owes.
Tax court decisions cannot be appealed. Federal district court decisions can be appealed by the losing party to the appropriate Circuit Court of Appeals, which is the 9th Circuit for California and Arizona. district courts. Any legal medical marijuana dispensary that is assessed additional taxes by the IRS will want to pay the additional taxes and have the Tax Court rule on the dispute. The practical problem with this tactic, however, is that most dispensary taxpayers will not have the cash to pay the amount of taxes in dispute and will be forced to litigate in the federal district court.
The choice of venue to litigate the dispute is significant. Dispensaries will want to pay the tax and go to the Tax Court where they expect the Court to apply the holdings of the CHAMPS case. Clearly the IRS does not want these medical marijuana dispensary Section 280E cases to go to the Tax Court where the CHAMPS case is bad precedent for the IRS. What the IRS is doing is going after dispensaries that have high income and expenses so that when it demands more taxes, the dispensaries most likely will not have the money to pay the amount in dispute and must then go to the U.S. district court. Because the amount of tax dollars in dispute will be so big, the loser in the district court will appeal to the 9th Circuit Court of Appeals where the IRS hopes it will get a favorable Section 280E ruling that will effectively allow it to tax legal medical marijuana dispensaries out of existence.
The Marin Alliance for Medical Marijuana is being audited by the IRS. When asked how much the IRS is demanding in back federal income taxes, Lynnette Shaw, the owner of this dispensary, would not disclose the amount, but she said, “It’s a staggering sum, millions and millions.” I’m guessing this dispensary does not have a few spare millions of dollars lying around to pay the IRS so it can litigate the dispute in tax court.
- “IRS targets medical marijuana businesses”
- “Things don’t look good for medical marijuana dispensaries fighting IRS, says NORML director”
- “Medical Marijuana Tax Problems?“
- “Could medical marijuana get the Al Capone treatment?“
Although I have a masters degree in income tax law from New York University Law School, I am no longer a practicing tax lawyer. I recommend that every dispensary hire a good experienced tax CPA or tax lawyer to advise the dispensary on the federal and state income tax issues arising from the operation of a medical marijuana dispensary.
Circular 230 Notice: Pursuant to recently-enacted U.S. Treasury Department regulations, I am required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including websites linked to, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.