How the IRS Smokes Pot Clinics

SMITH BRAIN TRUST — Maryland will award its first batch of medical marijuana licenses by the end of July. While winners won’t have to worry about federal raids when sales begin in 2017, dealing with the IRS will be another matter. “Interestingly, while the Drug Enforcement Administration has stepped aside on the enforcement of this still illegal substance in states where allowed, the IRS has not,” says certified public accountant Samuel Handwerger, a lecturer at the University of Maryland’s Robert H. Smith School of Business. He says the IRS is using Section 280E of the Internal Revenue Code to extract higher taxes from state-licensed marijuana distributors.

“Section 280E specifically disallows deduction of business expenses associated with the business of selling federally mandated illegal substances,” Handwerger says. “Since  marijuana is still considered a controlled substance, it is directly affected by section 280E of the tax code. This means that the deductions for the sale and distribution of legalized marijuana where allowed in any particular state are not allowed as tax deductions.”

Here’s where things gets complicated: The restriction does not include the cost of inventory, which is controlled by another section of the tax code. “Hence, the taxable income for these enterprises would be found using the formula of sales minus cost of goods sold equals gross income subject to tax,” Handwerger says. “Other business deductions are not allowed.”

Marijuana already is legal in some 25 states and Washington, D.C., and Congress passed a measure under the Obama administration that bans enforcement in these jurisdictions. But Handwerger says the tax code has not kept pace. “There is currently a case before the Tax Court whereby a taxpayer is disputing this interpretation of the code,” he says. Regardless of the political environment, he says the court should rule against the taxpayer. “After all, the law  is the law, albeit one needing to be changed,” he says. “But the change has to be made by Congress, and the courts can only rule based on the law.”

Handwerger says the taxpayer is arguing that the code was not intended to affect marijuana sales where allowed by state law, but this seemingly ignores the fact that the sale is still illegal at the federal level. “It is interesting to note that when section 280E was enacted, Congress specifically said that they were allowing for the cost of goods sold to be deducted so as to avoid a constitutional challenge of the section itself,” Handwerger says. “This is because the concept of taxing gross income as opposed to gross receipts has previously been well established by Supreme Court rulings.”

Unfortunately for state-licensed marijuana distributors, the Supreme Court rulings cover only the direct costs of goods sold. “This excludes other variable costs and fixed costs, commonly known as overhead expenses,” Handwerger says. “The right to deduct these costs has been relegated to specific statutes. There is no blanket allowance of overhead expenses under the principle of the tax code. Hence, this becomes an important test case for the Internal Revenue Service.”