September 10, 2019
The federal Internal Revenue Code (IRC) allows taxpayers to deduct various business expenses from their income for the purposes of computing their total tax bill for a given year, with numerous exceptions. Section 280E of the IRC, for example, prohibits deduction of expenditures involved with “the illegal sale of drugs.” More than half of all U.S. states allow the medical use of marijuana to some extent, but it remains a Schedule I controlled substance under federal law. This is causing problems for businesses that are complying with state cannabis laws. In late 2018, the U.S. Tax Court ruled that a California medical marijuana company could not deduct millions of dollars in business expenditures. The company has announced that it intends to appeal this decision on business tax deductions.
IRC § 162 allows taxpayers to deduct all “ordinary and necessary expenses” that they pay or incur as part of their “trade or business,” subject to various exceptions scattered throughout the statute. The exception for the “illegal sale of drugs” applies to any substance included in Schedules I or II of the federal Controlled Substances Act (CSA), or similarly prohibited by the laws of the state in which the taxpayer does business. The CSA classifies marijuana (or “marihuana”) in Schedule I, which requires a finding that a drug has “no currently accepted medical use in treatment.”
California law takes a substantially different view of marijuana, as do the laws of at least thirty-one other states, the District of Columbia, and several U.S. territories. In 1996, California became the first state in the U.S. to allow the use of marijuana for medical purposes, after voters passed Proposition 215, also known as the Compassionate Use Act of 1996. A 2005 decision by the U.S. Supreme Court, Gonzales v. Raich, held that federal law may continue to criminalize marijuana production, distribution, and possession even when state laws allow those activities. Conflicts between federal and state marijuana laws are an ongoing matter of dispute.
The taxpayer in the U.S. Tax Court case mentioned above was one of the first companies to enter California’s medical marijuana market. It is one of several medical cannabis companies to go public, although because federal law bars them from Wall Street, they have all done so on the Canadian Stock Exchange. The company prevailed in a fight with federal prosecutors in 2016, when the U.S. Attorney for the Northern District of California stopped pursuing charges. This included the dismissal of a civil forfeiture action.
The company’s current legal troubles involve deductions for business expenses under IRC § 162(a). The IRS declined to accept the deductions for the period from 2007 to 2012, based on § 280E. In a November 2018 ruling, the Tax Court rejected the company’s argument that marijuana is only part of its business. It found that “marijuana sales” accounted for 98 to 99 percent of their total revenue. The court also found that the U.S. Attorney’s dismissal of the forfeiture case did not bar the IRS, under res judicata, from pursuing a deficiency action. In a separate opinion issued in December, however, the court declined to assess accuracy-related penalties.
If you need assistance with a California tax appeal issue, the Enterprise Consultants Group’s tax advisors are available to answer your questions and discuss your rights and options. Please contact us online or at (800) 575-9284 today to speak with a member of our team.