As part of this November’s elections, California, Maine, Massachusetts and Nevada all voted to legalize recreational marijuana, while Arkansas, Florida and North Dakota approved medical cannabis initiatives. Montana, which legalized medical marijuana in 2004, also passed a measure to set up commercial cultivation operations and dispensaries. As a result, recreational marijuana use is legal in seven states, and medical marijuana use is legal in 28 states.
Demonstrating the upward trend of this evolving industry, consider CannaKorp, based in Stoneham, Massachusetts. It is developing the world’s first single-use pod and vaporizer system for marijuana smoking — in essence, a Keurig for marijuana. This is just one example of how the industry is expanding its offerings. Interest by investors, including some of the wealthiest family offices, is sky-high, so to speak, which is why we are so focused on the complex issue of taxation of regulated cannabis.
In a previously published article on the regulated cannabis industry (Tax Advisory Weekly 2016 - Issue 21), we discussed the history of IRC Section 280E and the case law that followed. We also discussed recent state developments, including those in Colorado, Oregon and Washington. In this article, we briefly revisit the history of the law from the 1970 Controlled Substances Act on, then discuss the tax planning opportunities that taxpayers should consider.
In 1970, Congress created a law to control the unlawful manufacture, distribution and abuse of dangerous drugs (“controlled substances”), the Comprehensive Drug Abuse Prevention and Control Act of 1970, 21 U.S.C. Section 801-971 (1970). This controlled substances act (CSA) assigned controlled substances to one of five lists, Schedule I through Schedule V; marihuana (aka marijuana) was included as an illegal Schedule I substance, along with opiates such as heroin and hallucinogenic substances such as LSD and mescaline. The manufacture and/or distribution of marijuana was therefore illegal under federal law.
The CSA remains the federal law today. As recently as November 24, 2016, the U.S. Drug Enforcement Agency rejected requests from the governors of Rhode Island and Washington to remove cannabis from the federal list of Schedule I substances. Thus, both marijuana businesses and patients remain trapped between the state and federal laws.
Federal income tax law does not differentiate between income derived from legal sources and income derived from illegal sources (James v. United States, 366 U.S. 213, 218 (1961)). Therefore, those in the marijuana business are obligated to pay federal income tax on their taxable income. A decade after the enactment of the CSA, the Tax Court in Jeffrey Edmondson v. Commissioner, T.C. Memo 1981-623 (1981) held that not only could the taxpayer recover its cost of goods sold (COGS), allowable because it is legally considered to be an adjustment to gross receipts and not a deduction in a long line of case law, but the taxpayer could also claim certain business deductions, including a portion of the rent on his apartment, which was his sole place of business, packaging expenses, telephone expenses and automobile expenses. Therefore, under Edmondson, these expenses were deductible despite the fact that the business in question was illegal under the CSA.
In response to Edmondson, Congress enacted IRC Section 280E in 1982, which disallowed all deductions or credits paid or incurred in the trafficking of controlled substances within the meaning of Schedule I and II of the CSA. In enacting IRC Section 280E, Congress thus proceeded to disallow deductions for expenses that are not illegal per se, such as salaries, rent and telephone. The Senate Report on IRC Section 280E also states that, to avoid possible constitutional challenges, IRC Section 280E was not intended to affect the adjustment for COGS (S. Rep. No. 97-494 (Vol. I), at 309 (1982)). Although regulations have not been issued related to IRC Section 280E, the IRS has stated that it will allow a deduction for COGS.
So how is COGS computed for purposes of IRC Section 280E? First, we need to start with the Tax Reform Act of 1986, which added the uniform capitalization rules of IRC Section 263A to the IRC.
Under Section 263A(a), resellers and producers of merchandise are required to treat as inventoriable costs the direct costs of property purchased or produced, respectively, and a proper share of those indirect costs that are allocable (in whole or in part) to that property. Flush language at the end of Section 263A(a)(2) provides, “Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.”
The flush language at the end of Section 263A(a)(2) was added by Section 1008(b)(1) of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) (P.L. 100-647), reprinted in 1988 U.S.C.C.A.N. 4621, as a retroactive, technical correction. Under Explanation of Provision, the Senate Report reads as follows:
The bill also clarifies that a cost is subject to capitalization under this provision only to the extent it would otherwise be taken into account in computing taxable income for any taxable year. Thus, for example, the portion of a taxpayer's interest expense that is allocable to personal loans, and hence is disallowed under §163(h), may not be included in a capital or inventory account and recovered through depreciation or amortization deductions as a cost of sales or in any other manner (S. Rep. No. 100-445, at 104 (1988)).
What does this mean? Chief Counsel Advice (CCA) 201504011 explains:
Read together, §280E and the flush language at the end of §263A(a)(2) prevent a taxpayer trafficking in a Schedule I or Schedule II controlled substance from obtaining a tax benefit by capitalizing disallowed deductions. Congress did not repeal or amend §280E when it enacted §263A. Furthermore, nothing in the legislative history of §263A suggests that Congress intended to permit a taxpayer to circumvent §280E by treating a disallowed deduction as an inventoriable cost or as any other type of capitalized cost. In fact, the legislative history of §263A(a)(2) states that “a cost is subject to capitalization ... only to the extent it would otherwise be taken into account in computing taxable income for any taxable year.” If a taxpayer subject to §280E were allowed to capitalize “additional §263A costs,” as defined for new taxpayers in §1.263A-1(d)(3), §263A would cease being a provision that affects merely timing and would become a provision that transforms non-deductible expenses into capitalizable costs. Thus, we have concluded that a taxpayer trafficking in a Schedule I or Schedule II controlled substance is entitled to determine inventoriable costs using the applicable inventory-costing regulations under §471 as they existed when §280E was enacted.
Therefore, IRC Section 263A cannot be used as a tax planning strategy to convert IRC Section 280E disallowed expenses to ultimately deductible inventoriable costs. Taxpayers should calculate COGS “using the applicable inventory-costing regulations under IRC §471 as they existed when IRC §280E was enacted,” or in other words pre-enactment of IRC Section 263A.
In addition, the IRS may require the taxpayer to use an inventory method for the controlled substance, unless the taxpayer is properly using a non-inventory method to account for the controlled substance pursuant to the IRC, regulations or other published guidance. CCA 201504011 states:
Consequently, if a producer or reseller of a Schedule I or Schedule II controlled substance is deducting from gross income the types of costs that would be inventoriable if that taxpayer were properly using an inventory method under §471, it is an appropriate exercise of authority for Examination or Appeals to require that taxpayer to use an inventory method, to use the applicable inventory-costing regime (as discussed under Issue (1) of this memo), and to change from the overall cash method to an overall accrual method. However, if that taxpayer is not required to use an inventory method (for example, small taxpayers properly using the modified cash method under Rev. Proc. 2001-10 or Rev. Proc. 2002-28 or farmers), it is not an appropriate exercise of authority for Examination or Appeals to require that taxpayer to use an inventory method. Instead, Examination or Appeals should permit that taxpayer to continue recovering, as a return of capital deductible from gross income, the same types of costs that are properly recoverable by a taxpayer both trafficking in a Schedule I or Schedule II controlled substance and using an inventory method under §471. Thus, for example, a producer of a Schedule I or Schedule II controlled substance should be permitted to deduct wages, rents and repair expenses attributable to its production activities, but should not be permitted to deduct wages, rents or repair expenses attributable to its general business activities or its marketing activities.
Therefore, with regard to inventory planning, there is a great amount of accounting work to be done to determine what costs are related to inventory and what costs are not related to inventory, as noted above, and the results of this analysis will have a direct impact on that taxpayer’s taxable income.
CHAMP to the Rescue
Can a taxpayer that sells medical marijuana that is subject to the IRC Section 280E disallowance rules above also be engaged in another business not subject to IRC Section 280E? In a 2007 case, Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173 (2007), known as “CHAMP,” the answer was a resounding “yes.” In this case, the taxpayer operated a dispensary as a service within a caregiving setting. Sixty-eight percent of its employees worked exclusively in caregiving, and the caregiving was substantially independent of the medical marijuana dispensary. Space was rented at a church for peer meetings and yoga classes, low-income members were provided hot lunches, and 47 percent of the members suffered from AIDS. All members paid a single membership fee “for the right to receive caregiving services and medical marijuana from” the taxpayer.
The Tax Court held that the taxpayer’s provision of caregiving services and its provision of medical marijuana were separate business activities because the taxpayer “was regularly and extensively involved in the provision of caregiving services, and those services are substantially different from the provision of medical marijuana.” Thus, the CHAMP case opened the door to allow tax deductions for caregiving or other services if these services embody a separate “trade or business” from that of selling medical marijuana.
But Look Out for Olive
In Olive v. Commissioner, 139 T.C. 19 (2012), the taxpayer was not so fortunate as it was in CHAMP. In Olive, the taxpayer operated “the Vapor Room” and the court denied its treatment as two businesses, a medical marijuana dispensary and a caregiving activity for patrons suffering from AIDS, HIV, cancer and other terminal diseases. Clearly, the taxpayer felt the CHAMP case applied. The Court applied nine factors from Trupp v. Commissioner, 103 T.C.M. (2012), in ruling against the taxpayer in Olive. Those nine factors were:
- Whether the undertakings are conducted at the same place.
- Whether the undertakings were part of a taxpayer’s efforts to find sources of revenue from his or her land.
- Whether the undertakings were formed as separate activities.
- Whether one undertaking benefited from the other.
- Whether the taxpayer used one undertaking to advertise the other.
- The degree to which the undertakings shared management.
- The degree to which one caretaker oversaw the assets of both undertakings.
- Whether the taxpayers used the same accountant for the undertakings.
- The degree to which the undertakings shared books and records.
See also Tobin v. Commissioner, T.C. Memo 1999-328, which again supports the conclusion that Olive had only one trade or business and lists the nine factors cited above.
In summary, Olive shows us that, for tax planning purposes, to maximize the deductibility of non-IRC Section 280E expenses, care must be taken to keep the various businesses as separate as possible.
Alvarez & Marsal Taxand Says:
The history of cannabis taxation leaves us with the important premise that, while IRC Section 280E disallows any deduction for ordinary and necessary business expenses for illegal controlled substance businesses, COGS is not considered an expense, but rather an adjustment taken into account in arriving at gross income. Under Treasury Reg. Sec 1.471-6(a) and -11, taxpayer must include as inventoriable costs all direct (e.g., the cost of inventory and delivery, and the cost of materials and labor for manufactured inventory) and indirect production costs (i.e., rent and utilities related to inventory). While a taxpayer cannot use IRC Section 263A to turn IRC Section 280E non-deductible expenses into ultimately deductible items, taxpayers should nonetheless be diligent in maximizing the proper expenses that should get allocated to inventory, and ultimately, COGS.
A second area of planning focus should be the CHAMP approach above; by separating the non-IRC Section 280E separate activity expenses from the non-deductible “trafficking in controlled substances activities,” and by carefully applying the nine criteria from Trupp, those expenses become deductible. The use of transfer pricing methodologies to document the separation of activities and to contemporaneously establish a proper expense allocation between the activities is recommended to support your deductions.
To the extent that the taxpayer expands its business to include research and development within the construct of IRC Section 174 and those activities do not fall within the scope of IRC Section 280E, a third planning strategy becomes in scope. Again, as we noted from CHAMP, such activities cannot involve the “trafficking in controlled substances activities.” A research credit study documenting the permissible activities, allocation of expenses, and calculation of the research credit would be highly recommended in this situation.
Finally, a planning note concerning the distinction between cultivation and dispensaries: the bulk of the activities of a cultivator does not involve the “trafficking” of a controlled substance. With the possible exception of transportation and delivery of the product to dispensaries, as well as certain other overhead expenses directly allocated to the sale of the product that might be considered “trafficking,” the majority of a cultivator’s expenditures should be COGS and therefore tax deductible. The reverse would likely be true for dispensaries: the deductible COGS could be minimal, and the vast majority of expenses would then fall under IRC Section 280E and would not be deductible. Again, as noted in CHAMP, diversification into other separate business activities would then be the focus of a taxpayer’s tax planning.