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Annette Nellen
Annette Nellen
Measuring the taxable income of a marijuana business

The Chief Counsel’s Office sheds some light on tax accounting for marijuana businesses.

February 12, 2015
by Annette Nellen, Esq., CPA, CGMA

In 1996, California became the first state to allow marijuana to be sold for medicinal purposes. Today, almost half of the states permit the sale of medical marijuana, and two states allow sales for recreational use. (See information from the National Conference of State Legislatures for the details.) Despite this timespan and the growing number of entities that grow and sell marijuana legally under various state laws, the proper tax treatment of these operations has been lacking.

In January, the IRS issued limited guidance in the form of Chief Counsel Advice (CCA) 201504011, yet it is the most that has been issued by the IRS to date. This article provides a brief look at why marijuana businesses may have difficulty determining taxable income with confidence. It also explains the recently released IRS CCA and offers some solutions.

The “War on Drugs” enters the tax law

The Tax Equity and Fiscal Responsibility Act, P.L. 97-248, added Sec. 280E to the Code. It provides:

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.

This provision was a response to Edmondson, T.C. Memo. 1981-623, in which the Tax Court allowed a taxpayer operating an illegal drug business normal business deductions and costs of goods sold in measuring taxable income.

The legislative history of Sec. 280E includes a reminder about the reach of the Sixteenth Amendment, which permits taxes to be levied on “incomes.” The Senate report to TEFRA states: “To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill” (S. Rep’t 97-494 (Vol. 1), 97th Cong., 2d Sess., at 309 (1982)). The rationale for this statement is that the U.S. income tax structure requires gross receipts to be reduced by the cost of sales to derive gross income (also see Regs. Sec. 1.61-3(a)).

The IRS has never issued regulations under Sec. 280E.

Sec. 280E in a UNICAP world

The Tax Reform Act of 1986 (TRA), P.L. 99-514, added Sec. 263A. This rule, called the UNICAP rule as shorthand for “uniform capitalization,” specifies items that retailers and producers must treat as inventoriable. It results in a broader list of items needing to be capitalized than applied under prior law. While most businesses view Sec. 263A as a nuisance, marijuana businesses may have viewed it as an opportunity because some expenditures not deductible under Sec. 280E may now be deductible as part of the cost of sales. This treatment is uncertain though, as the specific issue is not addressed in any legislative history or binding IRS guidance.

Adding to the confusion is a TRA technical correction that provides that if an item is not allowed in computing taxable income, it is not subject to capitalization under Sec. 263A. The example accompanying this correction was interest expense on a personal loan (Technical and Miscellaneous Revenue Act of 1988 (TAMRA), P.L. 100-647). Regs. Sec. 1.263A-1(c)(2)(i) provides an illustration of the disallowed portion of meals and entertainment expenses as not being an inventoriable cost.

Sec. 280E and state-sanctioned marijuana sales

The IRS and the Tax Court have held that Sec. 280E applies to the sale of marijuana sold for medical purposes, as allowed by some states. The federal Controlled Substances Act referred to in Sec. 280E makes no exception for medical marijuana. In Information Letter 2011-0005, the IRS noted that any exception would require a legislative change to either the Act or the Code.

In Californians Helping to Alleviate Medical Problems, Inc., 128 T.C. 173 (2007), the taxpayer provided caregiving to members of its club, who were people with debilitating diseases, including AIDS and cancer. The taxpayer also sold medical marijuana to the same members. The Tax Court ruled that involvement in a business of trafficking a controlled substance did not prevent the taxpayer from taking deductions for a business that was separate from the marijuana sales. The court noted that whether businesses are separate involves a question of fact that considers the economic interrelationship between the two operations (also see Olive, 139 T.C. 19 (2012)).

Sec. 280E, cost of goods sold, and inventory methods

CCA 201504011 addresses two questions.

  1. How is cost of goods sold determined for a taxpayer subject to Sec. 280E? Cost of goods sold is to be determined “using the applicable inventory-costing regulations under §471 as they existed when §280E was enacted.” According to the IRS, these regulations are Regs. Sec. 1.471-3(b) for resellers, and Regs. Secs. 1.471-3(c) and 1.471-11 for producers.
  2. May the IRS require the taxpayer to use an inventory method for the controlled substance? “Yes, unless the taxpayer is properly using a non-inventory method to account for the…controlled substance pursuant to the Code, Regulations, or other published guidance.”

The CCA provides a comprehensive history of Sec. 280E as well as Sec. 263A’s purpose and why it does not affect Sec. 280E. According to the IRS, Sec. 263A is a “timing provision” that “did not revolutionize inventory costing.” The IRS interprets the TAMRA correction to Sec. 263A to mean items nondeductible for a taxpayer selling controlled substances remain so. “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 nondeductible expenses into capitalizable costs” (footnote omitted).

Despite the answer to question 2 above, the IRS notes that a taxpayer might properly be using the cash method without inventory accounting if it is a small taxpayer subject to Rev. Proc. 2001-10 or Rev. Proc. 2002-28. The items allowed in computing gross income would be those permissible under Sec. 280E if using an inventory method under Sec. 471. “Thus, for example, a producer of a … 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.”

Other concerns

Tax practitioners with clients operating marijuana businesses permissible under state law face not only issues of interpreting how Secs. 280E, 471, and 263A apply, and determining whether a client has more than one business operation, but also ethical concerns. Although legal under the laws of many states, the production, sale, and use of marijuana is a federal offense. Are practitioners, particularly CPAs and attorneys licensed under state law, in violation of rules of conduct when they serve these businesses?

This topic is beyond the scope of this article, other than to note that the 2014 report of the IRS Advisory Council (IRSAC), released in November 2014, suggests that the IRS issue guidance stating that tax practitioners advising marijuana businesses are not violating Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10) (page 25). (For more, see materials linked to from the author’s 21st Century Taxation blog.)

Looking forward

As more states allow sales of marijuana, more taxpayers and practitioners will struggle with the issue of how to measure gross income and taxable income. The IRS Information Letters and CCA are not binding authority (see Regs. Sec. 1.6662-4(d)(3)(iii)). More is needed in the form of regulations or a revenue ruling.

Congress may someday amend Sec. 280E. For example, H.R. 2240 (113th Congress) proposed to modify Sec. 280E to allow an exception for “marijuana sales conducted in compliance with State law.”  Amending Sec. 280E may not be sufficient. The Controlled Substances Act should also be amended.

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Annette Nellen, Esq., CPA, CGMA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is a member of the AICPA Tax Executive Committee and Tax Reform Task Force. She has several reports on tax policy and reform and a blog.