Can Medical Marijuana Dispensaries Deduct Their Business Expenses?
The IRS has invoked drug laws to make it difficult for medical marijuana dispensaries to deduct their business expenses.
Medical marijuana has been legalized in 20 states plus the District of Columbia, and other states have legalization on the ballot. However, many of the more than 2,300 medical marijuana dispensaries in the United States have been fighting a running battle with the United States Justice Department and Drug Enforcement Administration, which has raided several dispensaries.
As if that wasn't bad enough, now the IRS is getting on medical marijuana dispensaries' cases. Of course, such dispensaries are supposed to pay local, state, and federal taxes; and, indeed, many have been positively eager to do so to help establish their legitimacy. One type of tax that the dispensaries are supposed to pay is federal income tax on their business profits. Their profit is determined by subtracting their business expenses from their gross income.
However, the IRS has begun enforcing a little known law adopted in the 1970s that bars tax deductions for business expenses incurred by drug dealers. (IRC Sec. 280E.) (Ironically, deductions are still permitted for other illegal businesses, such as prostitution and contract killing.)
This law came about when a convicted drug dealer got audited by the IRS. The agency concluded that he owed more than $17,000 in back taxes on his drug earnings, which he had never declared on his income taxes. The drug dealer appealed the audit, claiming that the IRS failed to consider the tax-deductible costs he incurred in conducting his “business.” The tax court held that the dealer was self-employed in the business of selling amphetamines, cocaine, and marijuana. Therefore, he was entitled to deduct the cost of goods sold from his drug-dealing income—and could take a home office deduction as well. Naturally, this ruling didn't go over too well with the public, hence the new law.
The law was intended to stop drug dealers from claiming tax deductions, but the IRS says it applies to medical marijuana dispensaries as well. Since 2008, it has audited several major dispensary owners and denied them deductions for their business expenses, such as rent, advertising, depreciation, legal fees, wages, utilities, and security services. It some cases, the IRS has demanded that the audited dispensaries pay millions of dollars in back taxes.
The tax court has upheld the IRS's actions. In one recent case, for example, the tax court unanimously found that the owner of the Vapor Room Herbal Center, one of San Francisco’s largest and most profitable dispensaries, was not allowed to take business deductions because the business was trafficking in a controlled substance. However, the dispensary was allowed to deduct the cost of the goods it sold because, technically, this is not a business deduction; rather, it is subtracted from gross receipts in determining a taxpayer’s gross income. Thus, the dispensary owner could deduct the cost of purchasing marijuana from growers. However, due to poor records, the dispensary owner was allowed only a portion of his claimed costs. This decision highlights the importance of keeping good records. (Olive v. Comm'r, 139 T.C. 2 (2012).)
Another tax court case gives medical marijuana dispensaries at least a glimmer of tax hope. The court ruled that a dispensary effectively had two businesses--selling medical marijuana and giving care to patients. The director there was an experienced health professional and he operated the dispensary with caregiving as the primary feature and the dispensing of medical marijuana (with instructions on how to best consume it) as a secondary feature. Thus, the court held he could deduct his expenses for the caregiving business. (Californians Helping to Alleviate Med. Problems, Inc. v. Comm'r (CHAMP), 128 T.C. 173 (2007).)
The upshot of these tax cases is that a medical marijuana dispensary that only sells marijuana will not be entitled to any tax deductions for its business expenses. But if a dispensary also provides substantial caregiving services--such as patient counseling, drug education, and advocacy--all expenses arising from these activities can be deducted.