Marijuana businesses in the US and US investors in foreign marijuana businesses face a potpourri of federal tax issues. For example, the federal income tax treatment of a domestic marijuana business presents challenges for those entering the field. In 1982, Congress passed Internal Revenue Code (IRC) section 280E in response to a Tax Court case concerning a drug dealer who claimed ordinary and necessary business expenses related to his drug sales. Section 280E disallows deductions and credits for amounts paid or incurred in the trade or business of trafficking in controlled substances prohibited by federal or the law of any state where the trade or business is conducted. A controlled substance is defined as a substance (such as marijuana) listed on schedule I and II of the Controlled Substance Act. Therefore, cannabis companies cannot take federal business-related tax deductions, which obviously puts them at a severe competitive disadvantage.
While section 280E denies deductions and credits, it permits taxpayers to take into account cost of goods sold (“COGS”), which is an adjustment to revenue for US tax purposes. The Sixteenth Amendment allows Congress to impose an income tax, and Congress noted in the legislative history that a denial of COGS would likely be unconstitutional as a tax on gross revenue.
A key issue for a domestic marijuana business is the computation of COGS. The IRC provides for various methodologies, including rules for manufacturers and resellers that require capitalization of direct and indirect expenses (e.g., rent, machinery, and labor) under section 263A. In IRS Chief Counsel Advice 201504011, the IRS took the position that businesses cannot capitalize such costs into COGS under section 263A. The IRS is bound by this guidance and will apply it on audit. However, businesses are not bound by this position, and there are good arguments that the IRS conclusion is incorrect. Businesses could substantially benefit from capitalization into COGS and should consider whether there is substantial authority to support a tax return position contrary to the IRS position.
Some members of Congress are interested in changing the law to permit taxpayers in a marijuana business to deduct their business expenses and claim applicable credits. For example, H.R. 420, the Regulate Marijuana Like Alcohol Act, and S. 597, the Marijuana Justice Act, would effectively remove marijuana from the Controlled Substances Act and section 280E, thereby allowing deductions and credits.
It is worth noting that some states decoupled from federal law and permit state-level ordinary and necessary business expenses and credits related to a marijuana business (for example, California, Colorado, Hawaii and Oregon).
The IRS is increasingly examining marijuana businesses, with some of the cases ending up in the tax court. For example, in Californians Helping to Alieve Medical Problems, Inc. v. Commissioner, the IRS attempted to disallow fully the business expenses and credits for a caregiving facility’s entire operations, when marijuana only represented a small portion of its business. The US Tax Court, however, found that the facility demonstrated that its marijuana activities were separate from its other caregiving work and permitted prorated deductions and credits. To that end, a taxpayer in multiple trades or businesses should ensure that the businesses are separate and distinct. One option is to establish separate entities, or at the very least have separate books and records that support separate trades and businesses.
But what happens if we add a cross-border connection to the tax question? Can a US investor claim foreign tax credits based on income from that investment? I will explore that in my next post.