Extras on Excise: Behind I.R.C. § 280E’s Buzz(kill) on Marijuana Legalization

 

Taxes sometimes get a bad rap for being boring. So Bloomberg BNA state tax law editors were excited when HBO’s “Last Week Tonight” with John Oliver did an entertaining (and timely) segment on April 2 about marijuana regulation and legalization and discussed some of the tax concerns for businesses in the industry. Oliver summarized several difficulties surrounding state legalization and regulation of marijuana, including how quirks in the federal tax code can add up to serious costs for the industry, which has brought in billions of dollars in sales for states.

The government demands its cut even for illegally sourced income, as Oliver humorously pointed out. I.R.C. § 61(a)(3) lists “gains derived from dealings in property” (i.e., “gross receipts less [costs of goods sold], which is the term given to the adjusted basis of merchandise sold during the taxable year” as one of the definitions of gross income for tax purposes, as the IRS explains in a 2015 memo, CCA 201504011. The definition doesn’t provide exceptions or special treatment for illegally-sourced income.

Here’s where it gets tricky for marijuana businesses: Normally, after calculating gross income, businesses can subtract “all ordinary and necessary business expenses” to calculate their taxable income. However, these deductions aren’t allowed for cannabis companies because I.R.C. § 280E prohibits businesses from deducting expenses for business activity if it consists of trafficking in federally prohibited controlled substances.

This provision has roots in the 1981 tax case Edmondson v. Commissioner, T.C. Memo 1981-623, where the Tax Court permitted a convicted drug dealer to claim business deductions and factor the costs of goods sold for marijuana, cocaine and amphetamines into his gross income calculations. In response, Congress enacted § 280E, disallowing business deductions for businesses conducting illegal activity. Essentially, this means that running a legal marijuana business is more expensive than running a business in another industry, because business in other industries can deduct expenses to lower their tax liability. The marijuana industry can still subtract the costs of goods sold (CCA 201504011 provides some guidance on how to determine these costs).

There are currently efforts in Congress to remove marijuana from the Controlled Substance Act (CSA) schedules, which would effectively permit marijuana businesses to make business deductions because § 280E only applies to prohibited substances, specifically Schedule I and II substances. H.R. 1227 (introduced on Feb. 27) proposes removing references to “marihuana” (also written as marijuana) and tetrahydrocannabinols from the CSA schedules. Alternatively, H.R. 1810 (introduced on March 30) would create an exception in § 280E that would allow marijuana businesses that comply with state cannabis regulations to deduct their business expenses instead of eliminating the substance from the CSA schedules. S. 776 (also introduced March 30) would remove references to marijuana and impose a federal excise tax on sales of marijuana and marijuana products.

Federal legislation addressing the conflicts between federal and state law stemming from marijuana legalization has been introduced in prior sessions but has not been enacted. While some members of Congress are friendly towards the substance, as evidenced by the newly formed Cannabis Caucus, the new administration heading the executive branch may be at odds with legalization advocates and make the issues Oliver’s program highlights more likely to continue.

Tune in next week for more coverage on marijuana taxation as we examine ongoing developments regarding medical marijuana licensing in the Maryland General Assembly!

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Do you think § 280E’s ban on deductions is the best policy for marijuana businesses?

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