Cannabis: Taxation Controversy & Confusion

Cannabis, Marijuana, Weed, Pot, Mary Jane – a rose by any other name is still a rose.  No matter what you want to call it, the industry surrounding this drug faces many uphill battles.  It does not matter if you grow it, cultivate it, distribute it or dispense it, if you are in this industry or are looking to become part of the industry, you have tax and accounting issues that most businesses would not and could not imagine.

First and foremost, no matter what your state says (more on that later), Cannabis is an illegal drug for federal purposes. There are 5 categories in which drugs are lumped.  Heroin and LSD, as one might expect is placed in the first category.  You must be thinking “What does these two dangerous and addictive drugs have to do with pot?”  Well, a lot.  In fact, marijuana has been placed in this category and is considered a dangerous drug.

That’s the federal government for you.  It is a political hotbed, to say the list.  However, we will not go there, as this not a political blog.

Now what about all the states?  44 states, including Washington DC and Guam have individually legalized the use of marijuana in some form or another.  The use ranges from medical to recreational to growing.  Each state passed their own laws, their own regulations and their own procedures on how to control the industry in their state.

Controversy: Federal Law vs. State Law

So how does this conflict between the Federal government and the states co-exist?  Well, the federal government has indicated that they will not crack down on these businesses. That does not mean they won’t.  In fact, in a recent tax case, part of the issue was the deductibility of over $600,000 worth of product confiscated by the Feds… it wasn’t allowed as a deduction. It is, after all, illegal as far as the Federal government is concerned.

Now, when it comes to taxes – for Federal tax purposes, the IRS, because it is an illegal business endeavor, will not allow for any tax deductions (deductible expense) against the income generated by this business.

So Why Report it on my Federal Income Tax Return?

You may not be aware, that there is an Internal Revenue Code Section (61) that, very specifically states, that all income is taxable from whatever source derived.  Think of Al Capone.  What was he sent to prison for?  Murder? Prostitution? Bootlegging?  Not a chance.  It was tax evasion.  He never reported his illegally received gains on a tax return.

So what happens to these businesses that are operating illegally for federal purposes, but legally for state?  Well, they better be reporting their gross income on the appropriate individual corporate or partnership tax return.  Oh, yes, trusts and estates can be involved, too.

How about deductions since it is mentioned that the IRS will not allow any deduction?  Congress enacted Internal Revenue Code Section 280E to get people to file returns and report this income, even if it’s considered illegal income.  This section says that cost of goods sold will be allowed as a reduction (not deduction) against gross sales. Semantics?  Maybe, but the courts have ruled that cost of goods sold is an adjustment in arriving at net sales. Remember, a rose by any other name…..?  Whatever reason, it helps.  Not entirely, but it helps.

But you can’t just call something “cost of goods” to reduce your taxes. There are very specific rules to follow… with court cases to back them up.

To make matters worse, in most cases, you cannot open a bank account if you are affiliated with this industry. This means you have to deal with cash, cannot take credit cards and cannot deposit the wads of cash you carry into a bank.  You better have a very large, very secure safe.

If you have employees, you have to pay them in cash.  For those of you that have payroll, you may know that you are required to make your payroll tax deposits electronically. This enlies the next question:

How Can We Do This Without a Bank Account?

This will be one of your biggest challenges, especially when the IRS can penalize you for not making these deposits electronically.

To fight this, you need to make sure that you have a professional that understands the nuances of 280E, how to set up your business when you may have an ancillary shop (i.e., one that offers counseling, munchies, or even paraphernalia) and to handle any issues that arise with the IRS or the state.  The states, like Colorado, have indicated that they WILL audit every business every few years and they have. Not for the reason you may think why a business may get audited, but for licensing reasons.  The IRS will also come in to audit a business to question as to what went into the 280E numbers claimed on the return.

Jeffrey Schneider, EA, CTRS has trained and learned what each business needs to pass muster.  He has read the statutes, regulations and court cases to help you muddle through the mind field of this industry.  In fact, Schneider travels the country teaching other tax pros on this subject.

So if you are a part of – or thinking of getting into – the cannabis industry, find a pro that knows this industry well. If you are thinking about starting a sidekick business as was mentioned before, make sure your pro understand how to get the most out of 280E.

Jeffrey Schneider, EA, CTRS, NTPI Fellow has the knowledge and expertise to help you reach a favorable outcome with the IRS. He is the head honcho at SFS Tax & Accounting Services as well as an Enrolled Agent and a Certified Tax Resolution Specialist.
Now What? I Got A Tax Notice From The IRS. Help! Defining and deconstructing the scary and confusing letters that land in your mailbox. Jeff defines and deconstructs the scary and confusing letters in a fashion that mixes attention to detail with humor and an intricate clarification of what is what in the world of the IRS.

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