Last week a U.S. Tax Court judge confirmed that federal law bars medical marijuana dispensaries from deducting business expenses on their tax returns. Judge Diane L. Kroupa upheld the Internal Revenue Service's decision to disallow expenses claimed by Martin Olive, owner of San Francisco's Vapor Room Herbal Center. Olive's dispensary closed last week after eight years of operation in response to threats from U.S. Attorney Melinda Haag, who said it was too close to a playground. The tax case stems from Olive's returns for 2004 and 2005, which included a Schedule C for the Vapor Room indicating expenses totaling $10,783 and $285,349, respectively. Judge Kroupa agreed those expenses, which included items such as wages, advertising, and supplies, were invalid under Section 280E of the Internal Revenue Code, which says "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…consists of trafficking in controlled substances…which is prohibited by Federal law." She said California's view of Olive's business is irrelevant:
The dispensing of medical marijuana, while legal in California, among other states, is illegal under federal law. Congress in section 280E has set an illegality under Federal law as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business. This is true even if the business is legal under State law.
Citing a 2007 U.S. Tax Court decision that let Californians Helping to Alleviate Medical Problems (CHAMP) deduct expenses related to "counseling and other caregiving services" even though the organization also distributed marijuana, Olive argued that the bulk of his expenses likewise were unrelated to "trafficking in controlled substances." Kroupa rejected that claim, saying Olive essentially was engaged in the business of selling pot, even if those sales were accompanied by "incidental" services such as advice and yoga classes. Counterintuitively, however, Kroupa said Olive should be allowed to subtract his "cost of goods sold" (COGS), which consisted mainly of his marijuana purchases, from his gross revenue, because COGS, which "is subtracted from gross receipts in determining a taxpayer's gross income," does not qualify as a "deduction" under Section 280E. As reported by Olive, his COGS amounted to a little less than $1 million in 2004 and about $2.8 million in 2005, around 90 percent of his gross revenue. Deeming Olive's records unverified and unreliable, Kroupa instead settled on a COGS share of 75 percent for both years, based on an accountant's testimony about the finances of three other dispenaries. The IRS had argued that Olive should not be able to subtract any COGS because his records were so shoddy.
A tax expert told A.P. that Kroupa's decision is "very important" and will have "a major impact" on medical marijuana suppliers. How major? Last year Lynnette Shaw, founder of the Marin Alliance for Medical Marijuana, said "every dispensary in the nation, past, present and future, is dead if this [disallowance of business expenses] is upheld." But Kroupa's ruling leaves some wiggle room. COGS, which she says is allowable, apparently accounts for the vast majority of a dispensary's revenues. Business expenses, which are not allowed, probably will consist mainly of wages, which accounted for 62 percent of the expenses claimed by Olive in 2005. Can't a dispensary be organized so that money given to the people who run it is treated as profits shared among partners rather than wages paid to employees? Alternatively, a dispensary where the work is done by unpaid volunteers would avoid most of the problems caused by the inability to deduct business expenses. And there is always the CHAMP approach, where medical marijuana distribution is an ancillary aspect of an operation that mainly offers other services to patients. One message is clear: keep good records and save your receipts.
In case you were wondering: It is well established that people owe federal taxes even on illegally earned income, so dispensaries take a big risk if they decide to avoid all these complications by keeping their businesses a secret from the IRS.