Marijuana Money Muddle

How does a pot dealer pay taxes and write checks?


As far as the federal government is concerned, any business involving the production or sale of marijuana-even if it is blessed by state law-is a criminal enterprise. But as Al Capone could tell you, the feds still want their cut. The Internal Revenue Service explains on its website that "income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Form 1040, line 21, or on Schedule C or Schedule C-EZ (Form 1040) if from your self-employment activity." When you fill out that Schedule C for your marijuana business, however, make sure not to put anything on Line 28, which is reserved for the expenses you are not allowed to deduct.

That complication bedevils medical marijuana dispensaries and will continue to be a problem for state-licensed stores selling pot for general use. It stems from 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…prohibited by Federal law." No matter how the Justice Department ultimately responds to marijuana legalization in Colorado and Washington, the inability to deduct business expenses will impose a big financial burden on pot stores and expose them to the risk of ruinous audits.

Two U.S. Tax Court decisions suggest a couple of ways to operate profitably despite Section 280E. In 2007 Judge David Laro ruled that Californians Helping to Alleviate Medical Problems (CHAMP), a San Francisco dispensary, could deduct expenses related to "counseling and other caregiving services" even though the organization also distributed marijuana. Relying on that decision, Martin Olive, the owner of another San Francisco dispensary, the Vapor Room Herbal Center, tried to deduct his business expenses but was shot down by the IRS. Last year Judge Diane L. Kroupa upheld the agency's decision, concluding that 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. But Kroupa ruled that Olive could deduct his "cost of goods sold," which she said was not covered by Section 280E.

The upshot of Kroupa's ruling is rather counterintuitive. A pot merchant cannot deduct ordinary business expenses such as rent and wages unless he can persuasively attribute them to activities other than selling marijuana. But he can deduct the cost of the marijuana he sells-either the price he paid for it or the expenses he incurred in growing and processing it. While that can of coffee in the break room may not be deductible, that jar of Lemon Diesel buds on the shelf is.

"For anyone who wants to get into this industry," says Wanda James, co-owner of Simply Pure, a Denver company that produces cannabis-infused edibles, "there is a handful of CPA firms that understand this stuff inside and out. It's beyond confusing. And you'll want to bring in your accountant when you're building your retail center or your dispensary, because [the area] where you sell pot can't be deducted, but the rest of the place can. You can't write off employees who are actually selling pot, but you can write off ones who are talking about it. It's crazy."

Greta Carter, executive director of the Seattle-based Coalition for Cannabis Standards and Ethics, helps run a six-hour seminar on the ins and outs of Section 280E. "If I'm in a dispensary," she says, "if I am talking to you about your health, and I am talking to you about the different types of medicine, I'm consulting you. All of that time is not actually done in the transaction of me giving you a Schedule I substance and you giving me money. So a portion of that conversation and that employee's salary can be legally deducted."

Another financial headache stemming from the continued federal illegality of the marijuana business is the difficulty of obtaining banking services. Financial institutions are reluctant to accept deposits from someone who sells pot, even when he is complying with state law, because they worry that it will get them into trouble with federal regulators or prosecutors. Simply letting the owner of a pot store open a checking account could be portrayed as money laundering.

"I'm very blessed to have a bank," says Toni Fox, owner of 3D Medical Marijuana Center in Denver. She uses Valley Bank and Trust in North Denver, which was also her bank during her 10 years in the construction business. "I established a very reputable business history with them," she says. "When I told them I wanted to get into marijuana, they thought I was crazy, but they came and toured the facility. They've been here several times, and they support me." According to Fox, an FDIC auditor "said they could keep us, but they couldn't take on anybody else."

Denver Relief co-owner Kayvan Khalatbari figures that "99 percent of the people in this industry in Colorado don't have a traditional banking relationship or banking account." How do they manage? "A lot of people are doing online cash management accounts, keeping money in a safe, doing all cash transactions," he says. "A lot of people are lying about the type of business they're in so they can get an account." Khalatbari did not have to resort to subterfuge to find a bank willing to take his business, although it helped that he also has two pizzerias and a property company with accounts there. What's the name of the bank? "I'm sorry," he says. "Trust me, I've wanted to say it so many times."