Maryland finally made the move to legalize the sale of medicinal marijuana. However, federal law still treats the sale of marijuana– even for medicinal purposes– as illegal. This split approach has the potential to cause a lot of confusion: while the state may consider the sale of medicinal marijuana as “above board”, an illegal status in the eyes of the federal government makes it unclear how (or if) to report income from such a business to the IRS. To many, it may seem like a bad idea to volunteer information to the federal government about the sale of a product that is considered illegal. From a cursory overview, therefore, it appears that the safer route is not to report any income from the sale of medicinal marijuana on a federal income tax return.
The Internal Revenue Service, however, takes a different approach. The sale of certain products may be illegal, but the IRS still wants to know about it, and still wants the income reported on your return. This is because the IRS treats all sources of income, regardless of its “legal” or “illegal” distinction, as income. So, even if the federal government views the sale of marijuana as illegal for any reason or purpose, if a business has made profit from such sales, it must still report it on its tax return. Despite the source of the income, it is all considered taxable.
Medicinal marijuana businesses should also be aware of another key provision wrapped up in the Internal Revenue Code, Section 280E. Section 280E of the IRC does not permit deductions for business expenses related to the sale of controlled substances. There is one large exception to Section 280E’s prohibition against business deductions for businesses that “traffic” controlled substances. Although marijuana is considered a Schedule I Controlled Substance according to the U.S. Department of Justice Drug Enforcement Administration (DEA), Section 280E of the Internal Revenue Code does permit deductions for Cost of Goods Sold (COGS). In this specific instance, COGS includes those costs related to the purchase or growth of the marijuana for sale. Otherwise, dispensaries are unable to deduct expenses tied to the sale of medicinal marijuana and business expenses that are otherwise considered completely acceptable deductions, such as rent or office utilities, will be disallowed pursuant to Section 280E.
The Tax Court case Californians Helping to Alleviate Medical Problems (CHAMP) 128 T.C. 173 clarified Section 280E’s reach. The Court agreed with the IRS reading of the Code and held that, regardless of the legality of marijuana in any particular state, its illegality for all purposes– whether medicinal or recreational– on the federal level permitted the IRS to disallow all business deductions incurred through the trafficking of the controlled substance. The CHAMPS Court also held, however, that a business involved in the trafficking of marijuana may include several other services or lines of trade in the overall business plan. According to the Tax Court, these other “legal” portions of the business are still entitled to normal business deductions. Section 280E, therefore, could only be applied to the “illegal” side of a business whereas the “legal” part of the business– for example, a counseling service contained in a business that also happened to prescribe medicinal marijuana– could still take their portion of business deductions.
The result is that, from a federal perspective, the legal versus illegal distinction doesn’t truly matter in the end. Business owners still need to report the income of sales of illegal substances on their state and federal returns. Although it may be counter-intuitive, it is the failure to report the income that will expose a business to the risk of further investigation. If you are concerned about your tax liabilities as a medicinal marijuana dispensary, or want to see how you may be able to identify and maximize your dispensary’s tax deductions, contact Frost & Associates today.