As of today, 23 states have legalized marijuana in some form. Some, like Oregon and Colorado, permit recreational use of the drug; others, like Maryland and Delaware, have only legalized marijuana for medicinal purposes. While the possession limits vary from state to state, there is one sticking point that exists across the span of states that have signed measures into law that legalize the drug: how to deal with the tax impact that grew out of the business of growing (and, more importantly, selling) marijuana.
The taxation issue stems back to 1982, when Congress passed 26 U.S. Code § 280E: Expenditures in connection with the illegal sale of drugs. The law prohibited deductions or credits to be given to any business involved in the trafficking of a controlled substance prohibited either by Federal law or by the law of the state where the business is being conducted. For marijuana shops, this means that the write-offs that non-drug related business are entitled to, such as rent, utilities, and other normal business expenses, aren’t available. Without such deductions, marijuana shops are required to pay more taxes on income without the set-off for business-related costs. So, although an individual state may have legalized marijuana in some form or another, the federal prohibition keeps an otherwise legal shop from escaping Section 280E’s regulation and, potentially, an audit notice from the IRS.
Depending on the size and success of the marijuana shop, taxes can be in excess of 60% or 70% of net income. Having to pay six-figure taxes threatens business growth, prevents new hires, and may result in some shops closing their doors permanently. Added to this already expansive list of headaches and obstacles faced by marijuana shops is the difficulty in opening bank accounts with federally insured institutions.
The combination of federal and state tax law on the issue not only creates difficulties for shop owners during the tax season.It also raises questions about how shops will choose to operate in the future to avoid what owners consider debilitating tax bills.Will shops begin to purposefully file incorrect tax returns and hope to fly under the watchful eye of the IRS? How will dual-purposes shops—ones selling marijuana and clothing, for example—file their returns?Is part of that business eligible for deductions, while the marijuana-selling part is not?
In response to these questions, some states, like Colorado, have begun to overhaul their tax laws.Legal marijuana shops in these states will be permitted to take deductions on state returns.Other shops are taking matters into their own hands.In order to combat their tax woes, owners have made their way into tax court to challenge their audit notices.