Section 280E of the Internal Revenue Code: Planning for Taxation of Medical Marijuana Businesses

October 19, 2016

NOTHING IN THIS DOCUMENT IS INTENDED OR SHALL BE CONSTRUED AS ADVICE TO PARTICIPATE IN, OR COUNSEL WITH RESPECT TO, CRIMINAL OR FRAUDULENT ACTIVITIES.  POSSESSION, DISTRIBUTION AND SALE OF MARIJUANA IS A SERIOUS CRIME UNDER FEDERAL LAW (AS IS TAX EVASION), AND NOTHING HEREIN SHALL BE CONSTRUED AS ADVICE TO VIOLATE ANY LAW.

This is another in our series of occasional musings on the Pennsylvania Medical Marijuana Act, 35 P.S. §10231.101 et seq. This time, a California marijuana dispensary’s challenge to a 1982 Federal statute raises some questions about taxation of potential participants in Pennsylvania’s medical marijuana industry.

Harborside Healthcare Center is a large California medical marijuana dispensary with three locations, upwards of 225,000 patients, and $30 million in annual sales. Harborside is challenging a $2.4 million federal income tax bill.[1] The challenge turns on Section 280E of the Code, added to the tax law in 1982 in response to a tax court decision that had allowed a drug dealer to deduct his ordinary and reasonable business expenses in computing taxable income.  After enactment of 280E, “[n]o deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business . . . consists of trafficking in controlled substances (within the meaning of Schedules I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.” (IRC §280E)

As we are taking pains to remind ourselves, medical marijuana remains a Schedule I Controlled Substance, and the activities of a marijuana dispensary or grower would constitute trafficking. Harborside would like the tax court to read the statute so that the deduction is allowable if the substance is legal under state law – basically changing “or” to “and” in the final clause. We wish them luck, but, assuming they are not successful, what reductions, if any, can a participant in Pennsylvania’s medical marijuana market make to its federal taxable income?

First, the participant (either a dispensary or a grower/processor) can reduce its gross income by subtracting its Cost of Goods Sold (Treas. Reg. §1.61-3(a)), since this reduction is neither a “credit” nor a “deduction”. Cost of Goods Sold is generally limited to the cost of inventory consumed in producing products, but may include some labor or other costs incurred in a manufacturing or processing operation, depending on accounting method. Recall that Pennsylvania requires participants in the market to make expenditures for security, product tracking, analytical laboratory services, and on-site medical personnel. These are costs that are necessary to operate in Pennsylvania but may not qualify as “costs of goods sold”.

Second, a grower/processor can probably deduct the 5% Pennsylvania tax on sales of medical marijuana to dispensaries under 35 P.S. §10231.901. There is an IRS Chief Counsel Memorandum (No. 201531016)  addressing a Washington State tax on sales of marijuana, which treated that levy as an excise tax and as a reduction in proceeds received rather than a “deduction or credit”.

Third, to the extent an organization’s business involves other activities for which it earns revenue (counselling; sales of products that are not controlled substances), the organization may be able to establish that it has business activities that are not “trafficking” and that deductions may be taken against non-marijuana business revenue.[2]  This seems difficult to do given the structures for grower/processors and dispensaries mandated by Pennsylvania law.

There is also the question of Commonwealth taxation. Pennsylvania income tax will apply to the market participant on top of the 5% excise tax. Will Pennsylvania taxpayers have to follow the federal rule of non-deductibility for their medical marijuana business expenses?

Hopefully, the legislature will take action on this. Colorado has adopted a simple statute that basically reads 280E out of Colorado law for licensed participants in the Colorado marijuana market. (Colo. House Bill 13-1042 enacted May 28, 2013). If Pennsylvania’s legislature does not act, I would submit that the answer depends on whether the participant is organized as a corporation or a limited liability company/partnership.

Most states’ individual and corporate state income tax regimes start with the individual’s or corporation’s federal return, and make adjustments here and there. Pennsylvania does this for corporations. The starting point for Pennsylvania corporate net income tax is the corporation’s federal return. But for individual tax purposes, Pennsylvania does not follow Federal 1040s, but requires individual taxpayers to divide receipts into particular categories that do not offset each other. One of those categories is net income from a trade or business. So a medical marijuana distributor organized as a corporation would start with a federal return on which its business expenses from the marijuana business can’t be deducted. Absent legislative action to allow the deduction for state purposes, the taxpayer might not be able to just take that deduction.  On the other hand, individual Pennsylvania returns are not tied to Federal 1040s, so one might argue that to the extent business expenses are deductible in computing Pennsylvania taxable income of an individual with an interest in a partnership or LLC in any old business, there should be no restriction on taking a deduction for business expenses of a medical marijuana business.

So there seems to be at least one good reason to organize a Pennsylvania medical marijuana business as a limited liability company or as a limited partnership with a corporate general partner!

Strassburger McKenna Gutnick & Gefsky continues to monitor issues in Pennsylvania’s emerging medical marijuana market as well as issues in business taxation and tax planning whether or not related to medical marijuana. For questions about medical marijuana, please contact Erica L. Laughlin or David L. Pollack of Strassburger McKenna Gutnick & Gefsky at elaughlin@smgglaw.com; dpollack@smgglaw.com or (412) 281-5423.  For questions about business taxation and tax planning, please contact David, or S. John Kelly at jkelly@smgglaw.com.

[1] See Smalley, Craig W.; Marijuana Dispensary Takes on IRS in Tax Court; Accounting Today.com (accessed 9/15/2016)

[2] Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 TC 173 (2007)