ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – THE MARIJUANA INDUSTRY AND THE IRS – THE LATEST GUIDELINES FOR INCOME RECOGNITION AND LEGAL DEDUCTIONS
By Robert S. Schriebman
The US Congress and the federal courts are not big supporters of the marijuana industry, nor is the IRS. In reading this article it is important to keep in mind that the IRS does not make the tax laws. It is the job of the IRS to issue regulations and guidelines that interpret the intention of Congress. On September 15, 2020 the IRS issued guidelines for the recognition of income and the allowance of certain deductions for the marijuana industry. This article will discuss those guidelines, and in addition, will set forth the operative portions of the Internal Revenue Code that govern the marijuana industry. In addition, I will discuss the US Tax Court decision in Harborside Health Center issued in November 2018. The case is still valid today. I will review IRC §§ 61, 280E, and 471. I will also discuss the elements of cost of goods sold (COGS).
IRC § 280E
The Tax Equity and Fiscal Responsibility Act of 1982 enacted IRC § 280E. Let’s take a look at it.
“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 (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule 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.”
This section says, in substance, that no tax breaks will be allowed for any business engaging in drug trafficking or for the sale of controlled substances prohibited by Federal law. This included the sales of marijuana and related products. We are all aware that many states have now legalized the use of marijuana including California. This state legalization may have given birth to “the worst of times.” States that have an income tax system, such as California, allow deductions and credits against business income in order to determine net taxable income. A tax is then paid on this net income either by the entity or a pass-through to the entity’s shareholders. However, under § 280E, the IRS may disallow below the line deductions and credits at the federal level.
The Harborside Health Center Case
On November 29, 2018 the US Tax Court decided the case of Harborside Health Center. Harborside Health Center v. Commissioner, 151 T.C. No. 11. In this case a medical-marijuana dispensary, operating legally, under California law, was refused Federal level deductions and credits. Harborside, in addition to marijuana sales, also offered various services and argued that the offering of services should allow it to by-pass § 280E and use IRC §§ 162 and 274 for deductions, etc. – the same code sections used by every other legally operated enterprise. The Tax Court held that Harborside could not deduct such things as cost of goods sold, cost of labor, utilities, etc.
Let’s look at a brief overview of the Harborside case and discuss the other related nightmares that go along with the decision. Somewhere, in all of this, may also be some insight for those looking to invest in the California marijuana industry.
The Harborside case is long and detailed – some 21 pages. However, one need not read too much further after reading Judge Holmes introductory remarks.
“Holmes, Judge: Patients Mutual (Harborside) owns what may well be the largest marijuana dispensary in America. To the Commissioner that just makes it a giant drug trafficker, unentitled to the usual deductions that legitimate businesses can claim, unable even to capitalize its indirect costs into its inventory, and subject to penalties for taking contrary positions on its tax returns for the tax years ending July 31, 2007 through 2012. Patients Mutual (Harborside) was to be treated like any other business because it follows California Law, it does more than distribute marijuana, and the Federal government already decided not to pursue a civil-forfeiture action against it.” (Harborside added)
I leave it to you to read the rest of the decision, but it seems to me that everything goes downhill from the beginning.
Latest IRS Guidelines
On September 15, 2020, the IRS issued guidelines for the recognition of income and the deductibility of expenses relating to the marijuana industry. The guidelines discussed IRC § 280E, income reporting, cash payment reporting obligations, the deductibility of cost of goods sold, payroll tax obligations, and the deductibility of ordinary and necessary busines related expenses. This article will review some of the high points of those guidelines. I will also discuss FAQs that were set forth in the guidelines.
IRC § 61 is most likely the foundational provision of the Internal Revenue Code – all thousands of pages. The section discusses the definition of gross income. Gross income means all income from whatever source derived including, but not limited to, the following:
- Gross income derived from business
- Compensation for services
- Distributive share of partnership gross income
There are 15 categories set forth in the statute. Over the years regulations and court decisions have included many more. Gross income includes income derived from the marijuana industry. The IRS recognizes that the industry conducts much of its business in cash and that cash must be reported to the same extent that income is derived from credit card transactions and checks. The IRS suggests obtaining a copy of Publication 334, Tax Guide for Small Business.
Estimated Tax Payments
Small business taxpayers, primarily sole proprietors, are required to make quarterly estimated tax payments using Form 1040-ES Estimated Tax Payments for Individuals. These payments may be made electronically.
Record Keeping Requirements
The marijuana industry, like any other business, is required to keep adequate books and records. Failure to do so may lead to stiff penalties in the event of audit. Inadequate books and records may also be a “badge of fraud.” Adequate books and records are required for every taxing agency, including the EDD. Inadequate books and records can lead to a 6-year time period IRS audit or an 8-year time period EDD audit.
Large Cash Amounts
The IRS guidelines provide that if the marijuana trade or business receives more than $10,000 in cash, in a single transaction, or in related transactions, Form 8300 must be completed and received within 15 days after receiving payment.
Frequently Asked Questions (FAQs)
Let’s look at several of the major FAQs set forth in the IRS guidelines.
Q: My marijuana business is legal in the state in which I operate, but the federal government considers me to be operating an illegal activity. Do I have the same income reporting requirements for both my state and the IRS? Do I have to pay federal payroll taxes?
A: The answer to both questions is “yes.” Under IRC § 61 discussed above, business income must be reported on a federal income tax return. You are also obligated to pay federal quarterly employment taxes using Form 941, and annual FUTA taxes at the end of the year using Form 940. When it comes to the federal government, income derived from a marijuana business is not exempt from taxation even though the business is deemed illegal by act of Congress (IRC § 280E).
Q: Am I subject to an IRS audit for operating what the federal government deems to be an illegal business? Am I subject to the same audit adjustments as a legal business? Am I subject to penalties such as the negligence penalty pursuant to IRC § 6662?
A: The answer to all of the above questions is “yes.” There is no immunity from an IRS audit because you are operating outside the federal law. The marijuana business is required to keep adequate and accurate books and records that reflect income, COGS, and deductions from COGS. An IRS auditor is free to look at whether you properly and accurately reported income. An IRS auditor is free to examine your deductions and to disallow deductions that cannot be used to arrive at taxable income. Like any other business, the IRS auditor has the discretion to assess several penalties under IRC § 6662, including the negligence penalty.
Q: I am operating a legal marijuana business in my state. On my state income tax return, I am allowed to claim business deductions related to my business in order to arrive at taxable income under state law. Am I allowed those same deductions to arrive at taxable income on my federal income tax return?
A: The answer to this question is both “yes” and “no.” Let’s look at the “no” first. Under IRC § 280E, you are not allowed credits or deductions that are incurred in operating your marijuana business even though the same expenses are allowed to arrive at state taxable income. See United States v. Oakland Cannabis Buyers’ Co-op, 532 US 483 (2001); see also N. California Small Bus. Assistants Inc. v. Commissioner, 153 TC 65 (2019); see also the Harborside Health Center case discussed above. Therefore, ordinary business expenses such as rent, utilities, advertising, labor or other selling expenses are not deductible for federal income tax purposes.
Now let’s look at what can be deducted. IRC § 280E does not prohibit marijuana industry deductions for cost of goods sold to arrive at gross income. The deduction of COGS is governed by IRC § 471. Let’s take a look at the definition of COGS and thereafter IRC § 471.
Definition of Cost of Goods Sold
The traditional definition of COGS is opening inventories plus additional inventories acquired during the year, less closing inventories. (Including shrinkage due to casualties, pilferage and shrinkage due to natural properties.) The COGS is subtracted from gross sales to arrive at gross income. IRC § 471 authorizes the IRS to compel the use of inventory accounting when deemed appropriate during an examination.
IRC § 471
IRC § 471(a) states “Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.
Pursuant to IRC § 471, a marijuana dispensary may not deduct “below the line” expenses from COGS such as advertising, rent, utilities or selling expenses.
For the marijuana industry in general, looking as I do through the eyes of a tax attorney with over 50 years of experience, I see chaos, a Titanic voyage waiting to happen. Clearly, the current situation between legal state activities and illegal federal activities, cannot go on much longer. An honest business person in the industry cannot survive economically. Congress needs to repeal IRC § 280E or omit the marijuana industry from its schedules of illegal activities. Foresight and plain economic common sense must be the watchwords for the next administration in Washington. The federal battle against marijuana usage has been lost and the legislative process must give up the ghost and pass laws that legalize marijuana usage throughout the United States. The income tax revenue from these changes and this new thinking will be huge.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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