As the National Taxpayer Advocate, I am the voice of *all* taxpayers within the IRS. As such, my office assists many different types of taxpayers in resolving tax problems with the IRS. While we typically focus on individual tax issues, our purview also includes business taxpayers. One such class of taxpayers involves marijuana-related businesses. I want to shed some light on the frustrations encountered by a growing segment of the business taxpayer population – the growers, distributors, and retailers of marijuana-related products – and educate them on federal tax law.
All but four states have legalized marijuana use in some form (i.e., for recreational or medicinal use). Per the Chief Economist for the National Cannabis Industry Association, there were 35,329 adult-use or medical licenses issued in the U.S. as of October 2021, up from 29,604 such licenses at the start of 2021. Revenue from the licensed marijuana industry is projected to grow to nearly $30 billion annually by 2025.
Despite being able to operate legally under state law, in the U.S., trafficking of marijuana remains a federal offense. Specifically, the Controlled Substances Act (CSA) makes it illegal under federal law to manufacture, distribute, or dispense marijuana, which is classified as a “Schedule I” controlled substance. Schedule I controlled substances are those drugs with a high potential for abuse, no currently accepted medical use in treatment in the United States, and for which there is a lack of accepted safety for use of the drug or other substance under medical supervision. Schedule I controlled substances include drugs such as heroin and LSD. Because marijuana is classified under this category of controlled substances under the CSA, the sale of marijuana remains a violation of federal law, even if permitted in a growing number of states.
Several bills (including the Marijuana Opportunity, Reinvestment, and Expungement Act of 2020, which passed the House in December 2020 by a vote of 228 to 164, and the Cannabis Administration & Opportunity Act, a bill introduced by Senators Booker, Schumer, and Wyden in July 2021) have been introduced seeking to remove marijuana from the definition of a Schedule I controlled substance under the CSA. On April 1, 2022, the House passed legislation to decriminalize marijuana at the federal level. While the Department of Justice has not made it a priority to prosecute businesses that comply with state law, the mere possibility of federal prosecution, no matter how slim, may deter businesses from entering into and/or engaging with the marijuana industry.
There are significant federal tax-related consequences for businesses engaged in the “trafficking” of marijuana, even in states that have legalized (or de-criminalized) the use of it. Section 61(a)(2) of the Internal Revenue Code provides that, for the purpose of computing taxable income, an individual’s or a business’s “gross income” includes “all income from whatever source derived,” including “income derived from business.” This includes income from illegal sources. Federal courts have consistently upheld Internal Revenue Service determinations that marijuana-related business, including state compliant marijuana dispensaries, have taxable income. These businesses must also pay employment taxes.
While businesses can generally deduct from their gross income “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on [the] trade or business” pursuant to section 162(a), there are exceptions. Section 280E, enacted in 1982, forbids businesses from deducting expenses from their gross income if the business consists of illegally “trafficking” in Schedule I or II controlled substances. Because marijuana is still classified as a Schedule I controlled substance under federal law, all cannabis businesses fall into the category of drug trafficking and remain prohibited from writing off otherwise legitimate business expenses. (Similarly, because marijuana is not a federally recognized course of medical treatment, individual taxpayers are prohibited from claiming associated expenses as itemized deductions on Schedule A of their Form 1040 tax return.)
There is an exception for the cost of goods sold (COGS); marijuana businesses can offset their gross receipts by their COGS, even for products considered controlled substances under federal law. Even so, marijuana-related businesses end up paying federal taxes on gross profit rather than net income.
Example. A marijuana retailer has gross revenue of $1,000,000. It spent $750,000 on COGS and incurred another $200,000 in business expenses (which are nondeductible per Section 280E). Assuming a 30 percent effective tax rate, the marijuana retailer has a federal tax burden of $75,000 ($250,000 taxable income x 0.30). Had the business been allowed to deduct the other $200,000 in business expenses, its tax burden would have been reduced to $15,000 ($50,000 taxable income x 0.30).
In the example above, the marijuana retailer incurred a tax burden five times as large as its non-marijuana-related business counterpart due to Section 280E. Not only is the marijuana retailer effectively taxed at a higher rate, it may take longer for a marijuana-related business to recoup its start-up expenses and turn a profit than other businesses.
Furthermore, in part because federal laws significantly limit access to financial institutions for marijuana-related businesses, many such businesses operate on a cash-only basis. If the business receives a cash payment over $10,000, it must file a Form 8300 with the IRS. Such businesses have a need to pay federal taxes in cash, and this can only be accomplished at designated offices where the IRS can accept it. Legislation designed to give marijuana-related businesses more direct access to banking services would make it easier for the IRS to collect the taxes those businesses owe, Treasury Secretary Janet Yellen acknowledged during a December 1, 2021, congressional hearing.
Regardless of your personal or political views, or whether this disparate treatment is fair or not, taxpayers involved in the production, distribution, or sale of marijuana should be aware that there are significant federal income tax challenges that apply to this industry and understand the federal tax consequences. To its credit, the IRS recently posted guidance here and on IRS.gov/marijuana, educating and informing marijuana-related business owners of the specific challenges they may face. Until Congress changes the law removing marijuana from the definition of a Schedule I controlled substance under the CSA, these businesses are not entitled to claim deductions and expenses like other businesses and need to understand the federal tax consequences in conducting its business.