The Cost of Running a Marijuana Business Remains High

This article was originally published in the September 2015 issue of the CEB California Business Law Reporter (37 CEB Cal Bus L Rep 32).


Photo Credit: Sean Logan | News21 

In Olive v Commissioner (9th Cir 2015) 792 F3d 1146, the Ninth Circuit upheld a decision of the U.S. Tax Court that a medical marijuana dispensary was a trafficker in a controlled substance and precluded from deducting its business expenses for federal income tax purposes.

Martin Olive owned and operated the Vapor Room Herbal Center, a medical marijuana dispensary located in San Francisco. Patrons of the Vapor Room could purchase medical marijuana and consume it on the premises with vaporizers supplied by the Vapor Room. The Vapor Room was set up much like a community center with couches, chairs, and tables located throughout. Games, books, and art supplies were available for the patron's general use. The Vapor Room also provided other amenities such as sandwiches, pizza, beverages, snacks, yoga, and movies. Staff members of the Vapor Room also provided counseling to customers on various personal, legal, or political matters relating to medical marijuana and educated customers on how to use vaporizers and consume medical marijuana responsibly. All of these services were provided at no charge.

In tax years 2004 and 2005, the Vapor Room reported net income of $64,670 and $33,778, respectively. These totals reflected the deduction of expenses in the amounts of $236,502 for 2004 and $417,569 for 2005. The Internal Revenue Service disallowed the deductions and the Tax Court upheld the IRS's disallowance based on IRC §280E.

Internal Revenue Code §280E provides:

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.

The Ninth Circuit stated that the test of deductibility was whether the Vapor Room is a "trade or business [that] consists of trafficking in controlled substances." Although the use and sale of medical marijuana is legal under California state law (see Health & S C §11362.5), the use and sale of marijuana is still prohibited under federal law (see 21 USC §812(c)).

The Ninth Circuit held that the test for determining whether an activity constitutes a "trade or business" is "whether the activity was entered into with the dominant hope and intent of realizing a profit." U.S. v American Bar Endowment (1986) 477 US 105, 106 S Ct 2426. The court found that the only income-generating activity was the sale of medical marijuana. The other services were provided at no cost. The court further concluded that the Vapor Room's business consisted of trafficking in controlled substances, and affirmed the Tax Court's holding that the Vapor Room was not entitled to deduct its expenses for federal income tax purposes.

The Vapor Room cited Californians Helping to Alleviate Medical Problems, Inc. v Commissioner (2007) 128 TC 173 (CHAMP) in support of its right to deduct its expenses. In CHAMP, the taxpayer provided extensive counseling and caregiving services (and charged for such services) in addition to providing medical marijuana. The Tax Court concluded that CHAMP's primary purpose was to provide caregiving services to its members; the provision of medical marijuana was secondary, and CHAMP was entitled to deducts its business expenses related to the caregiving services.

The Ninth Circuit gave an analogy to illustrate the difference between the Vapor Room and the business in CHAMP. Bookstore A sells books and provides complimentary amenities such as a comfortable seating area, coffee, tea, and cookies. Bookstore A also provides free weekend story time or after-school reading circles for free. The "trade or business" of Bookstore A consists of selling books. In contrast, Bookstore B sells books, but it also sells coffee and pastries, which customers can consume in a café-like seating area. Bookstore B engages in two "trades or businesses," one of which is selling books and other of which is selling food and beverages.

The Vapor Room also argued that §538 of the 2015 Consolidated and Further Continuing Appropriations Act (Pub L 113-235, 128 Stat 2217) precluded the government from defending against its appeal to the Ninth Circuit. Section 538 provides that specified funds may not be used to prevent states "from implementing their own state laws that authorize the use, distribution, possession, or cultivation of medical marijuana." The Ninth Circuit held that although §538 may prevent the use of federal funds to prevent states from implementing marijuana laws, in this case the government was enforcing a tax, which does not prevent people from using, distributing, possessing, or cultivating marijuana in California; enforcement of IRC §280E may make it more costly to run a marijuana dispensary, but it does not change whether the activities are authorized by the state.

Note that under federal tax laws, marijuana businesses are allowed to deduct their "cost of goods sold" (COGS) to compute their federal income tax liability, but they are generally not allowed to include purchasing, handling, storage, or administrative costs in their COGS. In a recent internal memorandum issued by the IRS Chief Counsel's Office, the Service ruled that the Washington Marijuana Excise Tax was, under IRC §164(a), a tax that could be treated as a "reduction in the amount realized on the disposition." In other words, the excise tax is not deductible under IRC §164 as a business expense, and it is not included in COGs, but so long as it is imposed on the "disposition of property" (i.e., in this case the sale of marijuana), it can be treated as a reduction in the amount realized from that disposition.

Note further that under CHAMP, marijuana dispensaries can engage in a second business on the same premises and deduct expenses allocable to that business, such as an allocable portion of rent, payroll expenses, janitorial expenses, etc. In CHAMP, the caregiving services appeared to be more extensive than the marijuana business, so it is not clear whether a court would look as favorably on a second business that was clearly subordinate to the marijuana dispensary. A bakery, anyone?


Marilyn Barrett practices tax and corporate law in Los Angeles. She is a former chair of the Taxation Sections of the State Bar of California and the Los Angeles County Bar Association, and is a certified public accountant.

Ms. Barrett has authored more than 40 articles for legal journals and, since 1994, she is the contributing editor on Federal Taxation for the CEB California Business Law Reporter.



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