Another day, another IRS summons enforced against a marijuana dispensary. I have to give the pot shops credit. They come up with really cool names. The LLC unsuccessfully fighting the IRS summons in District Court was called Futurevision LTD, which is pretty neat, but not neat enough apparently. The do business as Medicine Man. It is nice that they get to have cool names, because it is really hard to make money in the semi-legal pot business – particularly after tax. It may be that providing services to the industry might be a more lucrative opportunity like the story of the guy who made his fortune selling picks and shovels during the gold rush. Last week I spoke with Keegan Peterson of Wurk and attorney Nick J. Richards of Dill Dill Carr Stonbraker and Hutchings, who are helping the owners and managers of marijuana dispensaries navigate the regulatory and tax minefield that their semi-legal industry exists in.
Semi-legal?
According to this article in Governing 26 states and the District of Columbia have laws legalizing marijuana in some form with three more on the way. Marijuana remains illegal under the federal Controlled Substances Act. Drug enforcement is generally handled by state and local law enforcement, which makes this situation a confusing mess. The Obama administration Justice Department adopted a kind of “Let’s fight crime someplace else” attitude. It is embodied in a memo from Deputy Attorney General James M. Cole (the Cole Memo). What the Cole memo recommends is prosecutorial discretion particularly in states that have strong regulations.
The Department’s guidance in this memorandum rests on it expectation that states and local governments that have enacted laws authorizing marijuana-related conduct will implement strong and effective regulatory and enforcement systems that will address the threat those state laws could pose to public safety, public health, and other law enforcement interests. A system adequate to that task must not only contain robust controls and procedures on paper, it must also be effective in practice.
Nick Richards told me that Colorado regulators have taken this warning to heart with an intense “seed to sale” tracking system. The current Attorney General indicated that there might be a different approach, but for now the Cole Memorandum remains in effect.
About Wurk
Wurk is a great picks and shovels stories. Keegan Peterson was practically dragged into founding the human resources compliance company in response to the special problems that the intense regulation of the cannabis industry creates. The federal illegality made it difficult to establish banking relationships requiring the companies to do business in cash. (There has since been progress on the banking front, although it is still a struggle.) They still needed to be in compliance with payroll and withholding rules thanks to those “robust controls and procedures”.
At a more sophisticated level, which is where this tax blogger is interested, detailed payroll records will help determine how much of the wage expense is deductible for income tax purposes, something that many companies can just take for granted. Thanks to Code Section 280E, only expenses that can be classified as cost of goods sold, in accordance with regulations as they were in effect in 1982, can be deducted in arriving at federal taxable income, but not other expenses such as selling expenses. Keegan Peterson remarked:
Section 280E of the Internal Revenue Code is hindering the growth of cannabis businesses. Some businesses are paying effective tax rates in excess of 70%. Our goal is to help these businesses properly track their labor in an attempt to reduce their tax burden. With better audit data around labor activities, businesses can show that their labor is allocated to Cost Of Goods Sold (“COGS”) instead of selling or administrative activities. COGS is the only allowable deduction under S280E, so doing this reduces their tax burden.
Mr. Peterson referred me to Nick Richards for more on that.
The Problem With Deductibility
Back in the Nancy Reagan “Just Say No Days”, Section 280E was added to the Code. It denies drug dealers deduction for their ordinary and necessary business expenses. That rule applies to marijuana even in the states that have the type of robust regulation that will keep the Justice Department off people’s back, at least for now. Futurevision and a few other companies thought that they might be able to keep the IRS from auditing them on that issue since it involved the IRS in making a determination about criminal activity. When Nick Richards, a former IRS attorney, heard about that approach, he did not think it would work, and, as it turned out it did not.
Nick sent me a powerpoint presentation. Among the highlights are that ten states have “seed to sale” tracking – online reporting of growing plants, harvests, transfers, and sales- and that the IRS is using these reports to find unreported income, illegal activity and industry statistics. State revenue departments are also interested not only for income tax but also excise and sales tax.
One way to mitigate the effect of 280E is to allocate expenses to a separate legal business. This technique was upheld by the Tax Court in Californians Helping to Alleviate Medical Problems in 2007. Free services such as yoga, instructions in use of vaporizers and on-site munchies do not help though.
Nick indicated that the IRS has been very aggressive in auditing cannabis establishments. Audit coverage is high and there is little give. They are looking deeply into payroll records for 280E disallowance and holding firm on not updating what goes into cost of goods sold. Based on the 471 interpretations, cannabis establishments are not being allowed to have the advantage of bonus depreciation.
On States Rights
I find it amusing how attitudes about state versus federal supremacy will shift depending on the issue. Activists and advocates use the Constitution like a drunk uses a lamppost – more for support than illumination. Marijuana is one of those areas where many, although not all, conservatives lose their enthusiasm for states rights and seem to prefer a more robust federal government. I find just a little bit of a historical detour irresistible in closing.
Back in the day, you often heard about states rights as opposed to slavery as a cause of the Civil War. Ironically, the South Carolina Declaration of Causes of Secession cites states not following federal law as one of its reasons for separation:
The General Government, as the common agent, passed laws to carry into effect these stipulations of the States. For many years these laws were executed. But an increasing hostility on the part of the non-slaveholding States to the Institution of Slavery has led to a disregard of their obligations, and the laws of the general government have ceased to effect the objects of the Constitution. The States of Maine, New Hampshire, Vermont, Massachusetts, Connecticut, Rhode Island, New York, Pennsylvania, Illinois, Indiana, Michigan, Wisconsin and Iowa, have enacted laws which either nullify the Acts of Congress or render useless any attempt to execute them. In many of these states the fugitive is discharged from service or labor claimed, and in none of them has the state government complied with the stipulation made in the Constitution.
If you look at the US Marshals Service Association Roll of Honor, you will note the third name James Batchelder, Deputy US Marshal, May 26, 1854. Batchelder was not killed by desperadoes in the Wild West, but in a confused struggle with a Boston mob trying to prevent Anthony Burns from being returned to slavery. Unitarian minister, Thomas Wentworth Higginson, who was on the scene, helping to lead the mob, counted Batchelder as the first act of violence in the chain that leads to the firing on Fort Sumter.
There may have been others but the passage of Northern personal liberty laws that sought to prevent the return of people who had escaped bondage was probably one of the liveliest states rights issues in our early history. Hopefully, we’ll work the marijuana thing out in a much less dramatic fashion.