Thirty states and the District of Columbia currently have laws broadly legalizing marijuana in some form. However, marijuana remains illegal under Federal law, and this creates an uncertain landscape for marijuana businesses in the preparation of their Federal income tax returns and in handling an IRS audit. In addition, marijuana businesses must be aware of cash handling issues. This article addresses a few of the common tax issues facing marijuana businesses and why these businesses should seek the advice of a tax lawyer in any communications with the Internal Revenue Service.
Section 280E, Business Expenses, and Costs of Goods Sold
In very general terms, the Internal Revenue Code (IRC) allows businesses to deduct “ordinary and necessary” expenses incurred during the taxable year in carrying on a trade or business. See specifically IRC Section 162.
However, under IRC Section 280E, businesses are prohibited from deducting business expenses or taking credits related to income from the sale of federally controlled substances, including marijuana. Interpreted strictly, IRC Section 280E prohibits a marijuana business from deducting any business expenses – even salaries, wages, employee benefits, training, rent, travel, advertising, and depreciation.
Attempts to fight Section 280E in Tax Court have been unsuccessful. For example, the IRS audited Canna Care Inc., a California medical marijuana dispensary, and denied Canna’s deductions for operating expenses, including significant amounts for employee salaries and vehicle expenses. The company appealed the IRS’ findings to the United States Tax Court. Relying on section 280E, the Court upheld the IRS’ determination and denied all of Canna’s deductions. See Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206.
However, in Californians Helping to Alleviate Medical Problems, Inc., v. Commissioner, 128 T.C. 173 (2007)(“CHAMP”), the government acknowledged that Section 280E does not prohibit a taxpayer from claiming costs of goods sold (COGS). Footnote 4 of the opinion provides as follows: “respondent [the IRS] concedes that the disallowance of sec. 280E does not apply to costs of goods sold, a concession that is consistent with the caselaw on that subject and the legislative history underlying sec. 280E.” The CHAMP Court also allowed business expense deductions related to the taxpayer’s separate counseling and caregiving business. According to the Court, “section 280E does not preclude petitioner from deducting expenses attributable to a trade or business other than that of illegal trafficking in controlled substances simply because petitioner also is involved in the trafficking in a controlled substance.”
Most recently, on June 13, 2018, the United States Tax Court issued its opinion in Alterman & Gibson v. Commissioner, T.C. Memo. 2018-83.
During the years before the Court, the taxpayers owned a medical marijuana dispensary in Colorado. The dispensary sold smokable marijuana as well as edibles. It also sold marijuana paraphernalia such as pipes, papers, and other items used to consume marijuana. The IRS audited taxpayers and allowed their costs of goods sold, but disallowed all business expense deductions (under Section 280E) except depreciation.
The Tax Court upheld the IRS’ disallowance of all business expense deductions, even those related to that portion of the taxpayers’ business that sold non-marijuana products such as marijuana paraphernalia. Specifically, the Court stated:
Under the circumstances, we hold that selling non-marijuana merchandise was not separate from the business of selling marijuana merchandise. First, Altermeds, LLC, derived almost all of its revenue from marijuana merchandise. Second, the types of non-marijuana products that it sold (pipes and other marijuana paraphernalia) complemented its efforts to sell marijuana. Altermeds, LLC, had only one unitary business, selling marijuana. If, however, selling non-marijuana merchandise were considered a separate business, then the expenses of that business would be deductible. See CHAMP, 128 T.C. at 183-185.
In sum, the Alterman Tax Court opinion reemphasizes the Court’s past rulings related to marijuana businesses: (1) business expenses are not deductible under Section 280E; (2) costs of goods sold are allowable, as long as they are calculated correctly; and (3) business expenses may be deductible if a marijuana business also conducts a second, ancillary business that is completely separate from the sale of marijuana.
The challenges inherent in fighting back against an IRS audit were also exposed in the Tax Court case of Feinberg v. Commissioner, T.C. Memo. 2017-2011. In that case, the IRS audited a Colorado business licensed for the cultivation and sale of medical marijuana. The IRS disallowed business expense deductions under 280E and also made adjustments to the business’ claimed costs of goods sold. The COGS adjustment was the main issue before the Tax Court. Interestingly, the IRS actually reclassified some of the business’ deductions as COGS, giving the taxpayers greater COGS than originally claimed on its returns. At trial, the business produced no business records pertaining to its operations. Instead, it chose to rely exclusively on an expert report provided by an accountant who specializes in marijuana industry cost accounting. The business contended that its expert report established that the COGS allowed by the IRS were incorrect.
The Tax Court concluded that under Federal Rule of Evidence 702, the expert report was not admissible. Specifically, the Court stated: “The conclusions in the [expert] report are an attempt to present reconstructed income tax returns as evidence of petitioners’ correct tax liabilities. The report is not based on personal knowledge of THC’s business. To determine the correct COGS for THC, substantiation of THC’s expenses is necessary. A reconstructed income tax return based on industry averages does not take the place of substantiation and does not help determine a fact in issue.”
The marijuana business also argued that it should be allowed greater COGS than what the IRS allowed under the Cohan rule. Under Cohan, the Tax Court may estimate the amount of a deductible expense if a taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount. The Cohan rule also applies to COGS. However, in Feinberg, the Tax Court found that even under Cohan, there must be sufficient evidence in the record to provide a basis upon which an estimate can be made; because the business provided no evidence to support COGS higher than what the IRS allowed, the Court upheld the IRS’ final COGS adjustment. The Feinberg case highlights the importance of retaining a competent tax attorney when dealing with any IRS audit, especially if the audit results in litigation in U.S. Tax Court.
IRS Audits of Gross Receipts
Marijuana businesses must also be concerned with IRS audits of their gross receipts, specifically, the IRS’ use of indirect methods of proof. Although neither the Tax Code nor Treasury regulations define or specifically authorize the use of indirect methods of proof, case law has held that indirect methods of proof are acceptable and they need not be exact, but must be reasonable in light of surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954).
The IRS will use indirect methods of proof under various circumstances, including: books and records do not accurately reflect total taxable income received and the revenue agent has established the likelihood of unreported income; expenses appear to exceed income; irregularities in the taxpayer’s books and records; gross profit percentage changes significantly from one year to another; taxpayers’ bank accounts have unexplained deposit items; taxpayer does not make regular deposits and uses cash; tax returns show significant increase in taxpayer’s net worth which is not supported by recorded income; and no method of accounting has been regularly used or the method does not clearly reflect income.
The IRS uses a variety of indirect methods of proof including: the bank deposits analysis (most common), net worth analysis, cash-t analysis, and the mark-up method.
Anytime the IRS intends to perform an indirect method of proof audit of gross receipts, the taxpayer should consult with a tax attorney, as there are exposure risks including a potential IRS criminal investigation or civil fraud referral. A competent tax attorney can advise of these risks and can help limit the taxpayer’s exposure. A tax attorney can also defend against the conclusions drawn by the IRS agent after he or she completes an indirect method of proof audit.
Marijuana businesses must also be concerned with the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of Treasury that collects and analyzes information about financial transactions in order to combat money laundering and other financial crimes. FinCEN’s self described mission is to safeguard the nation’s financial system from illicit use and money laundering and to promote national security by collecting, analyzing, and disseminating financial intelligence. To that end, the Bank Secrecy Act (BSA) requires financial institutions to file currency transaction reports (CTRs) for cash transactions exceeding $10,000 (daily aggregate amount) with FinCEN. It also requires institutions such as banks, money services businesses, securities firms, insurance companies, casinos, and loan and finance companies, to file suspicious activity reports (SARs) anytime a transaction doesn’t make sense, is unusual for that particular client, appears to be done for the purpose of hiding or obfuscating a transaction, or show deposits structured to avoid CTR requirements (i.e., multiple deposits totaling over $10,000 but divided up to avoid the $10,000 threshold). CTRs and SARs are important tools that FinCEN uses and shares with other regulatory agencies – including the IRS – in its attempt to combat money laundering and the use of Federally backed financial institutions to hide illicit monetary transactions.
A 2014 FinCEN memo stated as follows: “Because federal law prohibits the distribution and sale of marijuana, financial transactions involving a marijuana-related business would generally involve funds derived from illegal activity. Therefore, a financial institution is required to file a SAR on activity involving a marijuana-related business (including those duly licensed under state law) in accordance with this guidance and FinCEN’s suspicious activity reporting requirements and related thresholds.” Therefore, in no uncertain terms, under Federal law, a bank must file a SAR whenever it conducts a transaction with a marijuana-related business, even when the transaction is below the CTR $10,000 threshold.
In addition, because marijuana businesses deal largely in cash, they must be aware of Form 8300 requirements. Any business that receives more than $10,000 in cash in a single transaction or related transactions must complete a Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business. Form 8300 is a joint form issued by the IRS and FinCEN. Marijuana businesses, especially wholesalers, must be cognizant of Form 8300 filing requirements.
The IRS began auditing Colorado marijuana businesses related to their Form 8300 filing requirements in 2016. One business owner, who wished to remain anonymous, reported that some of the marijuana business directed audits came from the IRS’ fraud division. In all of the Colorado Form 8300 audits, the IRS used a questionnaire and posed questions unrelated to Form 8300 requirements. For example, the questionnaire asked the following questions: How did you get started in the business? Who are your competitors in the wholesale marijuana industry? If a bank account exists is all of the cash deposited into the bank account? Asking beyond the audit scope, open-ended questions is a tactic commonly used by IRS revenue agents and why it is important to retain an experienced tax attorney whenever the IRS conducts an audit or investigation, no matter how well the business has maintained its books and records, and stayed in compliance with federal tax obligations and Form 8300 filing requirements.
If you own a business selling, growing, or producing marijuana, you need to work with an experienced tax lawyer to understand your tax rights and responsibilities. The landscape is changing so quickly that you need a legal advocate on your side to help you navigate it all. If your business is audited and you don’t have detailed information about every single transaction, you risk forfeiting your COGS claim and you could be subject to penalties for filing an inaccurate tax return.
Silver Law PLC operates in Arizona and Nevada and all of its lawyers are former trial attorneys for the IRS. A tax lawyer from our team can help you understand how the complex Tax Code applies to your marijuana business operations. We’ll help you ensure that you are meeting your obligations. If you have been audited or are facing collections, we are also in a position to help you navigate that process. We can either find ways to bring down your tax debt or can negotiate a settlement for you. Call us today and talk with a tax lawyer in Las Vegas or Phoenix to learn more.
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