Let’s journey back to 1981.  REO Speedwagon just sold out and did a ballad.  Ronald Reagan is in the White House and his wife Nancy’s response to the crack cocaine epidemic is to, “Just say No.”  John Lennon was murdered by a psycho and Paul McCartney was the most hated person in America because of his response to his chum’s death.  The video game revolution has begun with arcades springing up all over the landscape offering games like Pac-Man and Asteroids.  The Houston Astros had those ugly multi-colored home jerseys and the Oakland Raiders won the Super Bowl, directly before they split and moved to LA. 

Now imagine falling asleep in Algebra class in 1981 and waking up in 2017.  You might be surprised to learn that marijuana is legal in 28 different states and the District of Columbia.  However, for all those involved in the ‘legal’ marijuana business, the 80’s are still haunting you.

Jeffrey Edmonson was a drug dealer who got caught in the 1970’s and was put in prison for many years.  Because of the “War on Drugs” that was in full swing when he got out of jail in the ‘80’s, the government decided it was the perfect time to stick it to him again.  They chose to audit his 1974 tax return, knowing full well that he was selling drugs that year.  The IRS reconstructed his drug sales income in order to get money out of him for taxes.  Back then, when someone got arrested for dealing drugs, the government would then attempt to extract taxes from your income. Just because the income was illegally gained, didn’t mean the IRS didn’t want their piece of the pie. 

But Mr. Edmonson outsmarted them.  The IRS was trying to reconstruct his income as if he were self-employed.  They said that he was in business for himself, so he took it a step further and introduced his expenses.  No drug dealer back then would think of keeping a paper trail, after all, they had just nailed Al Capone for tax fraud.  Mr. Edmonson’s attorney, however, knew about something called the Cohan Rule.  By applying the Cohan Rule, you could reasonably expect to have some expenses for any income that you receive, if you are in business for yourself. The IRS only wanted taxes on the income, but they weren’t giving him any credit for his expenses.  Mr. Edmonson had a different view – he figured that he had already paid his price and done his time in prison. He and his attorney took the matter all the way to the US Tax Court.

In this 1981 case, Jeffrey Edmondson v. Commissioner, the petitioner was considered self-employed, having sold amphetamines, cocaine and marijuana as his primary business. He received 1.1 million amphetamine tablets, 100 pounds of marijuana and 13 ounces of cocaine on consignment in 1974.  Edmondson did not have a beginning inventory, yet had an ending inventory of 8 ounces of cocaine. He did not keep any books or records of sales and expenses. However, he was required to reconstruct his income and expenses for the purposes of filing his 1974 tax return in response to a jeopardy filing made by the IRS in 1975. He claimed $105,300 in Cost of Goods Sold (COGS) in 1974.  In addition to COGS, Edmonson had other expenses. In the opinion of the court, the judge allowed the COGS but also telephone, auto and rental expenses.

Congress didn’t like that, and in 1982 they enacted Section 280E, which disallowed all expenses except COGS for Federally illegal activities. 

Believe it or not, we are still dealing with 280E today.  Under federal law, cannabis is treated like every other controlled substance, such as cocaine and heroin. The federal government places every controlled substance in a schedule according to its relative potential for abuse and medicinal value. Cannabis is classified as a Schedule I Drug, which means that the federal government views it as highly addictive and having no medicinal value. Doctors may not "prescribe" cannabis for medical use under Federal law, though they can "recommend" its use under the First Amendment.  That being said, cannabis businesses everywhere are now dealing with Section 280E.

At this point in the game, under Section 280E, when you filed your Federal Tax Return the only expense that you could deduct from your return is the cost of the cannabis.  You couldn’t deduct salaries paid to employees, rent, utilities, telephone, or any other expenses.  But then the US Tax Court again came to the rescue.

In 2007, in the case of Californians Helping to Alleviate Medical Problems (CHAMP) Inc. v. Commissioner, the U.S. Tax Court held that a business that operated both a marijuana dispensary and provided caregiving services to patients could divide its business expenses and deduct the expenses associated with the caregiving activities. Even though Section 280E still prevented it from deducting any of the expenses associated with its dispensary operations.

To drive home this point once again, in Canna Care, Inc. v. Commissioner, the Court once again found that under Section 280E, no deduction was allowed for operating expenses due to the fact that marijuana is a controlled substance, and at the federal level, selling it is considered trafficking in the sale of narcotics.  In this case, Canna Care offered other services similar to the CHAMP case and those expenses were allowed. 

Currently, Harborside is the country’s largest cannabis dispensary, grossing $30 million in sales. It has three locations and a network of 225,000 patients. They are even taking it a step further and trying to get Section 280E repealed. In June of 2016, Harborside spent a week in Tax Court over a $2.4 million bill from the IRS.

While we await that case to make its way through court, what can you do as a cannabis entrepreneur?  Just like anything else, you need someone on your team that knows these laws inside and out.  My firm started the Cannabis Accounting Group to help our own clients in the cannabis industry and we now offer one-of-a-kind expert advice in the taxation of Cannabis businesses. 

For most businesses, tax planning is a year-round activity.  However, in the cannabis industry, if you don’t have someone that knows how to professionally navigate tax laws, it might end up costing your business hundreds of thousands in tax dollars.

Craig W. Smalley, MST, EA, has been admitted to practice before the Internal Revenue Service as an Enrolled Agent, has a Masters in Taxation, and is a Certified Tax Resolution Specialist.  In practice for 23 years, he is the CEO and Founder of Cannabis Accounting Group, CWSEAPA®, PLLC, and Tax Crisis Center®, LLC.  All three companies have offices in Delaware, Florida, and Nevada.  He has been published in the New York Times, Chicago Tribune, NASDAQ, Yahoo Finance, and Christian Science Monitor, and is a Columnist for accounting trade journals Accounting Web, Accounting Today and AICPA Tax Insider.  He specializes in taxation of the cannabis industry, and is well versed on U.S. Tax Court Cases.  Finally, Craig has appeared as a guest on countless radio shows and podcasts.  He can be reached at craig@cwseapa.com, www.cannabisaccountinggroup.com or 1-844-CWSEAPA