As more and more states pass legislation either legalizing recreational marijuana or allowing medicinal marijuana, the more tax court cases we will see concerning marijuana businesses and their tax structure. Although marijuana may be legal in your state, the federal government considers it to be a Schedule 1 controlled substance and the sale of the drug is illegal.
Because the sale of marijuana is illegal federally, all marijuana businesses are subjected to Tax Code Section 280E which eliminates all business deductions except “Cost of Goods Sold (COGS). The code is applied to any business that consists of tracking a controlled substance and the IRS considers marijuana to be a controlled substance. This section of the code has created a great tax burden for marijuana businesses and has led to major decisions passed down from the U.S. Tax Court. We’re going to look at a few of these tax court decisions and how they will affect marijuana businesses across the country.
Alterman V. Commissioner
Altermeds was a medicinal marijuana business that was created in 2009 and sold marijuana it bought from third parties to its customers. It sold prerolled joints, buds and edibles to its customers, along with several products that did not contain marijuana like pipes, papers and other products that someone may use when using marijuana. After a Colorado law required medical marijuana businesses to grow at least 70% of it’s products, Altermeds began to produce its own inventory while still buying from other businesses. The IRS audited Altermeds for two years and disallowed all of the companies G&A expenses for those years due to Section 280E. This resulted in an underpayment of almost $400,000 to the IRS who also added on underpayment penalties. Altermeds argued that their business sold other non-marijuana merchandise and that this constituted a second business that was separate from the sale of marijuana and was not subject to Section 280E. Less than 4% of Altermed’s sales were of non-marijuana merchandise and so the court concluded that the sale of this merchandise was not a sperate business and could not stand on its own. Even if the Tax Court agreed with Altermed’s argument, none of the deductions attributed to the separate business would be allowed because Altermed’s failed to organize its expenses that were attributed to the business. They instead just took a percentage of the total G&A expenses and said that was due to the sale of non-marijuana merchandise.
One of the major takeaways from this case is that the IRS and The Tax Court are going to have a strict standard for marijuana businesses that are trying to establish multiple lines of business. If you are going to offer non-marijuana products, it’s important to set up a completely separate business entity and to maintain a separate expense record for that business. You need to treat it as its own business that has nothing to do with the marijuana. Keep income and expenses separate and be diligent in your bookkeeping so the IRS allows you to deduct those expenses. You must show that the alternate business is able to stand on its own, regardless of the marijuana business.
Alternative Health Care Advocates v. Commissioner
More recently the U.S. Tax Court issued an opinion regarding marijuana companies and their use of management companies. In this case, Alternative Health Care Advocates provided medical marijuana to Californians. Another company, the Wellness Management Group, provided management services to Alternative Health Advocates, including services like hiring and paying employees, managing HR for employees, paying advertising and marketing expenses and paying the rent and utilities. Wellness then made money by collecting fees for its services from Alternative. The management company did not provide services to any other company. The company was set up in hopes to avoid Section 280E and be able to take some business tax deductions as companies subjected to 280E can’t. The management company was arguing that since they didn’t sell marijuana, they were subjected to 280E. Unfortunately for Wellness, the Tax Court decided that Wellness’s management services were “trafficking” just as much as Alternative Health Care advocates were. This mean both companies were subject to 280E and all business deductions were eliminated. That means the money Alternative paid Wellness was taxed twice. The Tax Court says the double taxation was a direct result of how the businesses’ structure was put together.
Marijuana business owners are being advised to set up these management companies in an effort to avoid taxes but as we saw with Alternative, it is going to be tricky. If the Tax Court thinks the management company is just a stand-in for your marijuana business, chances are they will subject your management company to 280E as well. If you do decide to try a management company, it would be best to act as if the management company is subject to 280E as it’s better to plan to pay more in taxes than end up getting a huge tax bill after the IRS audits you.
If you are starting a marijuana business and aren’t sure how to set up your business entity and need help keeping your books straight, Polston Tax can help. We can help you set up your business in a way that will keep you compliant with both state and federal rules and maximize your savings. Call us today to set up a free consultation at 844-841-9857 or click below to schedule a free consultation.