A growing number of states have legalized the production and sale of marijuana, either for medical or recreational purposes, or both. However, marijuana remains illegal under federal law. It is classified as a Schedule I drug under the federal Controlled Substances Act [21 U.S.C. Sec. 812], and that distinction can make a big tax difference — for marijuana sellers and buyers.
There is no question that income from selling marijuana is taxable under federal law. The tax law broadly taxes income “from whatever source derived,” whether that source is legal or illegal [IRC Sec. 61(a); see James v. U.S., 366 U.S. 213 (1961)].
However, while marijuana sellers clearly bear the burden of federal taxation, they won’t necessarily reap the benefits of federal tax law rules.
Code Sec. 280E, enacted in the 1980s, specifically provides that “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business … consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) ….” Thus, while most businesses can deduct all their “ordinary and necessary” expenses, that’s not the case for marijuana businesses.
Marijuana sellers can take write-offs against gross receipts for the cost of goods sold (COGS). The IRS acknowledges that Sec. 280E does not disallow a marijuana business’s adjustments to gross receipts for COGS, but those write-offs are more limited than for other businesses [IRS Chief Counsel Memorandum, 201504011]. Under longstanding rules, direct costs (e.g., purchase costs for a reseller or direct material and labor costs for a producer) are treated as COGS [IRC Sec. 471]. In addition, under current uniform capitalization (UNICAP) rules, COGS also includes certain indirect costs, such as handling expenses and payroll costs. However, those additional write-offs for indirect costs are not allowed for marijuana sellers. According to the IRS, the UNICAP rules, enacted after Code Sec. 280E, did not change the character of indirect expenses from nondeductible to deductible.
Thus, while marijuana sellers can claim COGS write-off for direct expenses, such as the invoice price of marijuana purchased for a reseller, or the costs of seeds or plants for a producer, the tax law currently disallows deduction for a whole host of ordinary and necessary expenses, such as rent, utilities, marketing and wage payments.
On the other hand, marijuana sellers can’t skimp on those expenses. For example, courts have held that an “illegal” marijuana business is still subject to the legal minimum wage and overtime requirements of the federal Fair Labor Standards Act (FLSA) [see, e.g., Kenney v. Herliz TCS, Inc., 284 F. Supp. 1186 (D. CO 2018)]. Moreover, it is clear that marijuana sellers must comply with the federal tax law requirements for withholding and paying payroll taxes, even though the underlying employee wage payments and the associated tax payments are nondeductible for income tax purposes.
Current federal tax law allows a deduction for unreimbursed medical expenses to the extent the total of such expenses exceeds 10 percent of adjusted gross income [IRC Sec. 231]. As a general rule, a deduction is allowed for the cost of a medicine or drug if the medicine or drug is prescribed by a physician [IRC 213(d)(3)]. However, medical marijuana is a different story.
A revenue ruling dating back to 1997, shortly after California became the first state to legalize medical marijuana, provides that an amount paid to obtain a controlled substance such as marijuana is not a deductible medical expense — even if state law requires and the taxpayer obtains a prescription from a physician [Rev. Rul. 97-9, 1997-1 CB 77].
Under IRS regulations, the term “medicine and drugs” includes only items that are “legally procured” [Treas. Reg. Sec. 1.213-1(e)(2)] — and that means “legally procured” under federal law. In the ruling, the taxpayer’s purchase and use of medical marijuana was permitted under state law. However, notwithstanding state law, the IRS ruled that a controlled substance, such as marijuana, obtained in violation of the federal Controlled Substance Act, is not “legally procured” for purposes of the medical expense deduction rules.
Health Savings and Reimbursement Accounts
Health flexible spending accounts (FSAs), health savings accounts (HSAs), medical savings accounts (MSAs) and employer-sponsored health reimbursement arrangements (HRAs) allow for the payment of qualifying medical expenses with tax-free dollars. However, the definitions of qualifying medical expenses for purposes of these accounts parallel the definition for medical expense deduction purposes. Consequently, the costs of medical marijuana will not qualify for tax-advantaged treatment under these accounts.
Technically, there’s nothing to prevent a taxpayer from paying for medical marijuana with funds in an HSA or MSA (although some accounts use restricted debit cards or credit cards that would prevent such payments). However, amounts used for medical marijuana will be treated as nonqualifying distributions that are subject to tax and a 20 percent penalty [IRC Sec. 220(f); 223(f)].
On the other hand, the rules are different for HRAs and FSAs. Distributions from those types of plans must be restricted to qualifying medical expenses – or the plan will be disqualified [Notice 2002-45, 2002-2 CB 93, Prop. Treas. Reg. Sec. 1.125-5(k) (1)].
Key point: Given the growing trend toward legalization of marijuana at the state level, federal lawmakers have introduced proposals to follow suit at the federal level. Most recently, for example, Representative Earl Blumenauer (D-OR) introduced the legislation to remove marijuana from the schedule of controlled substance under the Controlled Substances Act [Regulate Marijuana Like Alcohol Act, H.R. 420, 1/9/2019]. However, to date, those proposals have gone up in smoke.