Better Move Quick If Your Cataracts Are Acting Up: Tax Court Strikes Blow to Medicinal Marijuana Industry

We may well remember today as the day the Tax Court, with its decision in Olive v. Commissioner, 139 T.C. 2, put an endto themedicinal marijuana industry.

We previously dropped you a heads upthat theIRS has beenwielding a little known Code section — I.R.C. § 280E, to be exact— to wage war on medicinal marijuana facilities.Section 280E provides that no deduction shall be allowed for any amount incurred in a business that consists of trafficking in controlled substances. Since marijuana finds itself on Schedule I of the Controlled Substances Act, the IRS has the ammunition necessary to deny all deductions — rent, utilities, wages, etc…– of any facility that buys and sells the drug.

So despite the fact that more than 15 states have legalized the sale of marijuana for medical purposes, the IRSmay welleffectively tax the industry out of existence, as it’s hard to imagine that any company can survive while paying income tax on 100% of its gross revenue.

As best we can tell, prior to today, the application of Section 280E to medicinal marijuana facilities has only been litigated once since the birth of the industry. In Californians Helping to Alleviate Medical Problems, 128 T.C. 173, (2002), a medical marijuana facility suffered a partial victory in defending itself against the application of I.R.C. § 280E.While the Tax Court agreed with the Service’s position that Section 280E was applicable despite the legality of the facility, the court only applied the provision to deny the deductions of the business that were attributable to the buying and selling of marijuana. Because the taxpayers in Californians were able to effectively argue that only a portion of their business involved the trafficking of marijuana, with the rest of their business focusing on counseling customers on which type of marijuana would best treat their particular ailment, they were able to salvage the deductions attributable to the counseling segment of their business.

Today in Olive,the taxpayer wasn’t so lucky. Again theIRS had deniedall of the deductions ofthe medicinal marijuana facilitypursuant to I.R.C. § 280E, and this time, the Tax Court showed no leniency.

The Vapor Room — established as a sole proprietorship by its owner, Martin Olive — was a California facility whose sole source of revenue was its sale of medical marijuana. Patrons went to the Vapor Room to relax and smoke or inhale vaporized marijuana; they did not specifically pay for anything else connected with or offered by the facility. Olive sold the majority of the marijuana to his customers for cash, though he did give someawayfor free.

Upon an audit, the IRS hit Olive from all angles, asserting that he 1) understatedthe income of the Vapor Room, 2) overstatedthe cost of goods sold, and 3) was not entitled to any operating expenses under I.R.C. § 280E.

Olive and the IRS split on the first two issues. The Tax Court agreed with the IRS that Olive’s shoddy records — in typical burn-out fashion, he bragged that the industry “shun[s] formal ‘substantiation’ in the form of receipts” — did not adequately substantiate his revenue. As a result, the Court required Olive to include in income the revenue reflectedon one of Olive’s ledgers, which was significantly in excess of the amounts reported on his tax returns.

With regards to the cost of goods sold, the Tax Court refused to side with the Service’s assertion that because Olive’s records were lacking, he wasn’t entitled to any deduction for cost of goods sold. Instead, the court looked to the testimony of industry insiders to determine that on average, the cost of goods sold of medicinal marijuana facilities were approximately 75.16% of revenue. The court then reduced Olive’s COGS to account for the fact that he gave away some of his product for free, reasoning that because he gave it away, it wasn’t held for sale and thus couldn’t be included in cost of goods sold.

Lastly, in the issue that the entire industry will be analyzing over their Friday morning wake-and-bake, the Tax Court agreed with the IRS that the Vapor Room was not entitled to deduct any of its operating expense pursuant to I.R.C. § 280E.

Even more damning, the Tax Court refused to afford Olive the wiggle room it showed the taxpayer in Californians. Despite Olive’s contention that his business was similar to the one in Californians — equal parts the sale of goods and the provision of counseling services — the Tax Court was unconvinced.

Petitioner asserts that the Vapor Room’s overwhelming purpose was to provide caregivingservices, that the Vapor Room’s expenses are almost entirely related to the caregiving business and that the Vapor Room would continue to operate even if petitioner did not sell medical marijuana. We disagree. We find instead that petitioner had a single business, the dispensing of medical marijuana, and that he provided all of the Vapor Room’s services and activities as part of that business. The record establishes that the Vapor Room is not the same type of operation as the medical marijuana dispensary in CHAMP that we found to have two businesses.

In reaching its decision, the Tax Court established a precedent that it will hold a medicinal marijuana facility to a strict standard in establishing that it offers multiple lines of business.

Petitioner essentially reads our Opinion in CHAMP to hold that a medical marijuana dispensary that allows its customers to consume medical marijuana on its premises with similarly situated individuals is a caregiver if the dispensary also provides the customers with incidental activities, consultation or advice. Such a reading is wrong. Petitioner also has not established that the Vapor Room’s activities or services independent of the dispensing of medical marijuana were extensive. We perceive his claim now that the Vapor Room actually consists of two businesses as simply an after-the-fact attempt to artificially equate the Vapor Room with the medical marijuana dispensary in CHAMP so as to avoid the disallowanceof all of the Vapor Room’s expenses under section 280E. We conclude that section 280E applies to preclude petitioner from deducting any of the Vapor Room’s claimed expenses.

What’s the lesson? Obviously, it’s a strange dichotomy of authority the medicinal marijuana industry finds itselfgoverned by. Blessed by state law, but persecuted by the IRS. In light of the Tax Courts decisions in Californians and now Olive — and understanding that there are at least two more I.R.C. § 280E cases working their way through the legal system — its hard to foresee any way the industry can survive.

For more information about our Tax Controversy Services, fill in the form below and our team will be in touch.