Source: http://www.keytlaw.com/arizonamedicalmarijuanalaw/2011/02/medical-marijuana-dispensaries-deductibility-nightmare/
Timestamp: 2017-05-26 11:18:26
Document Index: 157983713

Matched Legal Cases: ['§ 36', '§ 36', '§ 36', '§ 36', '§ 36', '§ 36', '§ 36']

Medical Marijuana Dispensaries; the Deductibility Nightmare
Medical Marijuana Dispensaries; the Federal Income Tax Deductibility Nightmare	Given the recent enactment of the Arizona Medical Marijuana Act, we anticipate a number of new business enterprises in the Arizona market attempting to comply with its “dispensary” provisions. Thoughtful entrepreneurs engaged in this fledgling industry will be wondering whether they will be permitted to deduct the expenses incurred in their business operations. This article will consider relevant tax provisions and attempt to provide a meaningful “rule of thumb” that these businesspersons, or their tax preparers, may find useful.
The starting point for determining “deductibility” of a business’s expenses is Internal Revenue Code Section 162. In general, the primary “rule of thumb” is that a business may deduct all expenses that are “ordinary and necessary” as long as they are “reasonable”. While these are often-used words in the English language, a couple of perhaps unusual implications (both of which are taxpayer friendly) should be noted before one thinks they understand this requirement. First, “ordinary” does not mean that the expense need be frequently encountered in the taxpayer’s industry. The law is not intended to penalize the innovator. A creative businessperson who attempts a new way of conducting business should not automatically be precluded from claiming a deduction for the “new” expenses.
Secondly, “necessary” does not mean that an expense must be incurred in order to be deductible. Only that the businessperson believes that the expense will be appropriate and helpful in conducting business. It may turn out that the expenditure was not actually helpful, but it still may have been believed “necessary”. Finally, even an “ordinary and necessary” expenditure must be “reasonable” when alternatives are considered. As one might guess, these requirements are not often used to actually limit the deductibility of expenses incurred in business operations when the owner honestly believes that such expenditures were actually business related.
A more frequently seen limiting factor is also found in Section 162. Specifically, payments that are illegal or against public policy are defined as not deductible. Sec. 162(c)(2) states that to be nondeductible the “illegal” payment must subject the payor to criminal penalty or to the loss of its business license. IRS regulations clarify that the important test is being “subject to” the criminal penalty – not that the criminal penalty actually be imposed in a given situation. Of course, this distinction may offer a bit of room for argument about whether the payment would have actually subjected the payor to the penalty (since none was actually imposed).
Revenue Ruling 62-194 is an early explanation of the public policy doctrine. It holds that a payment, even if not actually illegal, will not be deductible if it is against public policy. A number of court cases have “explained” this concept over the years and provided examples of expenditures that were found to have been against public policy. However, this limitation has not often been cited as the sole reason to disallow the deductibility of an expense and is now (since 1969) seldom seen as an actual threat in and of itself. In fact, Regulation 1.162-1(a) now states that a deduction (of “ordinary and necessary” business expenses) will not be disallowed solely because it is a violation of public policy. It should be noted, however, that the IRS will still use the “public policy” argument to disallow Sec. 165 losses (ie. confiscation of property) – see Revenue Ruling 77-126 and Technical Advice Memorandum 200629030.
Against this backdrop, we have a number of cases that have analyzed the operations of an “illegal” business and concluded that such business was, in fact, entitled to deduct its “ordinary and necessary” expenses. For example, see the 1958 Supreme Court case, Comr. V. Sullivan 356 US 27. The way to think about this issue is that one must examine the nature of the expenditure itself (is it legal ?) vs. the nature of the business – which may, in fact, be illegal. An expenditure that is itself illegal (and would subject the payor to criminal penalties) is not deductible.
Thus, in general, an illegal business would be permitted to deduct “ordinary and necessary” expenses incurred, which were not in themselves “illegal” expenditures, but would not be able to deduct any expenditure that was itself illegal.
Ability to Deduct Expenses
Given the way case law had developed in this area, and the still pervasive “public policy” issues surrounding the use of drugs in our culture, Congress passed a new law that was to be applied specifically to an “illegal drug business”. In 1982, Section 280E became effective and states that no deduction for any amount incurred in carrying on any illegal drug sale or business would be allowed. Thus, it would appear that Congress effectively overturned the existing “illegal business” case law as it pertains to dispensary operations. Their intentions seemed to be that public policy mandated that a severe penalty be imposed for those engaging in illegal drug activities and while they were probably not thinking of dispensaries when the law was passed, the statute has certainly ensnared the industry.
As is so often the case, what seems to have evolved is a bit different than one might have expected just from a superficial reading of the law. As this law began to be enforced, it was determined that a “deduction” was different from a “reduction to gross income” (ie. cost of goods sold). Thus, under Section 280E, although the drug dealers are no longer permitted any deductions incurred in connection with their illegal trade, it has been decided that they are permitted to offset their revenue with the cost of their inventory (Sundel v. Comr 75 TCM 1853).
Since Section 280E had been enacted specifically to deal with an “illegal drug business”, the previous tax concepts related to other illegal businesses were no longer considered applicable to an illegal drug business. Thus, under this new statute, the rules have been, in effect, turned upside down for the drug industry. While the drug dealers can no longer deduct otherwise legal “ordinary and necessary” expenses, they may, in effect, deduct the cost of their illegal purchases, the drugs. Rather ironic, given the apparent purpose of the Section.
The cases to date that have dealt with Section 280E have, for the most part, seen the deduction limitations imposed on taxpayers that have had rather poor accounting systems (based upon the facts evident in the published records). The courts have ended up permitting the cost of goods deduction frequently based solely upon estimates provided by the government. I predict that this will change as the dispensary industry grows and becomes more sophisticated.
Over the past decades, businesses in general have experienced increasing efforts by the IRS to capitalize additional costs as part of their recorded inventory (this will result in higher taxable income). They have modified their accounting systems to accommodate “full absorption” accounting, Section 263A accounting and court cases that have refined the definition of “inventory”. A cost accountant should be able to assist the business in identifying and capitalizing numerous otherwise “ordinary and necessary” expenses as inventory in order to comply with these concepts. That is, hopefully, convert disallowed deductions to permitted cost of goods sold.
It should be noted that this ability for an illegal drug business to capitalize otherwise “ordinary and necessary” expenses should be expected to come under attack by the IRS. Although it is certainly a requirement that most businesses capitalize such expenses, various regulations (see, for example, Regs. 1.471-3(d) and 1.263A-1(c)(2)) prohibit the capitalization of expenses “not otherwise deductible” and may, arguably, be considered applicable in these cases. Here, the interplay between the “new”, Section 280E and its developing case law, and the “old” will become severely contested in the courts. Although the outcome of this conflict is uncertain, I believe that the importance of a good cost accountant should become obvious to dispensary owners very quickly.
Another accounting concept that may come into play is the idea that a business entity can easily encompass more than one line of business. Although the expenses of the illegal drug business are nondeductible, the deductions of other business activities will remain deductible. Thus, the business owner will want to install a good accounting system and ensure that all deductions are properly allocated among the various businesses.
This appears to be the state of the law today. It is already being applied to dispensaries created under the medical use statutes (see Californians Helping to Alleviate Medical Problems, Inc. v. Comr 128 TC 173 (2007)).
It should be noted that although the above analysis is believed to have arrived at the correct conclusion, this writer finds that the level of uncertainty seems slightly higher than usual after the given amount of research. Given the politically charged nature of the topic, it feels as though it is more likely than not that some future judicial decision will shed new light on this question of deductibility and may certainly have the potential to surprise us. The answer to the question of what a dispensary will ultimately be permitted to deduct still remains a bit uncertain. However, I suspect that, for an entrepreneur willing to enter this business, with its numerous legal questions that have yet to be answered, this question will probably not be the one that causes him/her to lie awake at night.
Lance Meilech is a Certified Public Accountant practicing with the firm of AddingMachine.com in Phoenix. He has earned a Masters in Taxation and has been licensed as a CPA in Arizona since 2004. As a licensed professional, he provides a full range of accounting and tax services, including accounting and tax services for Arizona medical marijuana dispensaries. However, neither this article nor the author purport hereby to offer legal, tax or accounting advice in any form. This article is not a comprehensive assessment of issues that might be experienced in a particular business operation. Each reader’s situation is dependent on his/her facts and circumstances. As a result, each reader should consult his or her own advisor for information concerning his or her specific situation or may contact the author at info@addingmachine.com. Call Lance at 602-943-2060.
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2011-02-17T07:56:34+00:00	February 16th, 2011|Tax Issues|1 Comment	Share This Story, Choose Your Platform!
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Stakes Are High As Medical Marijuana Test Case Heads To Tax Court	One Comment	joncon
February 16, 2011 at 1:34 pm	Very interesting, anyone entertaining owning, operating, growing or working for a Arizona MM Dispensary would be seriously flawed in their ignoring the fact that if they file an IRS Federal Income Tax Form whichever 1099 W-2 SIGNED etc. this will be a written/signed acknowledgment/statement on a Federal document that by their signature they are in-fact part of an ongoing Criminal Enterprise from which they have or continue to profit!
I’m not sure what the Statue of Limitations are for these Federal Crimes or whether the DEA, DOJ, IRS will convene a Task Force to begin seizure of all funds, bank accounts, homes, cars, boats and any other assets from these ill-gotten funds produced from the MM business ownership/employment or any other connections to the trade, BUT who needs money besides the 90 plus percenters’ who only see the millions of dollars they are already spending if they get a dispensary license in AZ.
Certainly this current US administration don’t need no dam money… but why are they hiring 1100 more IRS agents oh yeah to make sure the additional 10% tanning salon tax gets paid… wonder what the other 1050 agents will be doing, oh sure of-course I forgot enforcing obamacare!!! How many CPA’s are REALLY ready to sign-off on dispensaries owner & their employee Federal Taxes especially when they know that I Mr. dispensary owner knows there’s more than a dozen ways to skin a not-for-profit and I’m already running an ongoing Criminal Enterprise “RICO nah they wouldn’t do that” so what hell a few more Federal Counts.
Personally I would NOT pay a cent in taxes I’d save it all for legal defense’s for when NOT if the G decides it’s time to ring the dinner bell and let the dogs out!
All the Legal States are in the same boat, lot of monies have been made and I’d bet a lot of Federal Income Taxes have been filed… talk about a money trail even a blind rookie IRS agent could follow. Interesting
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