Pot Dealer's Appeal Goes Up in Smoke; Expenses of Medical Marijuana Business Aren't Deductible.

(Parker Tax Publishing July 20, 2015)

While a taxpayer's medical marijuana dispensary business was legal under California law, Code Sec. 280E precluded him from deducting any amount of ordinary or necessary business expenses associated with the business, other than cost of goods sold, because it was a trade or business consisting of trafficking in controlled substances prohibited by federal law. Olive v. Comm'r, 2015 PTC 229 (9th Cir. 2015).

Background

In 2004, Martin Olive quit college and opened a medical marijuana dispensary in California. The dispensary had a single business, the distribution of medical marijuana. Olive sought the help of local friends and marijuana suppliers and began operating the unlicensed medical marijuana dispensary, which he named "The Vapor Room," as a sole proprietorship. The Vapor Room was a place where its patrons, almost all of whom were recipients under the California Compassionate use Act of 1996 (CCUA) (including some with terminal diseases such as cancer or HIV/AIDs), could socialize and purchase and consume medical marijuana.

Gross sales grew from over $1 million the first year to $3 million the second year. However, because of expenses, the amount of net income reported to the IRS was small. Upon auditing the business, the IRS assessed tax deficiencies and penalties because the IRS concluded that Code Sec. 280E precluded any deductions. Under Code Sec. 280E, a taxpayer cannot deduct any amounts, other than cost of goods sold, for a trade or business where the trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances prohibited by federal law.

OBSERVATION: The Tax Court allowed Olive to deduct his costs of goods sold, but because of questionable substantiation concluded that 75.16 percent of sales was a reasonable measure of the Vapor Room's COGS. Those deductions were not at issue before the Ninth Circuit.

Olive argued that his business did not consist of illegal trafficking in a controlled substance because the business was legal under California law. Thus, Code Sec. 280E did not apply. The Tax Court did not agree and, in Olive v. Comm'r, 139 T.C. No. 2 (2012), held that Code Sec. 280E precluded Olive from deducting any amount of ordinary or necessary business expenses associated with the operation of the Vapor Room dispensary because it was a trade or business consisting of trafficking in controlled substances prohibited by federal law. Olive appealed to the Ninth Circuit.

Analysis

On appeal, Olive focused on the wording in Code Sec. 280E. His argument relied primarily on the phrase "consists of." According to Olive, the use of the words "consists of" were most appropriate when a listing is meant to be exhaustive. The word "consisting," he argued, was not synonymous with the word "including." Relying on that proposition, Olive contended that, for Code Sec. 280E purposes, a business "consists of" a service only when that service is the sole service that the business provides. Because the Vapor Room provided caregiving services and sold medical marijuana, Olive said that his business did not "consist of" either one alone and therefore did not fall within the ambit of Code Sec. 280E.

To support his line of reasoning, Olive cited the Tax Court's decision in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173 (2007). In that case, the taxpayer's income-generating business included providing not only medical marijuana, but also extensive counseling and caregiving services. The Tax Court concluded that the business's primary purpose was to provide caregiving services to its members and that its secondary purpose was to provide its members with medical marijuana. After considering the degree of economic interrelationship between the two undertakings, the Tax Court concluded that the taxpayer in CHAMP was involved in more than one trade or business.

Olive also argued that Code Sec. 280E should not be construed to apply to medical marijuana dispensaries because those dispensaries did not exist when Congress enacted Code Sec. 280E. Congress added that provision, he argued, to prevent street dealers from taking a deduction. According to Olive, Congress could not have intended for medical marijuana dispensaries, now legal in many states, to fall within the ambit of "items not deductible" under the Internal Revenue Code.

The Ninth Circuit affirmed the Tax Court and held that Code Sec. 280E precluded Olive from deducting any amount of ordinary or necessary business expenses associated with the Vapor Room dispensary because it was a trade or business consisting of trafficking in controlled substances prohibited by federal law. The court called Olive's reliance on the CHAMP decision misplaced. To illustrate the difference between the Vapor Room and the business in CHAMP, the court drew an analogy between a business that sold books and offered its customers comfortable chairs and complimentary cookies and a business that sold books but also operated a cafin which customers could buy coffee and pastries. The latter business, the court noted, operated two trades or businesses while the former only operated one trade or business.

With respect to Olive's argument that the Ninth Circuit should consider Congressional intent in enacting Code Sec. 280E, the court said that had no bearing on its analysis. It is common for statutes to apply to new situations, the court noted, and found that the application of the statute was clear. According to the court, application of the statute did not depend on the illegality of marijuana sales under state law; the only question the court could ask was whether marijuana is a controlled substance prohibited by federal law. If Congress now thinks that the policy embodied in Code Sec. 280E is unwise as applied to medical marijuana sold in conformance with state law, the court concluded, it can change the statute but the court could not.

OBSERVATION: Even though states such as Washington and Colorado have begun legalizing both medical and recreational use of marijuana, it remains a controlled substance at the federal level. Accordingly, businesses that sell marijuana are still trafficking in controlled substances for purposes of Code Sec. 280E, and likely will be subject to the limitations on deductions imposed by that section for purposes of calculating their federal income taxes.

For a discussion of the nondeductibility of expenditures incurred in connection with the illegal sale of drugs, see Parker Tax ¶96,512. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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