In recent years, the use of medical marijuana has been on the increase. Indeed, at least 24 states plus the District of Columbia have made medical marijuana legal with more likely to follow. Can the widespread sale of recreational marijuana be far behind? It is already legal for recreational use in four states plus DC. This is not about whether or not marijuana should be legal for medical or recreational use, it is about the tax hurdles faced by businesses that sell marijuana.

Regardless of what action has been, or will be taken by the states, Federal law classifies marijuana as a Schedule 1 drug under the Controlled Substances Act meaning that Federal law considers the sale of marijuana as an illegal business. Additionally, under tax law, income tax is owed on profits realized in the operation of an illegal business. Indeed, it was the IRS and not the FBI that brought down Al Capone, as he was charged with tax evasion from failure to report illegal income.

Normally, operation of an illegal business does not present any tax problems. Report your income, deduct expenses, pay taxes and all is well with the IRS. In a Supreme Court case, it was noted that deductions are “a matter of grace” and Congress can disallow them as it chooses (and they so chose). In 1982, Congress enacted Code Section 280E which disallows business expense deductions for any business illegally trafficking in controlled substances. Ordinary and necessary business deductions are therefore disallowed for a business selling marijuana, even if permitted under state law.

All is not lost, however. “Gains derived from dealing in property” has been interpreted as Gross Sales minus Cost of Goods Sold (COGS). COGS is determined under Code section 263A, meaning the business can count as inventory the acquisition costs plus handling and storage expenses along with a pro-rated portion of certain business expenses.

What the business cannot deduct are the normal operating and sales expenses associated with that business. There are several implications here. First, if other products or services are sold, the business should be operated as though they two separate businesses with separate accounting for each. This assures that the business can demonstrate which expenses do not apply to the marijuana trade. Expenses common to both may be allocated between the two using a reasonable methodology.

Second, if the drugs are seized, they are not COGS but an inventory loss similar to a casualty or theft loss and not deductible.

A third issue arises with the excise tax many states levy on the sales of legal marijuana. The dollar amount of these can be significant. It has been held that these are taxes on the sale of property and a permitted reduction in the amount realized from the sale.

There is one other complication that may arise from the operation of a marijuana business. Under Federal law a bank, credit union, or other financial services company may not knowingly accept business accounts with businesses selling illegal drugs. So the business may have difficulty in making required tax deposits. An interim partial solution allows abatement of penalties if the company is legal under state law and can prove their inability to obtain a bank account.

Hopefully, these issues will be resolved as state and Federal laws are made compatible in this area.