Stakes Are High As Medical Marijuana Test Case Heads To Tax Court

Stakes Are High As Medical Marijuana Test Case Heads To Tax Court

Colorado may make headlines when it comes to revenues from the sale of marijuana, but California is making the news when it comes to marijuana-related taxes. A test case challenging the Internal Revenue Service (IRS) interpretation of expenses related to the sale of medical marijuana is headed to court: on Monday, June 6, Harborside Health Center, the country’s largest medical marijuana dispensary, will be in Tax Court to argue the application of section 280E of the Internal Revenue Code.

Under current federal law, marijuana is classified as a Schedule I drug, putting it in the same category as heroin, lysergic acid diethylamide (LSD), and ecstasy, among others. According to the Drug Enforcement Agency (DEA), “Schedule I drugs are considered the most dangerous class of drugs with a high potential for abuse and potentially severe psychological and/or physical dependence.” They are defined as “drugs with no currently accepted medical use.”

Despite federal law, twenty-five states and the District of Columbia currently have lawslegalizing marijuana for either medical or recreational use. States which allow marijuana for medical use include Alaska, Arizona, California, Colorado, Connecticut, Delaware, Hawaii, Illinois, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Montana, Nevada, New Hampshire, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Vermont and Washington – as well as the District of Columbia. In those states, doctors may recommend medical marijuana for patients but may not officially prescribe medical marijuana: that would be a violation of federal law.

For the most part, the feds have been mostly silent about the apparent contradiction between federal law and those state laws. That has been helped along by some court cases, including a ruling involving another California dispensary, the Marin Alliance for Medical Marijuana. In that case, the court agreed that Section 538 of the Consolidated and Further Continuing Appropriations Act of 2015 (yes, it was a budgetary decision) prohibited the Department of Justice from spending money granted by the appropriations bill to prosecute organizations or otherwise prevent certain states “from implementing their own State laws that authorize the use, distribution, possession, or cultivation of medical marijuana.” States listed in the Act include Alabama, Alaska, Arizona, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Illinois, Iowa, Kentucky, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nevada, New Hampshire, New Jersey, New Mexico, Oregon, Rhode Island, South Carolina, Tennessee, Utah, Vermont, Washington, and Wisconsin, as well as the District of Columbia.

You’ll note I said mostly silent. There’s one huge exception: taxes. Under federal tax law, taxpayers must report “all income from whatever source derived” unless specifically excepted (you’ll find that rule at 26 U.S. Code §61). That includes all illegal activities: from illegal gambling to prostitution to kickbacks. In fact, the IRS has a program, the Illegal Source Financial Crimes Program, as part of its Criminal Investigations department, which enforces tax rules on income obtained through illegal operations which would otherwise be part of the “untaxed underground economy.”

Clearly, then, to stay legal – for tax purposes – you need to report all of your income subject to tax. That’s what Harborside says it did. The IRS does not disagree. Nonetheless, in 2010, after an audit, the IRS sent Harborside a bill for $2.4 million. The reason for the tax bill? The IRS declared Harborside (and thus all medical marijuana dispensaries) to be drug trafficking organizations (DTOs) and therefore subject to a special tax rule found at Section 280E of the tax code. That rule says that expenses connected with the sale of certain illegal drugs – including Schedule I drugs, like marijuana – are disallowed:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

As you probably figured, section 280E was intended to target illegal drug traffickers, giving the feds more ammo to fight the war on drugs. It wasn’t contemplated that it might affect medical marijuana dispensaries made legal under state law. So you’d think that when the question came up, the IRS would back down. It did not. In addition to slapping Harborside with a $2.4 million tax bill for the two years under audit, the IRS demanded access to financial records for every subsequent year of Harborside’s existence and doubled down on similar dispensaries across the country. Harborside decided to fight back.