Introduction
In 1974, Jeffrey Edmondson described himself as "self-employed" on his tax return. He proceeded to take deductions on his rent, telephone costs, air travel expenses, car mileage, food, and other Costs of Goods Sold ("COGS") made in his regular course of business. There was just one problem. Mr. Edmondson was, in fact, self-employed as a drug dealer. Throughout the taxable year of 1974, Edmondson sold 100 pounds of marijuana, 13 ounces of cocaine, and over one-million amphetamine tablets. It probably doesn't surprise you that the IRS took issue with these deductions.
In Edmondson v. Commissioner, a 1981 case heard before the U.S. Tax Court, the Commissioner of the IRS moved to disallow these deductions because Edmondson was involved in the sale of illegal narcotics. Surprisingly, however, the Court found that there was currently no provision in the U.S. Tax Code preventing Edmondson from making these deductions. Moreover, there was no differentiation between legal businesses and illegal drug traffickers in the Code. The Court issued an amusing opinion in which it evaluated each of Edmondson's claimed deductions and determined nearly all were made during his regular course of business. As a drug dealer.
Declaring War On Drugs
Predictably, Congress leaped into action. One year later, in 1982, Congress enacted Section 280(e) of the U.S. Tax Code. The sole purpose of 280(e) is to disallow deductions made in connection with the illegal trafficking of Schedule I or II substances. Schedule I and II narcotics include marijuana, heroin, methamphetamines, LSD, and ecstasy. Schedule I drugs are defined as having "no known medicinal value." As a person living in reality in 2022, you may have just thought to yourself, "one of these things is not like the others."
At the time, 280(e) made perfect sense. The "War on Drugs" was kicking into gear, and Congress took action to prevent drug dealers from taking advantage of our tax system in service of their illegal trade. After all, disallowing drug dealers from taking ordinary and necessary business expense deductions is sound tax policy. However, American attitudes towards marijuana usage have changed dramatically in the preceding decades. There are currently 36 states that have legalized marijuana either for medicinal use or adult recreational use. Despite this, there has been no action taken by the Federal Government to address the issue. Marijuana remains federally prohibited under the Controlled Substances Act and remains on the list of Schedule I narcotics.
Block Deductions, Killing Growth
The effects of federal prohibition and placement on the Schedule I list have devastating tax implications for businesses engaged in the "legal" marijuana industry within their home states. 280(e) applies to both growers/cultivators of marijuana products and the consumer-facing dispensaries that sell the products. Any business expenses made by growers or sellers in the ordinary course of business are blocked by 280(e) from being deductible on Federal income tax returns. States typically use Federal tax returns as the basis for determining taxable income, so when businesses are barred from taking deductions at the Federal level, they are likewise prevented from taking similar state deductions.
The list of expenses that more traditional businesses can take that are closed off from the marijuana industry is extensive. This list includes staffing expenses like salaries or wages, rent, property tax, banking fees, advertising and marketing costs, business-related travel, etc. The standard corporate tax rate in the U.S. is approximately 21%. It is estimated that this number jumps to nearly 70% for marijuana businesses.
This creates a system where marijuana businesses are estimated to be paying taxes at a rate 3.5 times higher than other business entities, placing a massive undue burden on business owners. The current policy stifles small-business growth and prevents employers from being able to offer employees higher wages or benefits. It also forces employers to raise prices, which may lead consumers back to the black market instead of acquiring them safely and legally while also generating new tax revenue. State-legal marijuana businesses are also barred from working with large national banks to access capital markets to take on debt for expansion. This also means these businesses do not have access to credit card platforms, which forces marijuana sales to operate on a cash-only basis. This leads to marijuana businesses being subject to a disproportionate number of audits by the IRS, contributing to more non-deductible expenses.
COGS-Related Deductions
It's not all doom and gloom, though. Cannabis-focused businesses are permitted to take deductions on expenses related exclusively to inventory. These deductions are known as "Costs of Goods Sold," or COGS. COGS are any expenses made in the course of securing, holding, and processing inventory. This allows cannabis dispensary owners to deduct the invoice price of the cannabis bought from cultivators, transportation costs for the pick-up and/or delivery of the products, and some utility expenses for inventory areas. This means business owners must determine what percentage of their utility costs are allocated to inventory areas while excluding any customer-facing or sales-related areas. For marijuana growers and cultivators, COGS-related expenses include the raw materials used for growing the product, such as seeds, soils, and fertilizers. They may also make deductions for labor costs incurred prior to sale for employees who clean, trim, and package the inventory. They can also calculate what percentage of utilities support inventory areas and deduct those expenses.
While it is fortunate that marijuana-focused businesses are at least permitted to take COGS-related expenses, these deductions are minimal and confusing. They often take significant time and effort to determine appropriate deduction levels. As it stands now, marijuana businesses operate at a substantial disadvantage regarding tax liability. This system is preventing the growth of an industry that has been shown to produce massive new revenue streams for states that have taken legislative action. It is estimated that by 2025 the marijuana industry will see sales exceeding $25 billion. Colorado, for example, generated $424 million in tax revenue in 2021 alone. The State used this money to fund projects like new school construction or recidivism reduction programs.
Time To Act
The amount of potential tax revenue being left on the table by the Federal government's reluctance to legalize adult-recreational sales of marijuana is staggering. Even if Congress fails to pass a legalization bill, the power to reschedule marijuana rests entirely with the Attorney General. Given the amount of research and evidence supporting marijuana's use for legitimate medical purposes, it is perplexing that marijuana remains a Schedule I narcotic with no known medical benefits. It is time to give this new industry the same tax advantages any other legal business has. This article did not go into the myriad of other legal and economic effects this stagnation on the issue has caused. The number of problems solved and the amount of financial gain to bring in by de-scheduling or legalizing marijuana sales should make taking action a no-brainer. Unfortunately, many legislators seem to have no brain at all on this issue.
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