I.R.C. §280E: A Buzzkill For Those Who Keep Poor Records
By: Eli S. Noff, Partner & Mary Lundstedt
The recent Tax Court's Alterman v. Commissioner decision is a lesson in Accounting 101 for Cannabisseurs. Well, technically it's a valuable lesson about record-keeping to all taxpayers who are subject to Internal Revenue Code (I.R.C.) §280E-but with the currently high audit rates for the marijuana industry, it's particularly significant for taxpayers currently in that business.
Before learning our lesson from Judge Morrison, it is helpful to briefly consider the broader legal setting in which it takes place. Currently, there are nine states in the United States that have legalized recreational marijuana and 29 states that have legalized medicinal marijuana. However, federal law maintains that marijuana is a Schedule 1 controlled substance; thus, the sale of marijuana remains illegal under federal law. From the federal perspective, anyone selling is "trafficking."
Under I.R.C. §280E, the IRS disallows any deduction or credit "for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business . . . consists of trafficking in controlled substances . . . which is prohibited by Federal law or the law of any State in which such trade or business is conducted." However, I.R.C. §280E does not preclude a deduction for the cost of goods sold (COGS). So, the expenses involved in purchasing or growing the marijuana inventory are deductible. Any other expenses incurred by a seller, such as utilities and wages, are disallowed under I.R.C. §280E.
With the above information in mind . . . let's get into the weeds.
What Was This Joint's Story?
During 2009 through 2011, the petitioners were married and filed joint tax returns. In 2009, one of the petitioners incorporated Altermeds, LLC, under Colorado law. Medicinal marijuana was legal under Colorado law; however, it was illegal under federal law. Soon after incorporation, Altermeds, LLC, opened a dispensary-a retail store-in Colorado.
The dispensary sold various forms of marijuana. During 2010 and 2011, the dispensary began selling products that did not contain marijuana but were used to facilitate consumption of marijuana. These non-marijuana products were purchased from third-party sellers. Services were not provided.
In 2010, legislation went into effect that required medical marijuana businesses to grow at least 70% of the marijuana sold to customers. Altermeds, LLC, acted quickly to comply with the new law. It rented a warehouse and grew marijuana, while still purchasing an allowable amount from third parties. While Altermeds, LLC, clearly had employees, no records were kept that distinguished between hours worked at the growing site versus the dispensary.
Petitioners reported Altermeds, LLC, income on Schedule Cs of their 2010 and 2011 joint returns. In 2010, the sales of non-marijuana products were 1.4% of gross receipts. In 2011, 3.6% of gross receipts were the result of the sales of non-marijuana products. Furthermore, based on the findings of fact, the petitioners did not limit any deductions under I.R.C. §280E. Finally, the amount of COGS claimed was predominantly comprised of amounts paid for inventory purchases-without including production costs.
The years basically presented as follows:
|Cost of Goods Sold||($464,119)||($253,089)|
The 2010 and 2011 returns were audited by the IRS. After reducing the allowable deduction for COGS in each year and denying nearly all of the business-expense deductions, the notice of deficiency resulted in the following proposed tax and penalties:
|I.R.C. §6662(a) Penalty||31,564||46,684|
Petitioners wanted to hash this out in court, so they filed a petition with the Tax Court for redetermination of the deficiencies.
And the Arguments Went Up in Smoke
Petitioners presented different arguments in an effort to preserve the denied deductions. First, petitioners emphasized that Altermeds, LLC, sold non-marijuana merchandise. In petitioners' opinion, the sale of non-marijuana items constituted a separate business from the sale of marijuana, and as such, couldn't be subject to the limitations in I.R.C. §280E. While a similar argument persuaded the court in Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), the court here considered things differently. Rather, the court found that:
Under the circumstances, we hold that selling non-marijuana merchandise was not separate from the business of selling marijuana merchandise. First, Altermeds, LLC, derived almost all of its revenue from marijuana merchandise. Second, the types of non-marijuana products that it sold (pipes and other marijuana paraphernalia) complemented its efforts to sell marijuana."
Furthermore, according to the court, even if it agreed that there was a separate business, the "failure to properly brief the amount of deductions that would be attributable to this business would preclude us from allowing any deductions for the separate business." In other words, Altermeds, LLC's records failed to substantiate their marijuana versus non-marijuana expenses.
Next, petitioners argued that its non-deductible business expenses had been overstated and deductible COGS had been understated. Again, poor record-keeping prompted the court to state that:
Alterman and Gibson's argument for cost-of-goods-sold allowances relies entirely on purchase costs and production costs. It assumes that cost of goods sold equals purchase costs plus production costs. Thus, their method leaves out beginning inventory and ending inventory. Such a method is indeed improper.
The petitioners tried an alternate argument here, citing Cohan v. Commissioner,-that the Court should estimate beginning and ending inventories. The court made it blatantly clear that the lack of proper record keeping here made that an "impossible" task. The court held that the amount of COGS conceded to by the IRS-an amount that did not include production costs-was the correct amount, because there had been no proper record-keeping.
As for the negligence penalty, the court agreed that the petitioners were negligent-again because they did not maintain proper records.
Dispensaries and other businesses subject to I.R.C. §280E must maintain proper records. That includes: (1) properly classifying costs as inventory costs, (2) maintaining beginning and ending inventories, (3) keeping all substantiation, and (4) overall careful preparation of returns. Otherwise, the IRS has an efficient way to kill your buzz-it will deny all of your business expense deductions that aren't COGS.
If you have tax questions related to IRC 280E, please contact Eli Noff at Frost & Associates, LLC today.
 TC Memo 2018-83.
 21 U.S. Code §812(b).
 S. Rep. No. 97-494 Vol. 1, 309 (1982).
 Colo. Rev. Stat. sec.12-43.3-103(b)(2) (2010).
 128 T.C.173, 183 (2007).
 39 F.2d 540, 543-544(2d Cir. 1930).