Taxing Marijuana: Different Approaches by Governments and the IRS

January 22, 2013 — Leave a comment

As if the US tax code weren’t complicated enough, the recent surge of pro-marijuana laws adds yet another layer of complexity and confusion.

Screen Shot 2013-01-22 at 3.59.11 PM18 states and the District of Columbia have legalized medical marijuana, 14 states have de-criminalized the drug for recreational use, and 2 states — Colorado and Washington, recently voted for complete legalization.  Still, all marijuana use and possession remains illegal under federal law due to its classification as a schedule 1 controlled drug under the Controlled Substances Act of 1970.  As the medical and recreational marijuana industry continues to grow, so does the question of how to regulate and tax it.

The first attempt at taxing marijuana was the 1937 Marihuana (Yup, “Marihuana,” a term with an unknown Spanish origin) Tax Act, which levied an excise tax on the sale or distribution of cannabis.  The law, which critics still argue was made to destroy the hemp industry, did not criminalize marijuana; rather, it established fines and punishments for non-compliance.  Since the sale of pot went unregulated though, it ended up being more of a means for law enforcement officers to imprison or fine users than for collecting tax.  In 1968 the Act was overturned as unconstitutional, but was shortly replaced by the Controlled Substances Act of 1970 that made marijuana illegal for all purposes.

The nice thing about making pot definably criminal is that there shouldn’t be any confusion: Marijuana is illegal, therefore no marijuana industry should exist and we shouldn’t have to be talking about tax issues.  Except it does.

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Support for pro-marijuana laws has risen steadily since the 1970’s.  A 2011 Gallup poll (graph above) revealed that support for legalization hit an all-time high of 50%, with senior citizens being the most opposed.  State and local governments have responded to this trend, electing to ignore federal law and create their own marijuana rules.  Another Gallup poll (table above) reveals that 64% of adults believe the federal government should not interfere in states who choose to create their own marijuana laws.  President Obama even said that he would not make marijuana enforcement a top priority, saying, “We’ve got bigger fish to fry,” in an interview with ABC news’ Barbara Walters.

Medical Cannabis Growing Operation in Oakland,...

Medical Cannabis Growing Operation in Oakland, Ca. (Photo credit: Rusty Blazenhoff)

That’s all great and well, but what is the IRS to do?  As a branch of the federal government, they can’t ignore federal law or sway with public sentiment so easily.  As such, “legal” medical and recreational dispensaries are not able to deduct expenses due to Section 280e of the tax code, which bans business’ engaging in the sale of controlled substances from deducting any expenses.  For the industry, compliance with this structure could makes their tax liability too high to ever be profitable under current law.  There is some leeway in that activities not associated with the buying or selling of weed are taxed as a normal business.  So, if a dispensary operates a separate business such as counseling for patients, those expenses could be deducted.   For dispensaries who are unable to define such a separation though, they may be liable to pay taxes on up to 100% of their revenue, which has already happened to at least one unlucky company through an IRS audit.

State revenue collectors face the same challenge, since most states adopt the IRS code.  But here’s another curveball: In California, section 280e applies to personal income tax, but not to corporate tax.  Therefore, in states whose tax structure favor corporations, they may be able to fully deduct weed-related business activity expenses.  In other words, medical marijuana may be going corporate.

The IRS has more Section 280e cases coming up, so there may soon be  more clarity as to what the future holds for taxing marijuana in states where it’s sold.  In all likelihood either dispensaries will re-structure to adhere to the tax code, or the IRS will loosen its enforcement of Section 280e.  Unless Congress reforms marijuana laws though, there’s no end in sight to the tax mayhem surrounding legal pot.

What if marijuana were legal?  

Well for one thing, it would make this whole tax thing a lot easier.  For another, it could contribute more then $16 billion/year to deficit reduction.   Instead going after each dispensary individually and slapping them with backtaxes, the IRS could collect revenue through an excise tax on the sale of pot nationwide.  A 2005 study lead by Nobel Prize winning economist Milton Friedman estimated that legalization with an excise tax of about $50/ounce would result in $6.2 billion in new revenue and $7.7 billion in savings from federal and state expenditures on prohibition enforcement. Certain businesses might also get a boost according to the report, particularly agricultural groups and alcohol distributors.  Other studies have suggested similar numbers, but with no way to accurately predict changes in demand, regulatory costs, substitution factors, higher medical expenses, etc., the budget outcome is hazy at best.  There are plenty of other arguments to be made on both sides of this issue, but since this is tax-centered blog, we’ll conclude with this: State’s decisions to create their own marijuana rules has opened a floodgate of questions and challenges for regulating and taxing cannabis at all levels of government.  These issues are exacerbated by congress’ and the president’s lack of interest in the subject.  You’ve got to wonder what they’re smoking (sorry, I couldn’t help myself).

Want to learn more?
Check out this awesome interactive infographic from the TurboTax Blog that shows projected sales tax revenue from marijuana sales and more: The Legal State of Marijuana [Interactive]

JDKatz: Attorney's At LawJDKatz, P.C. is a full-service law firm focused on tax law and estate planning. We are dedicated to minimizing your existing liability and risks while providing valuable tax planning to streamline your tax issues in the future. Please call us at 301-913-2948 to schedule an appointment to meet with one of our trusted attorneys.

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