Tuesday, February 9, 2016
Death & Taxes: Still a Certainty, Even for MMJ - by Paul Samsays, CPA
No one likes to pay taxes, but they are a necessary evil of our economic system. Having worked as a government auditor, I can speak first-hand to how some of this money is wasted, however, it does to some good as well. Like educating our kids, maintaining infrastructure and providing for our common defense. Also, the medical marijuana industry needs to pay its fair share in the communities where they do business if we want to be accepted as a legitimate part of the local business community.
As the managing partner of Michigan’s largest medical marijuana CPA firm, I talk to lots of caregivers and retailers who are confused as to whether or not they need to file income taxes on sales of medical marijuana. The line of thought is that since it is federally illegal, then it shouldn’t be taxable either; not to mention, filing an income tax return on an illegal business would be a potential admission of guilt in court.
Ignorance of the Law is No Excuse:
Here’s the problem: right there at the beginning of the IRS code, which is just part of the U.S. Federal Code of Laws, Section 61 states: “all income foreign or domestic” is taxable and includes income earned illegally. What this means is that if you are running a gambling operation, whorehouse, or are a part-time hit man, you have to declare your income. And as long as you aren’t trafficking in a Schedule 1 substance, like marijuana, you can deduct the cost of wages, gambling tickets, linens and ammunition; dispensaries and caregivers are limited in they can deduct from their taxable income.
That said, we have found too many attorneys, CPA’s and IRS Enrolled Agents who have given their clients horrible advice, like claiming the income from MMJ but not the expenses, or hiding it in another business. These are bad ideas; you do have some rights and deductions for both dispensaries and caregivers. Remember Al Capone? Google it, youngsters; Al never went to prison for the myriad of crimes he should have, the government put him away for tax evasion.
Another big issue is the growth of our digital economy; if you want to show income to buy or rent a house, a car or other big-ticket item, you need to explain from where you got it, and how it is going to keep coming in going forward. For this, you need tax returns and if necessary, pay stubs. You can’t get that from a shoe box buried in your mom’s backyard. You are providing relief for people in need and taking risks with your capital and sadly, your freedom. With a tax return and paystubs, you can establish credit using your medical marijuana income.
Some dispensary owners and caregivers think that filing taxes will cause an alarm to go off at Government Central and an audit and law enforcement visit is going to happen within days of mailing the return. Nothing could be further from the truth: the IRS wants to get paid, not call in a raid. While the IRS budget has been cut by Congress for two years in a row and there has been a long-term hiring and pay freeze, the medical marijuana industry has exploded to 23 non-CBD only states. Should you be one of the less than 1% catch an audit, having a simple organizational plan and good record keeping for the information provided will substantiate your return. And getting there isn’t that hard, promise.
The Court Cases:
The history of Congressional and Tax Court actions gives a better idea of how we got here. In the early 80’s, there was a multi-drug dealer in Minnesota who was able to deduct the entire costs of his distribution empire from his income on his tax returns. Since this was during the high point of the Regan/Bush War on Drugs, Congress got pissed and changed the laws to prohibit any deductions, other than the cost of the inventory, or cost of goods sold, from income for anyone selling a Schedule 1 drug.
As we all know, marijuana has been improperly scheduled, but just like cocaine, heroin or designer drugs, it falls under this section of the IRS code (280E):
“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.”
The Tax Court has tried a few cases involving taxpayers that sell medical marijuana. In the seminal case in this area, the Tax Court held that the taxpayer trafficked in medical marijuana, which is a Schedule I controlled substance, and that §280E disallows all deductions attributable to that trade or business. The Tax Court also held, however, that §280E does not disallow the deductions attributable to the taxpayer’s separate and lawful trade or business. Californians Helping to Alleviate Medical Problems, Inc., v. Commissioner, 128 T.C. 173 (2007) (“CHAMP”).
In CHAMP, the government conceded that §280E does not prohibit a taxpayer from claiming cost of goods sold. What this means is that dispensaries with separate lines of business in their stores could deduct the portion of expenses allocated to that business, independently of the cannabis income and deduction.
Other more recent Tax Court cases have been disappointing: in Olive V. Commissioner (a.k.a. The Vapor Room), the 9th Circuit Court of Federal Appeals just this year affirmed a previous Tax Court decision that disallowed many of the dispensaries deductions. It was a tough set of circumstances to explain to the IRS. The owner of the Vapor Room, Martin Olive, was extremely disorganized and attempted to handle the IRS on his own, at least initially. Since most of the sales and medicine purchases were kept on yellow legal pads, the IRS was able to use what evidence he gave them to come up with estimates of his tax deficiency, so they teed it up and threw a number out there that resulted in an initial tax bill due of millions and millions of dollars. Since he didn’t track purchases from vendors at all, the IRS disallowed some of his medicine costs.
So here is the first takeaway: never do your own books when facing an audit and never give anything or discuss issues with the IRS without the help of your CPA or tax attorney. It got a lot more expensive for Mr. Olive as accountants and attorneys straightened out the mess and came up with a reasonable income amount and deductions.
The case did make a couple of important points: the Tax Court relied on testimony of industry insiders to determine the cost of goods sold as a portion of revenue (71%) based on expert testimony. The other lasting legacy of this decision is that the case history provides more precedent that a recreational or medicinal marijuana facility can have multiple lines of business, with only the business engaged in selling marijuana subject to the harsh disallowance provisions of Section 280E. This means dispensaries need to diversify their product and service offerings, as CHAMPS did, from just selling medical marijuana in order to deduct what would otherwise be more non-deductible expenses under 280E.
Other Ways to Save Money:
Another method to increase the cost of goods sold or inventory costs is to capitalize certain non-deductible costs under 280E into inventory, using another section of the IRS code, 263A, the Uniform Capitalization Rules (UNICAP), implemented in 1986. What this section does is require businesses with income larger than $10M or that meet certain production tests to put certain indirect costs into the cost of the finished product.
Here is how it works: a manufacturer like Ford, for example, makes a car in 2015 and includes the direct cost of labor and parts into the inventoried cost of the car. For this example, let’s say the direct parts and labor total $5,000; Ford then has to add in indirect costs, like human resources, quality inspectors, purchasing activities, etc. Let’s say these costs are another $2,500 for our car, so the total direct and indirect costs allocated to that car is $7,500. The both the indirect and direct expenses are not deducted until Ford sells the car to a dealer for resale, likely in 2016, so they don’t get to deduct the expense in the year the car was made, rather, in the year it actually sells. It’s a clever way to keep expenses in inventory and off a tax return as a deduction. The upshot of this code section: the IRS has had an impressive win record defending 263A exemption claims.
The problem with using 263A UNICAP rules is that most business do not meet the requirements; also, the IRS Office of General Counsel responded to using this method in a memorandum dated December 10, 2014. This memo is guidance to IRS field agents and reviewers on how to handle MMJ returns and it specifically denies using 263A to increase cost of goods sold. While the reasoning in the memorandum is weak, it will have to be tested in Tax Court with the right kind of circumstances. Or better yet, dealt with in Congress, which has the power to change the IRS code to address the tax issues with MMJ.
Caregivers Have It Easy:
For caregivers, the legal precedent and the IRS memo confirm what we have been asserting on tax returns for a while now: since caregivers produce an end-product, the component costs of that end-product are tax deductible (from the IRS memo dated Dec. 10th, 2014:
“a producer of a Schedule I or Schedule II controlled substance should be permitted to deduct wages, rents, and repair expenses attributable to its production activities”.
This means all of the supplies, utilities and other direct and indirect costs are fully deductible from income as a caregiver. Whether licensed or not going forward, caregivers are in the best place from a tax standpoint. Same goes for processors of concentrates or edibles; since a tangible product is produced, the production costs incurred are part of the total cost of the item and deductible from income.
Dispensaries Have It Worse:
Because all non-inventory costs are not deductible under Section 280E, everything that isn’t the cost of medicines sold is not deductible. However, there are ways to structure a retail outlet to minimize this reduction in ordinary business expenses, particularly if the dispensary also self-supplies from their grow to the retail outlet or has a lot of product prep costs.
The key to all of this is good organization and a firm grasp on what is going on with the business on a day-to-day basis. We have developed spreadsheets and other organization systems to help MMJ professionals get and stay organized before and after tax season. And they do not require a big investment in time and treasure for accounting software like QuickBooks, but can run off of bank statements and spreadsheets. Also, if income is required to be documented, we have methods to get you paystubs and help file the required payroll taxes, based on how well your business is doing each quarter.
If you have any questions for me on MMJ tax and accounting, please feel free to reach me at firstname.lastname@example.org or
call (517) 258-1424.