As Californians evaluate the potential for legalization of Marijuana it is important to consider the current state of conflict between state and federal laws and regulations regarding the production, distribution and sale of Marijuana. As MillarLaw specializes in tax issues this note will focus on tax and related financial problems. The public policy debate about the social and personal costs versus the potential revenue benefits of legalization are outside the scope of this analysis.

The Congressional Research Service recently published a report titled Marijuana: Medical and Retail-Selected Legal Issues (the Report). The Report highlights the complex interrelationships between state and federal laws governing Marijuana. The first intersection of conflict is in the Controlled Substances Act. According to the Report:

“When Congress enacted the CSA in 1970, marijuana was classified as a Schedule I drug. Today, marijuana is still categorized as a Schedule I controlled substance and is therefore subject to the most severe restrictions contained within the CSA. Pursuant to the CSA, the unauthorized cultivation, distribution, or possession of marijuana is a federal crime.”

The fact that 20 states have some form of legalization under state law does not prevent enforcement of federal laws. There are several federal statutory schemes that can and are being used to regulate the growth of the Marijuana “business”. Among them are the Bank Secrecy Act (BSA) and the Internal Revenue Code.

The Bank Secrecy Act provides in pertinent part:

“February 14, 2014, the Department of Justice and the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) issued guidance with respect to marijuana-related financial crimes.170 FinCEN’s guidance specifically addresses the obligations to file suspicious activity reports (SARs).”

The result of FinCEN guidance under the BSA is that most marijuana businesses are unable to open and operate bank accounts even when they are in compliance with state and local law.The result is that many usch businesses are forced to operate on a true “cash” basis, leading to profound record keeping issues.

The second intersection is with taxation under the Internal Revenue Code.

As stated in the Report, the Internal Revenue Code and the Regulations provide:

“Income from any source is ordinarily subject to federal taxation. This is so even when the activity that generates the income is unlawful. Marijuana merchants, however, operate under a special federal tax disadvantage. Section 280E of the Internal Revenue Code provides:

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 a result of this provision, marijuana merchants, unlike most businesses, may not deduct their operating expenses (e.g., general labor, rent, and utilities) when computing their federal income tax liability. Section 280E does not, however, apply to the cost of goods sold (COGS), which means marijuana sellers may subtract COGS when determining gross income. Courts and the IRS have interpreted Section 280E to apply to marijuana so long as it is a controlled substance under the CSA, regardless of whether the purchase and use are allowed under state law. Moreover, the customers of a medical marijuana merchant cannot deduct the amounts spent on marijuana as medical expenses.”

The combination of lack of banking ability and the limited deductions for the “business” make the federal tax costs of running such a “business” very problematic. But that is not the end of the story. For enter state and local taxing authorities who look to claim their share of revenue.

In California the “businesses” also known as “cooperative” face sales tax and local tax. State tax generally is inapplicable as the “businesses” are organized as cooperatives, a form of Mutual Benefit Corporation, a not for profit entity.

There third intersection is the enforcement of tax laws. The triangle of enforcement between local state and federal taxing authorities each when combined with information exchange agreements between agencies, makes doing business very complex. Record keeping in the absence of banking relationships may be hard to validate.

The logical conclusion is that the “business” faces organized challenges, from multiple audits all looking for the same result, impaired record keeping that results in civil and potential criminal penalties and tax deficiencies. This approach may be the single most effective weapons systems available to the marijuana opponents to eliminate non-compliant “businesses”

The proof of substantial non-compliance within the industry may also be a tool for use by governments to create a regulatory process that runs from growth to sale. In any case the need for timely complete and consistent tax reporting is an essential to the “business” model.

Former Senator and presidential candidate Barry Goldwater (R) Arizona, once said:

The income tax created more criminals than any other single act of government.

So it is with the efforts to legalize Marijuana, it is the tax system that may very well be the biggest impediment to state by state legalization. The key is to responding to multi-jurisdictional audits is in consistent and well supported record keeping. Even un-bankable businesses can and should keep proper records.

Regardless of the nature of the business, if a client has a need and desire to come forward to either face an audit or correct reporting errors we at MillarLaw can help. We understand the nuances of multi-jurisdictional tax reporting and can help clients avoid costly mistakes, including potential prosecution and substantial penalties.