Any close observer of the Denver retail marijuana scene has no doubt noticed the proliferation of chain pot shops at the expense of individual or standalone dispensaries, often referred to as "Mom and Pops."
One reason, according to attorney Nick Richards, is aggressive auditing being conducted at the state and federal levels.
"A lot of the low-hanging fruit has gone away in this industry," Richards says. "That's left many professional business folks who've gotten through this period of uncertainty, when nobody really knew how all this stuff would work. But now they're facing the threat of going out of business due to the harsh treatment of the state and federal tax authority."
The issues are so complicated, especially for laymen, that Richards provided a timeline (on view below) to help the average person understand the issues. But in the simplest terms, dispensaries are finding out that items they thought were deductible are being disallowed, causing entrepreneurs to be hit with giant bills that are putting their enterprises at risk. And, Richards stresses, "the Department of Revenue in Colorado has made it known that they're going to audit every single marijuana dispensary in the state."
A key part of the federal tax code at question, Richards says, is known as 280E, "which denies ordinary business deductions to dispensaries." The code passed Congress in 1981 after a ruling in a case known as Edmondson v. Commissioner temporarily allowed deductions on illegal businesses.
280E reads:
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.It's important to note that despite complaints from marijuana advocates stretching back decades, marijuana is still listed as a Schedule I narcotic, along with substances such as heroin and LSD.
Cut to the dawn of the millennium, and the rise of medical marijuana businesses. According to Richards, the Internal Revenue Service has been enforcing 280E against dispensaries, because even though they are legal in states such as Colorado, marijuana remains illegal federally.
The National Cannabis Industry Association has assembled a white paper about 280E; it's on view below. The document maintains that marijuana businesses often pay tax rates that are 70 percent higher than those faced by non-cannabis businesses. Here's a graphic illustrating that point, based on gross revenue of $1,000,000.
A partial change in the fed's utilization of 280E was necessitated by another important ruling, 2007's Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, known as the CHAMP case. "The tax court said the industry was allowed to take expenses that were not directly involved with trafficking in a controlled substance," Richards notes, citing as examples "all their counseling expenses and medically related, non-trafficking expenses."
Many Colorado dispensaries used CHAMP as a guideline, Richards says, adding that the IRS occasionally gave businesses leeway to "take some expenses that might otherwise not be allowed" — unless, that is, the business owner complained.
"CHAMP left some gray areas, and in an audit of a dispensary, the IRS might be willing to allow deductions within those gray areas," Richards mainttains. "But if they challenge it and go to court, they'll remove the beneficial treatment of those gray areas."
In 2013, by the way, Edward Roche, a professor at the University of Denver Sturm College of Law, wrote an article (a copy is also shared here) that "set forth some methods the industry might use to narrow the list of deductions 280E would disallow," Richards says. The feds have since rejected many of the theories espoused in the piece, but it offers an opportunity to dig more deeply into the marijuana taxation conundrum, which Roche describes as a "Catch-22."
Likewise, Richards points out that assorted agencies in Colorado have opposing positions that create more headaches for dispensaries. As we've reported, the Denver Department of Environmental Health has investigated ten pot grows for using illegal pesticides — substances that aren't on a list created by the Colorado Department of Agriculture. However, the Colorado Department of Revenue "has informally taken the position that marijuana isn't agriculture," Richards says.
This approach can be expensive for pot businesses. In Richards' words, "The state's current position is that marijuana cultivation is not entitled to agricultural exemptions for sales tax. For example, a tomato farmer's purchase of an irrigation system is likely to be exempt from sales tax if it exceeds $1,000. But a marijuana grower is denied the same exemption for its purchase of irrigation and other equipment for its farming operation.
"The Department of Revenue wants the courts to decide if dispensaries can be given exemptions," he adds. "So they're disallowing them at the audit level, leaving the industry no choice but to litigate the issue, thereby generating large legal fees. Together with IRS enforcement of 280E, that could lead to the next wave of dispensaries going out of business — big players gobbling up small Mom and Pops that can't pay these tax bills."
The news isn't all bad. Richards notes that the state is now allowing Colorado marijuana businesses "to claim a state tax deduction on expenses that would otherwise be disallowed under 280E," as long as taxpayers file a federal tax return "showing their tax liabilities as though expenses were allowed" and then include it with the paperwork for state taxes.
But he feels the DOR's aggressive enforcement of past taxes is contradicted by the state's decision to lower taxes on marijuana under House Bill 15-1367, a measure recently signed into law by Governor John Hickenlooper. The bill also created a one-day marijuana tax holiday in order to correspond with TABOR, the Taxpayers Bill of Rights, which states that taxes must be refunded if the amount raised exceeds estimates — which turned out to be the case during the first year of legal recreational cannabis sales.
"Under TABOR, you've already got more money than you can spend coming in from this industry," Richards argues. "But then you've got another state agency spending more money trying to collect additional dollars, and it's putting these Mom and Pops out of business.
"Everyone would agree that this industry should be heavily taxed," he allows. "But it should also be fairly taxed. And not only do we have huge, unfair taxes, but authorities are taking a hard line on an industry that is already creating more tax dollars than were authorized by voters."
Look below to see Richards's timeline for the latest taxation developments, followed by the aforementioned Ed Roche article and the National Cannabis Industry Association white paper on 280E.
Nick Richards's Marijuana Taxation Timeline
1970: Controlled Substances Act. Created five lists of controlled substances. MJ is Schedule I along with heroin and LSD.
1981: Edmondson v. Commissioner, TC Memo 1981-623. Allowed cost of goods sold and business expenses to an illegal business (cocaine, meth, pot).
1982: Congress passes Section 280E in response to Edmondson. 280E disallows all business expenses incurred in "trafficking" in a Schedule I or II controlled substance. Cost of good sold is still allowed as an offset to gross income because Congress only has the authority under the 16th amendment to the U.S. Constitution to tax "income." Taxation of the cost of the product purchased for resale would be a tax in excess to the income tax authorized under the 16th amendment.
2007: Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173 (2007) "CHAMP." Allowed business deductions attributable to the taxpayers in separate and lawful business (medical counseling).
2013: Ed Roche Article.
2013: U.S. Department of Justice announces it will not go after legal marijuana businesses.
2015: IRS Chief Counsel Memorandum in response to Ed Roche article.
2015: State of Colorado working to audit all marijuana businesses.
Current: Many audits underway (city, state, federal), businesses with tax bills going under, several cases in U.S. Tax Court to challenge 280E. State position on use tax exemptions and aggressive audits. Tabor.
Ed Roche: Federal Income Taxation of Medical Marijuana Businesses
National Cannabis Industry Association White Paper: 280E
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