Tax Paper

Memorandum

Facts

In 2014, almost half of states have legalized sale of medical cannabis, and Colorado and the State of Washington have been allowed to sell recreational cannabis. But federal law still classifies cannabis as a controlled substance, regardless of growing number of states that have legalized recreational and medical use of cannabis. On the other hand, the IRS Advisory Council issued a 2014 report recommending that a tax professional can prepare tax return for clients who engage in a cannabis business in the states that have legalized to sell cannabis, and he or she also can give advice to their clients or represent for them. Recently, Ohio State is also planning to legalize the sale of cannabis, so our client is considering investing $500,000 in the cannabis selling business.

Issues

1. Would income from the business be taxable under the Internal Revenue Code if Ohio authorizes cannabis sales but federal law still criminalizes it?

Short Answer

The Income from cannabis business would be taxable under the Internal Revenue Code.

Law and Analysis

Under Section 61(a) of the Internal Revenue Code, the gross income means all income from whatever source derived. It means that the gross income should include all income from different sources except for some items listed in Section 101 that are specifically excluded by IRC. According to this definition, even proceeds of illegal activities will form part of gross income, therefore, and will be taxable, so the income from illegal cannabis business should also be taxable.  

1. Are there any limitations or restrictions under the Internal Revenue Code relating to deducting business expenses like rent, advertising, supplies, salaries, or cost of goods sold?

Short answer

Yes. Section 280E limits business deductions for businesses that involve in trafficking in controlled substances, but cost of goods sold can be subtracted from taxable income.

Law and Analysis

Section 208E of 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.” According to the Section 208E, any clearly business expenses incurred in Cannabis trade or business like rent, advertising, supplies cannot be deducted, because Cannabis is still listed as a Schedule I controlled substance under 21 USC § 812(c)(10). On the other hand, Cannabis business is allowed to deduct cost of goods sold, since the cost of goods sold is not a business deduction but an adjustment to income. Section 61 of Internal Revenue Code states that ”gross income” is achieved by subtracting cost of goods sold from gross receipts. Also, Senate Report provides an explanation that “To preclude possible challenges on constitutional grounds, the adjustment to gross receipt with respect to effective cost of goods sold is not affected by Section 280E” according to S. REP. NO. 97-494 (Vol. I), at 309 (1982). This explanation ensures that cost of goods sold can be excluded without affecting by Section 280E.