Nevada Marijuana Businesses and Federal Income Tax Challenges Regarding Business Expense Deductions

In 2001, the Nevada Legislature decriminalized the sale and use of “medical” marijuana. Since then, the Nevada marijuana industry has been thriving. In the fall of 2016, Nevada voters approved “recreational” marijuana through a ballot initiative, and the official grand opening of the retail marijuana market began on July 1, 2017. By all accounts, business is booming for Nevada’s marijuana cultivators, production facilities, and retail stores. https://www.forbes.com/sites/monazhang/2017/12/26/nevadas-recreational-marijuana-market-hits-38m-soars-past-colorado/#338db13b4f94

However, marijuana remains illegal under Federal law, and this creates an uncertain landscape for marijuana businesses in the preparation of their Federal income tax returns.

In very general terms, the Internal Revenue Code (IRC) allows individuals and businesses to deduct “ordinary and necessary” expenses incurred during the taxable year in carrying on a trade or business. See specifically IRC Section 162. Therefore, it is commonplace for businesses to deduct a wide variety of expenses such as advertising and marketing costs, salaries and wages, rent, and depreciation on equipment used in the business.

But IRC Section 280E, once an obscure and overlooked provision in the tax code, has turned into one that marijuana businesses must pay attention to. Under Section 280E, businesses are prohibited from deducting business expenses or taking credits related to income from the sale of Schedule 1 or Schedule 2 controlled substances. Section 280E was added to the tax code in 1982 after a cocaine trafficker sued the government over his right to deduct business expenses. In that case, the government charged the cocaine trafficker with evading taxes on his income from the sale of cocaine; cleverly, he argued he was entitled to deduct the expenses of selling that cocaine in an attempt to reduce his tax burden. The government disagreed with this claim and eventually codified the ruling in the tax code at 280E so that no one else would try to make the same argument.

Interpreted strictly, IRC Section 280E prohibits a marijuana business from deducting any business expenses, even salaries, wages, employee benefits, training, rent, travel, advertising, and depreciation. Attempts to fight this argument in have not been successful. For example, the IRS audited Canna Care Inc., a California medical marijuana dispensary, and denied Canna’s deductions for operating expenses, including significant amounts for employee salaries and vehicle expenses. The company appealed the IRS’s findings to the United States Tax Court. Relying on section 280E, the Court upheld the IRS’s determination and denied all of Canna’s “ordinary and necessary” business expense deductions. See Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206.

However, marijuana businesses are still entitled to claim deductions for inventory and certain expenditures as Costs of Goods Sold (COGS). The Tax Court affirmed this position in the case of Olive v. Commissioner, 139 T.C. 19 (2012).

In Olive, the Tax Court did not back down from its position that a medical marijuana dispensary may not deduct its business expenses under section 280E because marijuana is a controlled substance. But the Court did allow the dispensary to deduct cost of goods sold. Note that in this case, the Court was not pleased with the taxpayer’s books and records it used as evidence to support its deduction for cost of goods sold. Likewise, the Court was not inclined to side with the IRS and its position that the taxpayer’s cost of goods sold was zero for the two tax years at issue.

Interestingly, in Olive, the Tax Court admitted the testimony of the taxpayer’s expert witness on the issue of the taxpayer’s claimed deduction for cost of goods sold. However, in a recent medical marijuana case before the Tax Court, the Court denied the same expert’s testimony and expert witness report. The Court found the expert’s testimony did not satisfy the Rules of Evidence Rule 702 or Tax Court Rule 143(g) of the Tax Court Rules of Practice and Procedure because he used insufficient facts and unreliable methodology. For example, the expert did not independently verify the taxpayer’s gross receipts even though there was a discrepancy between the general ledger and the tax return amounts. He also beginning and ending inventories in his cost of goods sold calculation, and generally did not provide enough information to explain how he arrived at his conclusions.

If you own a business selling marijuana Nevada, you need to work with an experienced Las Vegas tax lawyer to understand your tax rights and responsibilities. The landscape is changing so quickly that you need a legal advocate on your side to help you navigate it all. If your business is audited and you don’t have detailed information about every single transaction, you risk forfeiting your COGS claim and you could be subject to penalties for filing an inaccurate tax return.

Silver Law PLC operates in Arizona and Nevada and all of its lawyer are former lawyers for the IRS. An Arizona tax lawyer from our team can help you understand how the complex tax code applies to your marijuana business operations. We’ll help you ensure that you are meeting your obligations. If you have been audited or are facing collections, we can also help you navigate that process. We can either find ways to bring down your tax debt or can negotiate a settlement for you. Call us today to talk with a tax lawyer and learn more.

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