This article was originally published in the California Journal of Tax Litigation, Quarterly 3, 2014 Edition.
This is the second article of a three part series of articles. In the first article published in the Q2 Issue of the California Journal of Tax Litigation I discussed the federal income tax treatment of medical marijuana dispensaries. In this article I will discuss the California income tax treatment of medical marijuana dispensaries. This article does not focus on other taxes such as sales and use and business license taxes. In the next article, I will discuss numerous concerns and issues applicable to professionals who counsel and provide advice to the organizations, entities and individuals who are engaged with the medical marijuana industry.
Recap Of The Part One Article Dealing With Federal Tax Treatment.
Under the federal tax regime, the Internal Revenue Service and the United States Tax Court both take the position that any business that sells marijuana, even if for medical reasons, cannot deduct necessary and ordinary business expenses like a normal business. Section 280E of the Internal Revenue Code is the hammer behind this rule. The hand holding that hammer is the Controlled Substances Act (CSA), which was adopted in 1970. The CSA details the federal government’s position that marijuana is a drug that has no accepted medical use. For this reason, the manufacture, distribution or possession of marijuana, even if for medical purposes as established under state law, is a federal criminal offense. Consequently, while medical marijuana dispensaries are required to pay taxes on their earnings, they are not entitled to deduct business expenses such as rent, advertising and employee costs at the federal level. Does California treat these medical marijuana businesses and owners more favorably for income tax purposes?
California’s Income Tax Treatment Of Medical Marijuana Dispensaries.
In stark contrast to federal law, California law allows for the distribution of medical marijuana under Proposition 215, the Compassionate Use Act of 1996 (CUA). The initiative exempted certain patients and their primary caregivers from criminal liability under state law for the possession and cultivation of marijuana. In 2003, the California Legislature enacted additional legislation related to medical marijuana, requiring the Attorney General to adopt “guidelines to ensure the security and non-diversion of marijuana grown for medical use.” Although the CUA legalized the sale of medical marijuana, interestingly, it did not address the tax treatment of these activities. The 2003 guidelines published by the Attorney General also do not address the tax treatment. The guidelines simply refer to the California Board of Equalization’s online publication regarding sales taxes applicable to medical marijuana activities. There is no discussion of the state income tax treatment of these activities under the CUA or the Attorney General’s guidelines. Moreover, the California Revenue and Taxation Code does not carve out any exceptions for these types of business activities.
Thus, the applicable law that applies might be surprising to those who thought that, because medical marijuana sales is a legal activity in California, the tax treatment might be more favorable than the tax treatment under federal law. The reality is that in certain circumstances the tax treatment in California is even worse than the tax treatment under federal law. Even though medical marijuana is legal under Proposition 215, the distribution of medical marijuana is considered drug trafficking for California tax purposes under the California Revenue and Taxation Code for individuals. However, the distribution and sale of medical marijuana is not considered drug trafficking for California tax purposes under the California Revenue and Taxation Code for corporations. Does this mean that corporations get breaks that individuals do not? Well, in this particular circumstance, the answer is yes, corporations do.
Personal Income Tax Treatment Of Medical Marijuana Dispensaries.
Pursuant to § 17201(c) of the Revenue and Taxation Code, California conforms to Part IX of Subchapter B of Chapter 1 of Subtitle A of the Internal Revenue Code. Part IX of the Internal Revenue Code includes § 280E. Therefore, California follows § 280E of the Internal Revenue Code with respect to personal income tax treatment of medical marijuana dispensaries. The Public Affairs Office of the FTB confirmed that this is the State’s position on the subject. Thus, for personal income tax purposes, marijuana dispensaries are not entitled to deduct necessary and ordinary business expenses related to income derived from medical marijuana dispensaries. This would apply to medical marijuana dispensaries that operate as sole proprietorships, partnerships, LLCs taxed as a partnership, or trusts. A question remains whether corporations who have elected Subchapter S status will receive similar tax treatment. However, the bottom line is that when it comes to personal income taxes, California conforms with the federal government and will disallow the business expenses for these activities, even though medical marijuana dispensaries are legal in the State of California. Of course, California goes one step further than the federal government, making the state tax treatment of these activities possibly even worse than the federal tax treatment in certain situations.
Section 280E of the Internal Revenue Code disallows business expenses if the income is derived from drug trafficking activities. However, this section does not disallow costs of goods sold. California Revenue and Taxation Code § 17282 states that no deductions (including deductions for cost of goods sold) shall be allowed to any taxpayer on any of his or her gross income directly derived from illegal activities but only if the taxpayer was determined to be engaged in criminal profiteering or for related activities enumerated in Revenue and Taxation Code § 17282(a). Those activities include drug trafficking, which for personal income tax purposes conforms with § 280E. For this limitation to apply, the current law expressly states that a taxpayer must be found to be engaged in these activities through a final determination in a criminal proceeding, or a proceeding in which the state, county, city or other political subdivision was a party. If this occurs the income tax treatment of medical marijuana dispensaries is even more severe in California than under Federal law.
Corporate Income Tax Treatment Of Medical Marijuana Dispensaries.
California treats the income taxation of medical marijuana dispensaries that are taxed as corporate entities more favorably. This is because the corporate tax code under Part 11 of the California Revenue and Taxation Code does not have a provision similar to the personal tax code to make it conform with § 280E of the Internal Revenue Code. The conforming provision under § 17201(c) of the Revenue and Taxation Code does not apply to the California corporation tax code.
This means that a medical marijuana dispensary that is taxed as a corporation under the California Revenue and Taxation Code may, absent a final determination in a criminal proceeding that the corporation is participating in drug trafficking, be allowed full deductions for business expenses and cost of goods sold. The California Revenue and Taxation Code under § 24436.1 mirrors the language of § 17282 and disallows all deductions if the taxpayer was determined to be engaged in criminal profiteering or for related activities in a criminal proceeding, or a proceeding in which the state, county, city or other political subdivision was a party. Absent such determination, however, a medical marijuana dispensary taxed as a corporation under Part 11 of the California Revenue and Taxation Code should be allowed to deduct all its necessary and ordinary business expenses and cost of goods sold assuming the dispensary has adequate records to substantiate these items.
Based on the language contained in Revenue and Taxation Code §§ 17282(a) and 24436.1(a), it is clear that a state criminal proceeding would trigger the disallowance of the deductions, but the Code does not directly address a federal criminal proceeding. The Code section appears to include any court that is located in the State of California. The statutes only require the State or a political subdivision to be a party to the proceeding in which the taxpayer was determined to be engaged in the activities. The participation of the State or a political subdivision in a federal court proceeding is a gray area, and would have to be reviewed before determining the applicability of Revenue and Taxation Code §§ 17282 or 24436.1. The proceedings referred to in Revenue and Taxation Code §§ 17282(b) or 24436.1(b) are by their terms not limited to criminal proceedings. So presumably any other type of proceeding applies, including appeals of business license revocations. Also, I would assume that if there is a federal criminal proceeding involving a marijuana dispensarylocated in California and the crime involves unpaid taxes that restitution could include amounts owed to California. This could arguably make California an interested party to the criminal action brought in federal court. Also, a federal determination that the activities are illegal is res judicata and binding on the State of California, and the supremacy clause trumps the California statute. It remains to be seen how broadly the Franchise Tax Board will interpret this section of the Revenue and Taxation Code.
Although this article focuses mainly on the income tax treatment of the dispensary activities, one might be curious to know whether an individual with a prescription from a licensed physician is entitled to take a medical expense deduction related to the prescribed medical marijuana. IRS Revenue Ruling 97-9 addressed this question. The IRS takes the position that the cost of prescribed marijuana is not a deductible medical expense under federal law, even if California law permits its use when prescribed by a physician and the taxpayer has a prescription. Section 213 of the Internal Revenue Code allows a deduction for uncompensated expenses of an individual for a medicine or drug that is
prescribed and legally procured. However, an amount paid to obtain a controlled substance (such as marijuana) for medical purposes violates the federal Controlled Substances Act because it has not been legally procured. At least until the law is changed, California conforms to IRC § 213, so no deduction is allowed for California purposes, even though California allows the legal use of marijuana when prescribed by a physician.
In Summary –
California models the IRS and disallows all business expenses if the medical marijuana dispensary is not being taxed as a corporation under the State Revenue and Taxation Code. If the medical marijuana dispensary has been structured in a way to be taxed as a corporation under the Revenue and Taxation Code, it is entitled to deduct all of its necessary and ordinary business expenses assuming it has adequate records to substantiate these expenses. If there is a criminal court or other proceeding in which the state, county, city or other political subdivision was a party and it was determined that the medical marijuana dispensary engaged in illegal activities, the dispensary will not be allowed to deduct the business expenses or the cost of goods sold, regardless of whether the dispensary is structured to be taxed as a corporation, flow-through entity or sole proprietor.
In the third and final part of this three part series, I will review the problems and concerns that all practitioners need to know about before providing legal advice or representing a medical marijuana dispensary. Concerns include how filing a tax return may constitute an admission by the taxpayer that he or she is engaged in illegal drug trafficking and how practitioners who assist these taxpayers may by in technical violation of Circular 230, State Bar rules of professional conduct and, arguably, considered to be “aiding and abetting” the taxpayer in the commission of a federal offense.