Federal income tax is a tax on “net” income – gross income less allowable deductions. Unless, however, you are a drug dealer – Code Section 280E does not allow sellers of federally controlled substances to deduct their business expenses.
Since the time of enactment of Code Section 280E, numerous states have legalized the sale of marijuana products for medical and recreational purposes. Since such sales are legal under state law, should they punished for federal tax purposes via the disallowance of deductions? After all, Code Section 280E was aimed at illegal drug dealers, and these marijuana sellers are duly licensed under local law.
The 9th Circuit Court of Appeals has ruled that Code Section 280E applies to such state legal marijuana dispensaries. The court noted that Code Section 280E is based on legality under federal law, not state law. So as long as marijuana is illegal under federal law, absent a change in the Internal Revenue Code, marijuana dispensaries lose out on their business deductions. This effectively raises the rate of tax imposed on such businesses. In years when business expenses are high enough, the taxes may approach the net cash flow of the business and thus approach confiscatory rates of tax.
The only thing that will allow these dispensaries to remain in business is that cost of goods sold (i.e., the cost to purchase inventory) is not a deduction that is lost under Code Section 280E. Otherwise, if the cost of goods sold could not be deducted, it is likely that the taxes imposed on such businesses would equal or exceed their actual net profit.
So if you think federal law is irrelevant to marijuana sales in states that have legalized its sale – it still matters for federal income taxes!
Olive v. CIR, Tax Court Case No.l 13-70510 (July 9, 2015)