We are all aware that a state-legal marijuana business is illegal under federal law and cannabis businesses deal with this dichotomy between state and federal law on a daily basis. Unfortunately, the fact that a cannabis business is federally illegal does not alleviate the obligation to pay federal income tax because the tax code does not differentiate between income derived from legal sources and income derived from illegal sources.

Anyone who has ever owned or run a business understands that legitimate business expenses (such as cost of goods sold “COGS”, advertising expenses, insurance, employee wages, etc.) are deducted from gross revenues when determining the business’ taxable income. However, in 1982 Congress enacted Section 280E that forbids businesses from deducting otherwise ordinary business expenses from gross income associated with the “trafficking” of Schedule I or II substances. The IRS has subsequently applied Section 280E to state-legal cannabis businesses, since cannabis is still a Schedule I substance under the Controlled Substances Act.

On January 23, 2015, the IRS issued an internal memo that opined on how state-legal cannabis businesses should compute federal income taxes. In this memo, the IRS said that a state-legal cannabis business is unable to obtain a tax benefit by capitalizing disallowed deductions as an inventoriable cost. As a result, a state-legal cannabis businesses can deduct wages, rents, and repair expenses attributable to cannabis production activities if they are part of COGS. However, the IRS stated that you should not deduct wages, rents, or repair expenses attributable to general business activities or marketing activities that are not part of COGS. There is no easy answer for how a state-legal cannabis business should compute its federal taxes. Working with competent attorneys and accountants is the first step.

It is my view that this is the single most important issue for the cannabis industry to address. The inability for state-legal cannabis businesses to take deductions for normal business expenses has the potential to cripple to industry.