Despite medical marijuana
legalization prevailing in
nearly one-half of the 50
states, the U.S. Congress and
the federal court system have
not embraced this nascent business. In
July 2015, the Ninth Circuit affirmed the
Tax Court’s ruling in Olive v. Comm’r
[139 T.C. 19 (2012)] and held that
expenses incurred in a trade or business
that consists of trafficking in controlled
substances prohibited by federal law
are not deductible. In Olive, the Ninth
Circuit noted with approval an earlier
Tax Court case [Californians Helping to
Alleviate Medical Problems, Inc. v.
Comm’r, 128 T.C. 173 (2007), or
Champ] in which the court disallowed
trade or business deductions related to
the sale of medical marijuana. Absent
action by Congress to allow the deduc-
tion of these expenses, the issue
appears closed, and the tax implications
may force otherwise profitable medical
marijuana dispensaries out of business.
Olive Meets a Harsh Decision
In 2002, California legalized the sale
of marijuana for medical purposes. The
taxpayer operated a medical marijuana
dispensary called the Vapor Room in
San Francisco during 2004 and 2005.
The Vapor Room sold marijuana and
provided customers a place to lounge,
socialize, and purchase and consume
medical marijuana. It also provided
games and books for entertainment, yoga
and massage therapy, complimentary tea
or water and snacks, counseling on legal
or political issues related to marijuana,
and free use of vaporizers (an apparatus
used to inhale the principal component
of marijuana). Patrons were charged only
for the purchase of medical marijuana,
the sale of which provided the sole
source of revenue for the business.
The IRS disallowed deduction of all
business expenses (except cost of goods
sold) related to the sale of marijuana at
the Vapor Room. The Tax Court con-
cluded that Internal Revenue Code
(IRC) section 280E disallowed the
deduction of ordinary or necessary
business expenses paid or incurred
during the operation of the Vapor
Room. The Ninth Circuit upheld the
court’s ruling.
Trafficking in Controlled Substances
Treasury Regulations section 1.61-3(a)
defines gross income and provides that
“in a manufacturing, merchandising, or
mining business, ‘gross income’ means
the total sales less the cost of goods
sold.” IRC section 162(a) allows a
deduction for “all the ordinary and nec-
essary expenses paid or incurred during
the taxable year in carrying on any trade
or business”; however, otherwise
deductible trade or business expenses
MAY 2016 / THE CPA JOURNAL
46
TAXATION I federal taxation
TAX
Medical Marijuana Dispensaries Face
a Harsh Reception in Federal Court
By Wayne E. Nix and Ray A. Knight
Although more and more
states are legalizing the sale
of marijuana for medical pur-
poses, the federal govern-
ment, including the IRS, has
not yet adjusted penalties for
trading in what is still classi-
fied as a controlled substance.
This article discusses recent
cases on the issue and offers
tax planning suggestions for
minimizing the liabilities
related to running a medical
marijuana business.
IN
BRIEF
(02)_05-0116 Taxation_Knight_zEssentials.temp 4/22/16 12:38 PM Page 46
allowed under section 162(a) are disal-
lowed under section 280E for “any
amount paid or incurred during the tax-
able 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 con-
trolled substances.” Medical marijuana
is a controlled substance prohibited by
federal law. Deductions disallowed by
IRC section 280E include expenses gen-
erally described as selling, general, and
administrative, as well as financing.
Section 280E does not disallow the
deduction of cost of goods sold.
The Ninth Circuit found that the Vapor
Room was engaged in a trade or busi-
ness because the activity of selling
medical marijuana was entered into with
the intent of realizing a profit. The sale
of marijuana was the sole income-pro-
ducing activity of the business; therefore,
the court concluded that all expenses
(02)_05-0116 Taxation_Knight_zEssentials.temp 4/22/16 12:39 PM Page 47
