In a U.S. Tax Court decision in June, the owners of a medical cannabis dispensary in Colorado found themselves on the hook for tax deficiencies and penalties over two years—to the tune of nearly $500,000. The court’s opinion hinged on IRC §280E and the fact that the owners of AlterMeds LLC had not kept adequate records showing that certain “non-marijuana merchandise” expenses were eligible for deductions as part of a second, distinct business.
“What I think is remarkable about this case is frankly it's one of the first to directly address the issue with respect to a medical dispensary,” Josh Bauchner, head of the cannabis practice at Ansell Grimm & Aaron, tells Cannabis Dispensary.
Read the full court decision here.
The owners of AlterMeds LLC were a married couple, Laurel Alterman and William Gibson, who filed joint tax returns in 2010 and 2011. Those years coincided with the state of Colorado’s 2010 mandate, as the tax court points out, that medical marijuana businesses grow at least 70 percent of the marijuana they sold. The dispensary’s expenses increased immediately as the company shifted to a business model that was more vertically integrated under Colorado law. (AlterMeds is now known as Starbuds.)
To offset the tax burden in 2010 and 2011, Alterman and Gibson filed joint tax returns that claimed a laundry list of “non-marijuana merchandise” expenses—costs that went into products like rolling papers and glass pipes. The court, however, found that the owners of AlterMeds were unable to prove that the non-marijuana merchandise was part of a separate business that could be considered exempt from IRC §280E.
When the dispensary owners attempted to assert after the fact that those business deductions were costs borne by the second, non-marijuana business, audits determined the truth.
The IRS found that the couple had underreported gross receipts (the total amount of all income to a business) by $24,663 in 2010 and $8,359 in 2011. When it came time to deduct costs, the IRS audit cited §280E and denied all of the company’s claimed administrative expenses.
“The notice of deficiency made adjustments to the income of a Colorado medical-marijuana business, owned by Alterman, income that was reported on … both returns,” according to the court. After adjustments, the IRS determined income-tax deficiencies and accuracy-related penalties for 2010 of $157,821 and $31,564, respectively, and for 2011 of $233,421 and $46,684.
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable 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 controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
"[280E] is, reasonably applied, pretty clear," Bauchner says. "COGS (costs of goods sold) are deductible, but the expenses related to cannabis aren't. ... For many reasons, we therefore recommend that our clients create a separate entity -- a management entity, for example -- to run the costs through, which doesn't touch the plant and so that arguably permits those expenses to be deductible."
Indeed, according to the Tax Court, “if selling non-marijuana merchandise were considered a second business, then the expense of that business would be deductible.”
“Although Alterman and Gibson concede that AlterMeds, LLC, trafficked in controlled substances, they contend that it had a separate business of selling non-marijuana merchandise and that the business expense deductions of this separate business are not disallowed by section 280E,” the tax court wrote. “Whether selling non-marijuana merchandise was a separate business from selling marijuana merchandise is an issue of fact that depends on, among other things, the degree of economic interrelationship between the two activities.
“Under the circumstances,” according to the tax court, “we hold that selling non-marijuana merchandise was not separate from the business of selling marijuana merchandise. First, AlterMeds, LLC, derived almost all of its revenue from marijuana merchandise. Second, the types of non-marijuana products that it sold (pipes and other marijuana paraphernalia) complemented its efforts to sell marijuana. AlterMeds, LLC, had only one unitary business, selling marijuana. ... If, however, selling non-marijuana merchandise were considered a separate business, then the expenses of that business would be deductible."
For example, had AlterMeds deducted its non-marijuana expenses against the income of a separate management entity—a wholly distinct LLC—then the IRS would have permitted such deductions.
The burden is on the taxpayer to prove that the IRS was incorrect in its determinations. In this case, the owners of AlterMeds disputed the IRS’s findings, triggering the sort of trial that just concluded in Alterman v. Commissioner in U.S. Tax Court.
“The larger message here is that the IRS is going to be paying attention,” Bauchner says. “These businesses are very, very lucrative -- particularly out west. Obviously, they're predominantly cash-based businesses because of the banking situation. … As is usually the case, they want their pound of flesh, and so they're not going to be turning a blind eye to it anymore. They are going to be conducting audits. They are going to expect to be paid and paid correctly. And like any other business, people are going to have to maintain proper records retain good accountants, retain people internally—CFOs, bookkeepers, whatever it takes to ensure the business is being properly run.”
Bauchner says that the key to proper record-keeping is treating it like the cornerstone of a business that it is. The organizing principles of corporate formation begin in the earliest days of a business’s life; fortune favors the well-prepared, after all.
“And, frankly,” Bauchner says, “most are paying their taxes, and it's an inordinate amount of revenue that's been generated at the state and federal level from these businesses. I challenge anyone to come up with a situation where the federal government considers it to be a wholly illegal, criminal enterprise and yet was happily accepting tax revenue from it.”
He says that his firm guides clients in establishing a gamut of corporate entities: one entity to handle real estate, for example, and one entity to handle management and payroll. Alterman and Gibson could have set that in motion early on in the formation of their company, but, because the records were not there to prove they had, the IRS could not allow them to claim deductions that went against 280E.
“It's kind of a silly situation that we're creating here,” Bauchner says, “because you don't have to dig very deep to see how all of these different entities are interrelating with each other, but, again, there's nothing else like this [industry].
"With respect to cannabis in general, I think any message that they're trying to convey is, again, don't get sloppy,” he continues. “If you're sloppy with your accounting, what does that mean for your seed-to-sale protocol? What does that mean with who you're selling to and how you're selling it and the quality and everything else. If anything, it's a suggestion to businesses in the space to be careful, to take it seriously. It's probably a little bit of a clarion call: Cannabis is now Cannabusiness."
Top photo courtesy of Adobe Stock