Tax Issues Associated With Marijuana Sales Businesses
The proliferation of marijuana related growing and selling businesses here within the US, has created both fantastic business opportunities and unseen risks. The risk is in the dreaded IRS tax audit, which could bankrupt you as a business owner. Accordingly, a large percentage of your business related deductions that you have taken on your tax returns are going to be disallowed by the IRS if you are targeted for an audit. The reason is IRC Section 280E "Expenditures in the Connection With The Illegal Sale of Drugs," disallows most of your deductions that you probably took on your tax return. This will most likely result in a huge personal liability for you as the business owner.
The relief may be in how you calculate your cost of goods sold (COGS). You are missing an opportunity here to minimize your risk, so ask your accountant about these issues ASAP.
Think about what would happen if most of your deductions were disallowed and the IRS sent you a large adjustment on your two most recent tax returns for over 70% of what you think that you made over the last two years. How are you going to pay that bill? Can they go back 6 years under the substantial understatement rule? The best solution is not to get yourself into that problem in the first place by taking advantage of the limited tax benefits that are available to your industry.
The Federal Trap and your Business Profits:
Internal Revenue Code Section 280E: Expenditures in connection with the illegal sale of drugs
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 consists of the trafficking in controlled substances prohibited by Federal Law....
The IRS Threat:
There are a lot of people that are making a lot of money selling or growing marijuana because the State where they reside has legalized the sale activity and maybe even the general possession of the illegal substance. The IRS has issued summons to the revenue departments of States that tax marijuana businesses to get the names and addresses of these businesses for audit investigations. Some states like Colorado resisted and filed Federal lawsuits to quash the summons, but lost, the IRS won.
What these business people may or may not realize is that Federal Law still prohibits these State sanctioned activities, and that the business tax returns of these enterprises are detrimentally affected by the restrictions within the Internal Revenue Code, concerning the allowance of the deductions of ordinary business expenses. Moreover, you will not be able to deduct your employee wages, rent and other administrative expenses on your federal tax returns. Accordingly, you may be one IRS audit away from losing everything that you own from IRS seizure.
You may be allowed a deduction for Cost of Goods Sold (COGS)
The cost that you pay for the Marijuana that you sell, along with other limited COGS related items, would be your only allowable tax deduction. A US Supreme Court decision, allowed the deduction of the cost of the product itself, in calculating the income tax due for an illegal drug sales business. Therefore, allocating as much of your business expenses that would be allowed under the law, to COGS, is your only option to lower your tax liability.
Substantiation Requirements For Expense Deductions
Your accounting software general ledger is not going to be allowed as your only substantiation for business expenses you pay in cash. Olive v Commissioner, 139 TC 3. Moreover, if you are paying cash for your expenses, recording those transactions in accounting software, and then giving the Ledger to the IRS to prove you paid the expense is not going to fly. You must keep a contemporaneous record that lists the date, sale amount, expense item or inventory item, the seller, and the nature of each transaction. Taxpayers have the burden of proving expense deductions.
I personally believe that this cash log, listing daily transactions, is necessary to keep you from being investigated by the CID, IRS Criminal Investigative Division, due to the large amount of cash that you would be handling each day. Moreover, since you are receiving large amounts of cash, you would also be paying some of your expenses in cash, and you had better properly keep track of it.
I recommend putting every penny in the bank and then paying expenses like any other business does, through normal means other than with cash. But wait, you cannot open a bank account, right? You have a problem that needs to be closely monitored. If you transfer the money to another closely held company and then deposit that money in a bank account, you may be accused of federal criminal banking offenses such as money laundering and structuring. You will need to then keep track of every dollar that either comes in or goes out to pay expenses.
Bank Deposit Analysis procedures and Unearned income Claims
The IRS procedure of claiming you have unreported income based on their analysis of your bank account deposits does not shift the burden of proof to the IRS under IRC Section 7491(b).
Accordingly, the sentence in IRC Section 7491(b) relating to the "use of statistical information on unrelated taxpayers" does not apply to bank deposit analysis techniques, according to court interpretations of this statute. Therefore, the burden is on the taxpayer to prove the deposits are not income...
The Non Profit Option
Some tax professionals believe that a marijuana seller can operate under the veil of a non-profit organization to avoid IRC Section 280E.
I do not believe that one engaging in the State sanctioned sale of a controlled substance under Federal law should attempt this charade. First of all, 501(c)(3) organizations would not qualify if they were engaging in illegal activity under federal law (public policy doctrine). Secondly, I do not personally believe that a 501(c)(4) social welfare organization would qualify either, and in my opinion, you would be just getting yourself in bigger trouble with the IRS. 501(c)(4) organizations have too many restrictions relating to the exempt function purpose of the entity, and you are existing to sell an illegal product under federal law...and lets not forget the "public policy doctrine" as to promoting illegal acts under federal law.