How tax ruling may ‘kill’ U.S. medical marijuana industry

WASHINGTON, DC — Medical marijuana in the United States may have just had its Waterloo moment, according to a Detroit area attorney, who said an obscure federal tax court decision on Thursday may spell the end for the medicinal pot industry.

Paul McKenney, a federal tax attorney with Varnum LLP in Novi, called the Aug. 2 decision in Olive v. Commissioner, a case out of California, a “time release hammer” on the medical marijuana industry because it disqualifies all medical marijuana distributors from most tax deductions.

“Now, they’ve got a real problem,” said McKenney.

As a practical matter, “this may kill them” he said, because without qualifying for deductions, the industry can be virtually taxed into extinction by the Internal Revenue Service.

“The impact is a simple case of arithmetic.”

The United States Tax Court, which adjudicates disputes over federal income tax, unanimously ruled Thursday that Martin Olive, owner of the Vapor Room Herbal Center in San Francisco, underreported his income. The 19 judge panel decided that Olive was precluded from deducting the vast majority of the expenses he claimed because his retail medical marijuana business was trafficking in what federal law considers a controlled substance.

Although medical marijuana is legal in 18 states including Michigan, which passed the Medical Marijuana Act in 2008, it remains illegal under federal law, which trumps all other laws according to the Supremacy Clause of the U.S. Constitution.

“The dispensing of medical marijuana, while legal in California, among other states, is illegal under federal law,” wrote Tax Court Judge Diane L. Kroupa. “Congress has set an illegality under federal law as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business. This is true even if the business is legal under state law.”

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It’s particularly damming to the medical marijuana industry because it means medical marijuana and “care-giving” businesses may only be able to deduct a small fraction of gross receipts and other standard business expenses.

Olive’s business was operating under the California Compassionate Use Act of 1996, but according to Section 280E of the federal Tax Code, no deduction shall be allowed for any amount incurred in a business that traffics in controlled substances, which gives the IRS the ammunition to deny deductions for rent, utilities, wages and other expenses associated with operating a business.

For enforcement purposes, what separates a pharmacy from a medical marijuana dispensary is a federal license, said McKenney.

McKenney said the obscure code section dates to the Reagan Administration, when the IRS shifted some of their resources to combat drug trafficking.

The tax court found that Olive could deduct some inventory costs, also known as the cost of goods sold, where proven, but Olive conducted most of his vaporizer-inhaled medical “herbal” business in cash and kept poor records. Located in a Victorian house on San Francisco’s Haight Street, the Vapor Room operated for more than eight years before closing Tuesday, facing a huge IRS bill, McClatchy Newspapers reported.

The description of his business from the ruling:

Olive “designed the Vapor Room with a comfortable lounge-like community center atmosphere, placing couches, chairs and tables throughout the premises. He placed vaporizers, games, books and art supplies on the premises for patrons to use at their desire. He set up a jewelry-store-like glass counter with a cash register on top and jars of the Vapor Room’s medical marijuana (dried herb, food and baked goods) inventory displayed underneath and behind the counter.”

The dispensary was open weekdays from 11 a.m. to 8:30 p.m., and on weekends from noon to 8 p.m. All staff were qualified to work and partake in the facility. Olive and staff “occasionally sampled the medical marijuana inventory for free and they would regularly hang out at the Vapor Room after business hours.”

The dispensary would deliver to terminally ill patrons, discussed their illnesses, counseled each other in legal matters, and wrote letters to incarcerated distributors.

Olive’s 2004 and 2005 net income was $64,670 and $33,778, respectively.

Neither staff, nor the other patrons paid Olive a stated fee to frequent the Vapor Room. Nor did Olive require that any patron purchase medical marijuana from him to frequent the Vapor Room or to take part in its activities or services. Patrons had access to all of the activities and services that the Vapor Room provided and
marijuana was routinely passed throughout the room for consumption without cost
to patrons who wanted to partake.

marijuana tax cour ruling snap.jpgPage 10 of the U.S Tax Court ruling in Olive v. Commissioner.

The Vapor Room regularly offered chair massages with a therapist… and patrons, while at the Vapor Room, regularly drank complimentary tea or water and they occasionally ate complimentary snacks or light food such as pizza and sandwiches.

McKenney said it’s likely this will take a few years to fully play out. He said the judges did not rule on whether marijuana is legal or illegal under federal law, but simply applied the law in determining how the industry can be taxed.

The ruling is likely to rile those passionate about the benefits of medical marijuana, but due to the unanimity of the decision, marking the court’s highest level of precedent, the odds of it being overturned on appeal are small, he said.

From a business standpoint, “are you going to put money into something that just got a death knell from the tax court?” he asked, rhetorically. In a few years, because of the tax burden, people will eventually realize they cannot make money selling medical marijuana.

“Basically, they are in the position of making buggy whips, only this is going to happen faster,” he said. “For those who are trying to put (medical marijuana) under, it’s a huge victory.”

Published: Friday, August 03, 2012, 6:45 PM
Updated: Friday, August 03, 2012, 8:31 PM
By Garret Ellison |

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