One Simple State Tax Code Tweak to Favor Marijuana Taxpayers over Tax Evaders

April 20, 2015

In states with legalized marijuana, legislatures have partially converted an almost completely untaxed black market industry into a taxed and regulated industry that helps fund schools, healthcare, law enforcement, research, substance abuse treatment, and other government expenses. However, this conversion is not total: states have elected to § 280E, illegal drug traffickers are not permitted to deduct any of their business expenses. This provision of the tax code was passed into law in 1982 to prevent drug dealer kingpins from deducting expenses like guns and smuggling yachts, but the IRS chooses to treat state legalized marijuana operators as illegal drug traffickers. The irony of this interpretation is that it punishes taxpayers trying to comply with the law and creates a competitive advantage for the very drug dealer kingpins § 280E was enacted to punish.

Perhaps the largest expenses these operators are forbidden from deducting under § 280E are the excise taxes and license fees they pay to the state. By disallowing these deductions, the IRS significantly increases the effective tax rate on marijuana. For example, an ounce of marijuana sold in Washington is subject to a pyramiding 25 percent excise tax at three levels: production, processing, and retail. The IRS ignores these expenses and taxes the amount paid as part of a taxpayer’s net income, and as a result the effective rate of each tax increases significantly. This creates a problem of fundamental fairness; taxpayers are assessed an income tax on revenue that actually accrues to the state.

States could unilaterally correct this problem by changing the type of taxes they place on the marijuana industry. IRS treatment of sales taxes depends upon how a state defines the tax. If the state defines the tax as being levied on the seller, the tax is included in gross receipts. On the other hand, if the tax is defined as levied on the buyer, the seller is treated as a mere collector custodian of the state’s revenue and the amount levied is not properly included in gross receipts. For most businesses this is a distinction without a difference; sales taxes levied on a seller can be deducted as an expense. However, for dispensaries denied deductions by § 280E, this distinction could reduce federal tax exposure by huge amounts. Creative legislators could even redefine license fees as custodial sales taxes, by requiring retailers to collect the license fees from consumers instead of charging them directly to retailers.

Such redefinition wouldn’t lower a state’s marijuana tax income, but might instead increase tax revenues by helping to level a playing field artificially tilted toward the tax evading black market alternatives § 280E was intended to punish. States can’t force the IRS to reconsider its interpretation of an antiquated tax code section, but they should consider reducing its impact whenever possible. Until the states make a change or Congress acts to modernize § 280E, tax policy will continue to favor the illegal drug trade, not businesses trying to comply with the law.


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