Marijuana Tax Problems

Can a cocaine, marijuana and methamphetamine dealer deduct his scale from his federal tax bill?

Because the IRS said, “No,” from jail the drug dealer took them to court. In a 1981 decision, the tax court agreed with the defendant. Totally ignoring his illegal activities, the court decided that one-third of his rent, the scale, his telephone and auto expenses were legitimate deductions. Other travel and entertainment spending was rejected but only because of insufficient substantiation.

The Congressional Reaction

Horrified (I guess) that an existing tax regulation helped drug dealers, the Congress sought to make illegal activity an exception to tax code provisions. Adding Section 280E to the tax code in 1982, they said that any business involved with a controlled substance could not take a tax deduction or credit.

Classified as a controlled substance, marijuana is covered by Section 280E. Recently, the Supreme Court said so too was medical marijuana.

Where are we going? To the incentives created by tax policy.

The Marijuana Response

When small businesses write off wages, utilities, and rent, the amount on which they pay federal income tax shrinks. As a result, because of 280E, the effective tax rate for a marijuana business can be as high as 93 percent, far exceeding a small business average of 15 to 35 percent. One marijuana entrepreneur said his $275,000 tax bill was “unbelievable.”

Responding to high tax rates, retailers say said they are tempted to take the deductions and hope the IRS does not notice they sell marijuana. Others are manipulating their expense allocations by deducting a disproportionate segment of costs from non-marijuana parts of their business. A third group has pointed out that excessive taxes have constrained business growth.

Our Bottom Line: Tax Incentives

Behavioral economists like to tell us that taxes create incentives. Concerned about tax scofflaws, England’s “nudge squad” sent a letter telling people that everyone else paid taxes and so should they. Displaying they had selected the right incentive, the positive response rate exceeded prior punitive letters.

As for the taxes themselves, sales taxes could diminish consumption. A high marginal tax rate can discourage work. When regulations and taxes apply to businesses with 50 employees, many stop hiring at 49.

Similarly, Section 280E creates a host of undesirable incentives for legal marijuana business people.