Smoking Out The Money - 6.17.2015

Smoking Out the Money:Current Tax Issues Related to

Medical Cannabis

Wednesday, June 17, 2015

William E. Taggart, Jr. William E. Taggart, Jr. P.C.

Josh P. DavisWilliam E. Taggart, Jr. P.C.

The Risks in Providing Financial Services to the Marijuana Industry

Under the Controlled Substances Act (“CSA”), it is illegal under federal law to manufacture, distribute, or dispense marijuana. There are many states that impose and enforce similar laws.

Financial Services andthe Marijuana Industry

• Despite more and more states passing laws that legalize marijuana in various forms, the federal government still lists marijuana as a Schedule I controlled substance under the CSA

• As such, financial institutions who provide services to marijuana-related businesses face pressure from federal agencies.

The Cole Memorandum

• On August 29, 2013, Deputy Attorney General James Cole issued a memorandum to all United States Attorneys providing updated guidance on marijuana enforcement and priorties under the CSA.

• Outside of the below enforcement priorities, the federal government has traditionally relied on states and local law enforcement agencies to address marijuana activity through enforcement of their own narcotics laws.

• The Enforcement Priorities include:• Preventing the distribution of marijuana to minors;• Preventing revenue from the sale of marijuana from going to criminal enterprises, gangs, and cartels;• Preventing the diversion of marijuana from states where it is legal under state law in some form to

other states;• Preventing state-authorized marijuana activity from being used as a cover or pretext for the trafficking

of other illegal drugs or other illegal activity;• Preventing violence and the use of firearms in the cultivation and distribution of marijuana;• Preventing drugged driving and the exacerbation of other adverse public health consequences

associated with marijuana use;• Preventing the growing of marijuana on public lands and the attendant public safety and

environmental dangers posed by marijuana production on public lands; and• Preventing marijuana possession or use on federal property.


• Following the August 29, 2013 Memorandum, the Financial Crimes Enforcement Network (“FinCEN”) issued guidance to clarify Bank Secrecy Act (“BSA”) expectations for financial institutions that elect to provide financial services to marijuana-related businesses.

• The purpose of the FinCEN guidance is to facilitate marijuana-related businesses’ access to financial services, while ensuring that the activity is transparent and the funds are going into regulated financial institutions.

• Notwithstanding the FinCEN guidance, financial institutions remain at risk for money laundering, unlicensed money transmitting, and BSA offenses based on participation in violations of the CSA through the provision of financial services to marijuana-related businesses.


• Processing money from marijuana sales puts federally insured banks at risk of drug racketeering charges.

• Because of the threat of criminal prosecution, most financial institutions decline to allow marijuana-related businesses to open accounts.

• The bulk of the FinCEN guidance is devoted to the handling of cash on which the marijuana business has almost exclusively relied until quite recently.

• A business operating on a cash-only basis is a prescription for tax evasion problems.

FinCEN Risk Assessment

• FinCEN stated that as part of its customer due diligence, a financial institution should consider whether a marijuana-related business implicates one of the Cole Memorandum priorities or violates state law.

• A financial institution that declines to provide financial services to a marijuana-related business is also required to file Suspicious Activity Reports (SARs).

• As a consequence of the burden and risks associated with the FinCEN guidance, most banks continue to decline to knowingly handle marijuana related businesses.

Filing Suspicious Activity Reports on Marijuana-Related Businesses

• The obligation to file a SAR is not affected by any state law that legalizes marijuana-related activity.

• A financial institution must file a SAR if it knows, suspects, or has reason to suspect that a transaction conducted or attempted by, at, or through it:

Involves funds derived from illegal activity or is an attempt to disguise funds derived from illegal activity;

Is designed to evade BSA regulations; or Lacks a business or apparent lawful purpose.

“Marijuana Limited” SAR Filings

If it is reasonably believed that a financial transaction does not implicate one of the Cole Memo priorities or violate state law, the memorandum directs the financial institution to file a “MARIJUANA LIMITED” SAR that contains:Identifying information of the subject and related parties;Addresses of the subject and related parties;The fact that the institution is filing the SAR solely because the subject is engaged in a marijuana-related business; andThe fact that no additional suspicious activity has been identified.

FedEx Indictment

• Most marijuana related businesses in California appear to have established banking relationships, but consider:

• In July 2014, a San Francisco federal grand jury indicted FedEx with conspiracies to traffic in controlled substances and misbranded prescription drugs for its role in distributing them for illegal Internet pharmacies.

• In August 2014, DOJ added additional charges, including conspiracy to launder money.

FedEx Indictment

• The case is a key test for how much legal responsibility delivery companies bear for the contents of the packages they deliver.

• If FedEx is found guilty, the U.S. Attorney’s Office says FedEx faces a potential maximum fine of twice the revenues it made on the business, or about $1.6 billion.

Marijuana Delivery Services

• A flourishing & unregulated industry of marijuana delivery services is circumventing state bans on storefront dispensaries and bringing medical marijuana directly to people’s homes.

• Delivery services in Colorado and Washington, which have legalized recreational marijuana, remain illegal - both states specifically require in-person purchases.

• In Colorado, some delivery services have tried to get around that law by requesting donations for deliveries, because giving away marijuana is allowed. As many of you may be aware this is a fiction that has been utilized in California since 1996.

Deducting Illegal Payments

• Although the sale of medical marijuana is now legal in 23 states and DC, the IRS is applying the provisions of Section 280E to businesses operating in the medical marijuana industry to deny otherwise valid business deductions.

• Section 280E is at the center of the conflict between federal and state laws with respect to medical marijuana, which is a controlled substance within the meaning of Schedules I and II of the Controlled Substances Act.


• Congress added Section 280E to the IRC in response to a decision allowing a drug dealer to deduct business expenses.

• 280E provides that sellers of controlled substances must pay taxes on their gross revenue instead of their net income - producing much higher taxes - presumably acceptable when applied only to drug dealers.

• 280E applies to state-sanctioned marijuana sellers as well as illegal drug dealers. 280E creates a disincentive for legitimate marijuana sellers.


• The two most significant cases in this area arose in California.

• Both involve the business of providing medical marijuana legally to patrons under the California Compassionate Use Act of 1996 (CCUA). In both cases, the IRS used Section 280E to deny deductions for otherwise legitimate business expenses.

Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP)

• Section 280E does not preclude deduction of expenses attributable to a trade or business other than that of illegal trafficking in controlled substances simply because the business was also involved in the trafficking of controlled substances.

• The Tax Court found that CHAMP was involved in both providing caregiving services & dispensing medical marijuana, two separate & distinct businesses.

• CHAMP permitted deductions for expenses of providing caregiving services, where the services stood on their own merits.

Martin Olive v. Commissioner

• Section 280E precluded Martin Olive from deducting any of his claimed business expenses.

• Determinations: all revenue came from the sale of marijuana. A second business did not exist simply because patrons also were provided with snacks, a massage, or a movie, etc.

• Currently on appeal in the Ninth Circuit. Oral Argument occurred in April of 2015, however no Opinion has been issued yet.

CHAMP and Olive

• Both CHAMP and Olive allowed Cost of Goods Sold to reduce gross revenue from sales to determine gross income.

• CHAMP authorized the deduction of expenses relating to health counseling activities, but not the expenses relating to trafficking in a controlled substance.

• Olive should be viewed as an affirmation of the allowance of Cost of Goods Sold, a failure of proof with respect to a separate health counseling business activity, and as a complete failure of proof relating to business expenses.

2015 Developmentsin the Cannabis Industry

Office of Chief Counsel (IRS) Memorandum

• On January 23, 2015, the Office of the Chief Counsel issued advice specifically addressing 280E to IRS counsel lawyers throughout the United States.

• 2 Major issues– 1. Requires the maintenance of inventory / requires

the capitalization of all costs of production of medical cannabis products.

– 2. Treats all other costs that are not capitalized as trafficking expenses – non-deductible under 280E.

• This CCA memorandum allows IRS lawyers to require taxpayers to correct their accounting methods which creates greater deficiencies.

June 9, 2015 Memorandum

• On June 9, 2015, the IRS issued an internal memorandum approving the waiver or abatement of the 10% penalty for the failure to pay specified federal taxes by Electronic Funds Transfer (EFT).

• This memorandum was in reaction to the Allgreens case which arose in Colorado.

• This is not a solution as the burden will remain on the taxpayer to prove a good cause defense based on the inability to secure banking services.

Representation Opportunities in the Cannabis Industry

Vertically Integrated Dispensary

• A medical cannabis business (“Safe Harbor”) operates as a vertically integrated indoor grow and dispensary in San Pedro, California. A and B are partners in the business.


• Safe Harbor was accurately denominated a “not-for-profit” organization. Following generally accepted record-keeping practices, Safe Harbor conducts its business as follows:

Allocates substantially all its costs to Cost of Goods Sold;

Provides health related classes and counseling to its members to which it allocates most of its floor space and a majority of its payroll; and

Maintains detailed records of its cash expenditures for bulk purchases of product.


• However, CPA has advised the owners of Safe Harbor that the IRS has selected the most recent income tax return of Safe Harbor for audit.

Internet Distribution of Medical Cannabis

• Before the owners of Safe Harbor were notified of the IRS audit, the owners of Safe Harbor were approached by two friends - E and F - with an idea for expanding on the success of Safe Harbor.


• E and F decided to build on the name and success of Safe Harbor to create Safe Harbor Delivers, a state-wide “virtual dispensary” that guarantees 24-hour delivery of Safe Harbor’s medical cannabis products anywhere in California.


• The small dark cloud, however, has been extended to Safe Harbor Delivers.

• CPA has advised the owners that the IRS auditor has expanded the audit of Safe Harbor to include the prior and subsequent year and has asked for copies of all of the bank statements for the Safe Harbor dispensary as well as of its owners and of any other businesses in which the owners have interests.

Smoking Out The Money - 6.17.2015

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