CO: Tax Court Again Denies Deductions Of State-Legal Marijuana Facility

Photo Credit: James MacDonald

For the past decade I’ve lived in Colorado, home to 14,000 foot summits, the 2016 Super Bowl champions, and lots and lots of legal weed. Now, we can debate whether legalized medicinal and recreational marijuana is healthy for an individual, profitable for a government, or morally palatable to a society, but what is not up for debate is this: the widespread availability of legal weed has given rise to a marked increase in amusing anecdotes.

Case in point: last week my friend and I went out for what was intended to be a moderate mountain bike ride. As tends to happen, however, two hours quickly turned to three, and then four, and before we knew it, we had been pedaling for nearly five hours. This was problematic for two reasons: first, we had only brought enough food for half that duration, and second, my buddy was in danger of missing the start of his son’s baseball game.

At long last, we returned to the trailhead, where my famished friend, before even changing out of his bib shorts or mounting his bike upon its rack, began tearing through his car for any morsel of food. He quickly grew frustrated, because on this day he had borrowed his wife’s car, so his usual supply of energy bars was nowhere to be found.

Finally, he opened the center console, and pulled out a sandwich bag filled with chocolate squares. One…two…three were popped into his mouth and swallowed, and as he went back for round two, I saw his face change. For it was at that moment that he realized that these were not ordinary chocolates, but rather his wife’s supply of “emergency” edibles in the event she felt overly stressed at work.

Needless to say, that was the most fascinating Little League game he ever sat through.

Anyhoo, where was I…oh yeah, legal weed. It makes for great stories, but really confusing tax treatment. You see, while nine states have legalized recreational marijuana — with another 29 allowing for medicinal marijuana — the sale of the drug remains illegal from a federal perspective because marijuana continues to be listed as a Schedule 1 controlled substance.

This creates a big problem from a federal tax perspective. Why? Well, back in 1982, Congress enacted Code Section 280E, which provides that no deduction — other than the cost to purchase or grow the marijuana inventory, or what we call “Cost of Goods Sold (COGS)” — is allowed for any amount incurred in a business that consists of “trafficking in controlled substances.” As a result, despite the fact that the sale of marijuana may be perfectly legal from a state perspective, the IRS has the ammunition necessary to deny all non-COGS deductions — things like rent, utilities, wages, supplies, etc… – of any facility that sells the drug.

As you might imagine, when the IRS successfully applies Section 280E, it can cripple a dispensary. The business is forced to pay tax on 100% of its revenue reduced only by COGS, with absolutely no reduction for typical general and administrative expenses, an untenable result that has caused more than a few dispensaries to be taxed out of existence.

This takes us to a case decided today by the Tax Court; just the latest in a long line of decisions that have shown the punishing effect of Section 280E: Alterman v. Commissioner, TC Memo 2018-83.

Facts in Alterman

Laurel Alterman formed Altermeds LLC — a medicinal marijuana dispensary — in mid 2009. At first, Altermeds was simply a retail operation; it grew none of its own marijuana. Instead, it purchased its product from third parties, and then sold it to customers, either as prerolled joints, dried buds, or edibles. Importantly, Altermeds also sold products that contained no marijuana, such as pipes, papers, and other items “used to consume marijuana,” which I assume was just a giant box of share-size Funyuns.

Beginning in September 2010, a new Colorado law required a medical marijuana facility to grow at least 70% of the marijuana it sold. As a result, Altermeds began renting a warehouse and producing its own inventory, while continuing to also purchase some product from third parties for resale.

On its 2010 and 2011 tax returns, Altermeds reported the following revenue, COGS, and other expenses:

                   2010        2011

Revenue  $894,922   $657,126

COGS    ($464,119) ($253,089)

G&A      ($385,489) ($384,817)

IRS Audit

The Service audited Altermeds 2010 and 2011 tax returns, and summarily denied all of the G&A expenses for 2010 and 2011 — expect for depreciation deductions — under Section 280E. In addition, the IRS reduced the allowable COGS deduction in each year to $452,292 and $232,772, respectively. These adjustments resulted in a $157,821 deficiency for 2010 and a $233,421 underpayment for 2011, with the IRS tacking on sizable underpayment penalties for good measure.

Taxpayer Argument: G&A Expenses

Alterman made several arguments in hopes of preserving a portion of the denied deductions. First, she pointed to the fact that Altermeds sold not only marijuana, but also other “non-marijuana merchandise.” The sale of these pipes and papers, she argued, constituted a second business, separate and distinct from the sale of marijuana; a business that was not subject to Section 280E.

This was clearly a nod to the sole case in which a marijuana facility was able to overcome a Section 280E attack. In Californians Helping to Alleviate Medical Problems (CHAMP), 128 T.C. 173, (2002 ) — the taxpayer achieved a partial victory against the IRS. In CHAMP, the court acknowledged that a marijuana facility can have multiple lines of businesses, only one of which is “trafficking in a controlled substance,” with Section 280E applied only to the offending line of businesses.

The taxpayers in CHAMP were able to effectively argue that it operated a separate business focusing on counseling customers on which type of marijuana would best treat their particular ailment; as a result, they were able to salvage the deductions attributable to the counseling business.

Altermed’s argument was not nearly as persuasive, however. Whereas in CHAMP, a sizable portion of the revenue generated by the facility was attributable to consulting services, less than 4% of Altermed’s sales were of non-marijuana merchandise. As a result, the court concluded that the sale of this merchandise was not a separate business, but rather an activity that merely complemented its efforts to sell marijuana.

Now, it would be reasonable to question how the consulting business in CHAMP didn’t also complement the taxpayer’s efforts to sell marijuana, but even if the court had agreed to view Altermed’s sale of non-marijuana merchandise as a separate business, no deductions attributable to this business would have been allowable, because Altermed’s failed to substantiate the expenses attributable to this business line. Instead, Alterman simply took a percentage of total G&A expenses and presented it as attributable to the sale of non-marijuana merchandise, a lazy approach that was not accepted by the Tax Court. Thus, the court concluded that all of the G&A expenses — aside from a small amount of depreciation — were attributable to Altermed’s sole business of trafficking in a controlled substance, and were nondeductible under Section 280E.


The courts have not been kind to taxpayers who attempt to avail themselves of the CHAMPS “second line of business argument.” In Olive v. Commissioner, 139 T.C. 2, (2012),  the taxpayer was a California facility whose sole source of revenue was its sale of medical marijuana. Patrons went to the Vapor Room to relax and smoke or inhale vaporized marijuana; but that was not all they did. The Vapor Room was set up like a community center; with couches, chairs, and tables located throughout the establishment. Games, books and art supplies were available for patrons’ general use. The Vapor Room also offered services such as yoga, movies, and massage therapy. Customers could drink tea or water during their visits, or they could eat snacks including pizza and sandwiches. Importantly, however, all of these additional amenities were provided free of charge.

The Tax Court agreed with the IRS that the Vapor Room was not entitled to deduct any of its operating expense pursuant to Section 280E, refusing to afford Olive the wiggle room it showed the taxpayer in CHAMP. Despite Olive’s contention that his business was similar to the one in CHAMP — equal parts the sale of goods and the provision of additional services — the Tax Court was unconvinced:

Petitioner asserts that the Vapor Room’s overwhelming purpose was to provide caregiving services, that the Vapor Room’s expenses are almost entirely related to the caregiving business and that the Vapor Room would continue to operate even if petitioner did not sell medical marijuana. We disagree. We find instead that petitioner had a single business, the dispensing of medical marijuana, and that he provided all of the Vapor Room’s services and activities as part of that business. The record establishes that the Vapor Room is not the same type of operation as the medical marijuana dispensary in CHAMP that we found to have two businesses.

In reaching its decision, the Tax Court established a precedent that it will hold a medicinal marijuana facility to a strict standard in establishing that it offers multiple lines of business.

Petitioner essentially reads our Opinion in CHAMP to hold that a medical marijuana dispensary that allows its customers to consume medical marijuana on its premises with similarly situated individuals is a caregiver if the dispensary also provides the customers with incidental activities, consultation or advice. Such a reading is wrong. Petitioner also has not established that the Vapor Room’s activities or services independent of the dispensing of medical marijuana were extensive. We perceive his claim now that the Vapor Room actually consists of two businesses as simply an after-the-fact attempt to artificially equate the Vapor Room with the medical marijuana dispensary in CHAMP so as to avoid the disallowance of all of the Vapor Room’s expenses under section 280E. We conclude that section 280E applies to preclude petitioner from deducting any of the Vapor Room’s claimed expenses.

As you can see, if a facility is to have any hope of wielding the CHAMPS argument, it must be prepared to:

1. Show that the alternate business line is extensive enough to “stand on its own;” in other words, it would be a viable business for the taxpayer even in the absence of the sale of marijuana, and

2. If the taxpayer asserts it has a second line of business, it should treat it like a second line of business, accounting separately for its income and expenses so that if the IRS or courts are kind enough to agree with the taxpayer, the amount of deductible expenses are readily available.

Taxpayer Argument: COGS

With its “alternate business line” argument denied, Altermeds turned to the last refuge of the targeted marijuana facility: arguing that the business had overstated its non-deductible G&A expenses and understated its deductible Cost of Goods Sold. Specifically, Altermeds alleged that its true COGS for 2010 and 2011 was $600,217 and $417,570, respectively (compared to the $452,292 and $232,772 allowed by the IRS).

There were several problems with this argument.  First, Altermeds’ bookkeeping was less than reliable. Cost of Goods Sold is determined via a fairly simply formula: COGS = Beginning Inventory + Purchases + Production Costs  – Ending Inventory

For 2010 and 2011, however, Altermeds reported only $12,279 and $0 of ending inventory, respectively. The Tax Court recognized that it was exceedingly unlikely that on New Years Eve of both years, Altermeds had been cleaned out of any and all inventory. Thus, the court concluded, Altermeds was improperly deducting every dollar of purchased and produced marijuana as COGS, even if that marijuana was still on hand at year end.

In addition, the court was unconvinced by some of the G&A-to-COGS changes proposed by Altermeds. For example, Alterman argued that 40% of the services performed by employees at the dispensary — the wages of whom were added back as part of the Service’s application of Section 280E — was spent “trimming” the marijuana of its stems and seeds to make it more salable, a task the taxpayer argued was production related and should be deductible as COGS. The court, however, found that there was no evidence that the employees spent ANY time trimming the marijuana, a conclusion that was reached, in part, by the testimony of the employees themselves.

Because Altermeds hadn’t bothered to keep a detailed inventory count, the court gave no credence to its calculation. As a last gasp, Altermeds argued that the court should simply take a percentage of its total revenue — as determined based on the testimony of industry experts — as its supportable COGS, as the court had been willing to do in Olive. Here, however, the court declined to do so, because for unstated reasons, it found the expert’s testimony inadmissible and thus the application of a ratio was impossible.


Recordkeeping, recordkeeping, recordkeeping. This should go without saying, but if you work in an industry in which the IRS has a tool at its disposal to deny ALL OF YOUR NON-COGS DEDUCTIONS, you had better be meticulous in your record keeping. As we discussed above, if you’ve got a (substantial) second line of business, treat it like one, separately recording revenue and expenses. But even if you don’t, you HAVE to maintain consistent, thorough, and defensible allocations of costs between G&A expenses (that are subject to Section 280E) and COGS (which are not). To argue that you have half-a-million in COGS without bothering to record opening or ending inventory is to set yourself up for a quick defeat.