On July 5, 2014, Governor Andrew Cuomo signed New York Assembly Bill 6347, permitting the medical use of marijuana in the state. This continued a trend of states considering limited use or legalized sales and use of marijuana in some form. In most of these states, the transactions are restricted to individuals acquiring the drug for medical purposes. Four states, however—Colorado, Alaska, Washington, and Oregon—as well as Washington D.C., have each recently decriminalized the sale/use of cannabis for recreational purposes. Following this trend, a recent Gallup poll found that 58% of Americans agree that the use of marijuana for some purpose should be legalized.

At the federal level, marijuana is still officially a controlled substance. Although the Obama administration took a more relaxed policy towards legalized medical marijuana enforcement, it remains to be seen what direction the Trump administration will take.

The dual legal status of marijuana presents an interesting legal and ethical conundrum for CPAs and other professionals who will invariably encounter clients or prospective clients in this industry. For tax purposes, will the IRS treat these businesses as legal or illegal? If these businesses are deemed illegal, are their expenses deductible? If so, under what conditions are their business expenses deductible? Finally, what are the legal and ethical implications for professionals serving clients engaged in these businesses?

Regulatory Framework: Legal or Illegal?

Currently, the legality of the marijuana industry is confusing at best; marijuana is illegal federally, but it is simultaneously legal in 25 states. Under the Constitution, the federal government is allowed to regulate anything rooted in its specifically enumerated powers; in the case of marijuana, Article I, Section 8 gives the federal government the power to regulate interstate commerce and the instrumentalities thereof. Furthermore, Article I, Section 8, Clause 18 of the U.S. Constitution gives Congress the power to regulate anything that is necessary and proper to support its regulation of interstate commerce, even if that means regulating items that remain fully intrastate. The federal government’s power to regulate marijuana was affirmed by the Supreme Court in Gonzales v. Raich [545 U.S. 1 (2005)].

To make matters more confusing, states are allowed to fully deregulate marijuana if they so choose, thereby preventing their own law enforcement personnel from investigating and prosecuting certain marijuana related crimes. Furthermore, the federal government is not allowed to commandeer state resources (e.g., law enforcement personnel) to enforce federal law. Thus, in situations where marijuana use is legal at the state level, federal law enforcement personnel are still fully able to prosecute marijuana related crimes; however, they may not have the help of state law enforcement personnel, which is often essential. In addition, states that fully deregulate marijuana risk losing federal funding, especially for state and local law enforcement agencies.

he Obama administration decided on a policy of, under certain conditions, looking the other way in states that elect to legalize marijuana, as outlined in what is known as the Ogden Memo. This Department of Justice document provides specific guidance to states with legalization initiatives seeking to avoid federal interference, directing them to include provisions that 1) criminalize marijuana use and driving, 2) criminalize under-age consumption, 3) prevent use and sale on federal lands, and 4) prevent the transportation of marijuana into other states. While this policy held during the Obama administration, its future under President Trump and Attorney General Jeff Sessions is currently uncertain.

The biggest hurdle for dispensaries is the current tax framework, which treats marijuana growers more adversely than both legal and illegal businesses alike.

Tax Framework

Like all legitimate businesses, marijuana dispensaries must compile financial data for management purposes, to obtain loans, and to file tax data. This greatly increases the accounting needs of dispensaries, and makes their operating environment somewhat hostile. Unlike other businesses, the federal legal status of dispensaries means that many of them cannot obtain startup loans, hold checking accounts, or even write checks.

The Obama administration’s policies helped the federal government and states avoid an awkward enforcement regime, but there are still traps for the unwary. To date, federal policies and statutes regarding legalized use in states allowing medical or recreational consumption of marijuana have not been updated, and enforcement policies from the 1980s are still in effect. Thus, while marijuana distributors and growers may not face criminal sanctions, they could find it quite difficult to do business. The inability to write checks or access a bank account are among the biggest limitations hindering the growth of marijuana dispensaries.

The biggest hurdle for dispensaries is the current tax framework, which treats marijuana growers more adversely than both legal and illegal businesses alike. Under Internal Revenue Code (IRC) section 61, unless specifically excluded, all sources of income are taxable, regardless of their origin. Under the recovery of capital doctrine, taxpayers are allowed to recover their cost of goods sold. In addition, IRC section 162 provides a current deduction for all ordinary and necessary business expenses. Generally, these rules apply regardless of a business’ legal status; thus, expenses such as rent, utilities, and advertising are generally allowable as deductions.

There are notable limitations to the deductions specified under IRC section 162. For example, deductions for transactions that violate public policy (e.g., bribes, kickbacks and fines, or penalties paid to the government for violations of law) are disallowed. Therefore, expenses such as speeding tickets, parking fines, and illegal bribes are specifically denied as deductions for all taxpayers.

There is, however, an additional limitation for taxpayers engaged in the trafficking of controlled substances. IRC section 280E denies all ordinary and necessary business expenses paid or incurred in connection with the sale or trafficking of controlled substances listed on Schedule I or II of the Controlled Substances Act. Currently, 21 USC 812(c)(10) lists marijuana as a Schedule I drug. Furthermore, the courts have held that the sale of marijuana constitutes trafficking, regardless of legality at the state level. Thus, the ordinary and necessary deductions available to most businesses (both legal and illegal) are denied to the marijuana industry.

Marijuana dispensaries do receive some relief, because IRC section 280E specifically excepts cost of goods sold from its denial provisions. This allows marijuana dispensaries to deduct certain inventoriable costs. Therefore, it would be prudent for marijuana dispensaries and growers to structure their businesses around such deductible costs.

What the Current Tax Environment Means for Marijuana Dispensaries

Although the marijuana industry is growing rapidly, current tax laws and the uncertainty of the marijuana industry’s federal legal status place significant hardships on entities. CPAs considering taking on dispensaries as clients should keep these hardships in mind. In addition to both federal and state tax considerations, dispensaries may incur legal, banking, and credit issues that may not arise for traditional businesses.

In addition to federal taxes and regulations, depending on the location, there may be significant state regulations and taxes associated with running a dispensary. In many cases, the state will implement stringent regulations in order to ensure that marijuana does not cross state lines or enter the black market. Furthermore, states often implement steep taxes along with these regulations. For example, in Colorado, an initial state license to operate a dispensary costs between $7,000 and $14,000 to obtain and approximately $4,000 to $8,000 annually to maintain.

As noted above, dispensaries may face substantial hardships obtaining banking and credit services. For example, many federally insured banks are hesitant to open accounts or loan funds to marijuana-related businesses. Drug trafficking laws are designed to ensure that banks do not provide accounts or capital to any drug-related enterprise and make no distinction between state-level legal businesses (marijuana dispensaries) trafficking in Schedule I drugs and typical illegal drug trafficking. Even though the federal government has somewhat relaxed restrictions on banks serving state-sanctioned dispensaries, the regulations still require banks to heavily police these accounts. Due to the added costs and oversight required, many banks are simply unwilling to do business with dispensaries.

Implications for CPAs

Marijuana retail is already a booming industry, and is expected to grow as more states legalize marijuana for medical or recreational purposes. This growth could provide significant opportunities for CPAs seeking to broaden their client base. CPAs should, however, be aware of various client attributes and legal/ethical considerations that may arise.

CPAs should be aware that the structure of their clients’ businesses will significantly alter their tax needs. Businesses generally prefer to avoid classifying expenses as costs of good sold because they cannot deduct these expenses until the inventory item is sold. Dispensaries, however, will want to structure their businesses in a way that maximizes costs of goods sold while minimizing nondeductible expenses. CPAs should familiarize themselves with tax inventory costing rules under IRC section 471; this could help dispensary clients structure their businesses in such a way as to insure all qualifying expenses are allocated to costs of goods sold.

In providing advice to these clients, CPAs may want to consider the aggressiveness of their tax advice. Marijuana is federally illegal, so it may be impractical to take aggressive stances. Furthermore, many dispensaries may want to shy away from aggressive tax stances, since they might view paying their fair share as legitimizing their business.

CPAs should also keep in mind that many dispensary clients may not have access to banking or loans. Therefore, these businesses tend to avoid checks, and CPAs might be paid in cash.

CPAs should check their state boards’ rules and regulations regarding dispensaries, although, presumably, providing accounting services to such entities would be legally sanctioned in states where the consumption of marijuana is legal. Furthermore, the AICPA has noted that CPAs may face reciprocity challenges if moving to a new state that does not permit CPAs to take on marijuana clients.

For CPAs looking to expand their practices to include dispensaries, the AICPA has provided guidance in a report issued in July 2015 (updated in January 2016) entitled An Issue Brief on State Marijuana Laws and the CPA Profession(http://bit.ly/2y9B9PH).

Finally, but most importantly, CPAs should consider the legal implications of providing accounting services to dispensaries, and may want to seek legal advice before making a commitment. Applicable rules include federal laws, state laws, and state accountancy board rules and regulations. Marijuana is still illegal under federal law, and so is aiding and abetting drug-related enterprises. Although the Obama administration chose a policy of nonenforcement in legalized states, there is a new presidential administration and attorney general. Advice ordinarily offered to the purchaser of illegal narcotics may also be applicable to accountants serving marijuana dispensaries: Let the buyer—and the seller’s accountant—beware.

Richard L. Russell Jr., JD, CPA is an assistant professor of accounting at the Metropolitan State University of Denver, Denver, Colo.
Richard L. Russell, JD, CPA is a lecturer at Jackson State University, Jackson, Miss.