As of mid-2015, twenty-three states and the District of Columbia had legalized medical marijuana under varying restrictions and regulations.1, 2015), http://www.governing.com/gov-data/state-marijuana-laws-map-medical-recreational.html [http://perma.cc/KY5Z-AKW7]. For example, in 1996, California passed the Compassionate Use Act,2 which legalized the use of medical marijuana in the state. By August 2006, over 200 dispensaries were providing medical marijuana to about 200,000 patients in California.3 Perhaps surprisingly, federal criminal law4 has not proven to be the most substantial hurdle for these dispensaries; instead “[t]he federal tax situation is the biggest threat to [state-sanctioned marijuana] businesses and could push the entire industry underground.”5 Under § 162 of the Internal Revenue Code (I.R.C.), “ordinary and necessary” business expenses are tax deductible.6 However, I.R.C. § 280E specifically states that “[n]o deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business . . . consists of trafficking in controlled substances . . . which is prohibited by Federal law.”7 Thus, medical marijuana dispensaries, at least to the extent that they traffic marijuana, are excluded from the tax benefits of § 162.
Commentators have suggested various methods for dispensaries to plan around this additional tax burden.8 One suggestion that has been implemented is bundling together the provision of caregiving services with the sale of medical marijuana.9 Since the expenses associated with these caregiving services are tax deductible under I.R.C. § 162, the dispensary might reduce its tax liability by allocating as much of its shared expenses as it can toward the caregiving services. Recently, the Ninth Circuit addressed the tax treatment of this particular method. In Olive v. Commissioner,10 the court held that the owner of a medical marijuana dispensary was not entitled to any business tax deductions — even for expenses associated with caregiving services provided alongside the sale of marijuana — because his business consisted solely of trafficking marijuana and thus fell under the exception listed in I.R.C. § 280E.11
Despite this outcome, Olive suggests that the Ninth Circuit might endorse a previous U.S. Tax Court case, Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner12 (CHAMP). If the Ninth Circuit were to adopt CHAMP’s framework, medical marijuana dispensaries would be able to deduct the business expenses associated with their caregiving services from their tax liability, as long as those caregiving services embody a “trade or business” that is separate from the sale of medical marijuana. While some unsettled questions would remain on the margins, Olive, together with CHAMP, would provide much guidance on what it means for caregiving services to constitute a separate “trade or business” in the medical marijuana dispensary context. The substance of this guidance, in turn, would discourage marijuana dispensaries from attempting to use caregiving services to circumvent their tax liability.
In 2004, Martin Olive opened a medical marijuana dispensary, the Vapor Room Herbal Center (“Vapor Room”), in San Francisco, California.13 In addition to selling medical marijuana, the dispensary provided vaporizers, games, books, and art supplies for customers to use and also held regular activities — such as yoga classes, massages, and movie showings — all free of charge.14 The Internal Revenue Service (IRS) audited Olive’s 2004 and 2005 tax returns and issued a notice of deficiency, stating that Olive was not allowed to deduct either the reported cost of goods sold (COGS) or the reported business expenses, both due to lack of substantiation.15 The IRS later conceded that Olive’s reported business expenses were substantiated but argued that § 280E precluded these expenses from being deductible.16 Olive petitioned the U.S. Tax Court to review the IRS’s audit determination.17
First, the Tax Court noted that Olive bore the burden of proof to show that the IRS’s deficiency determination was incorrect.18 On the issue of COGS, the Tax Court disagreed with both the IRS’s and Olive’s estimates and instead independently determined a COGS amount.19 The Tax Court then turned to Olive’s expenses. It agreed with the IRS that under § 280E, none of Olive’s expenses were tax deductible.20 The Tax Court rejected Olive’s narrow reading of § 280E as precluding only “illegal underground businesses that have a single business of drug trafficking.”21 While admitting that a business can have multiple activities that are taxed differently, the Tax Court found that the Vapor Room’s sale of medical marijuana was inseparable from the other services provided.22 Thus, the Tax Court held that Olive was not entitled to any deduction for business expenses.23 Lastly, because the application of § 280E to medical marijuana businesses was decided after Olive filed tax returns in 2004 and 2005, the Tax Court reduced the IRS’s accuracy-related penalty by the amount Olive underpaid as a result of deducting business expenses.24
Olive appealed to the Ninth Circuit the Tax Court’s decision that the business expenses were not deductible.25 Writing for the three-judge panel, Judge Graber26 affirmed the Tax Court’s decision.27 First, to determine whether Olive’s ordinary and necessary business expenses would be tax deductible under § 280E, the court considered whether Olive’s Vapor Room was a “trade or business” that “consisted of” trafficking marijuana.28 Taking these contested phrases in turn, the court stated that “[t]he test for determining whether an activity constitutes a ‘trade or business’ is ‘whether the activity was entered into with the dominant hope and intent of realizing a profit.’”29 Applying this test, the court found that the only “trade or business” of the Vapor Room consisted of the selling of medical marijuana, because although the Vapor Room provided other services — such as food, drink, movies, and counseling — the selling of medical marijuana was the only income-generating activity of the business.30
Next, the court examined whether the Vapor Room’s business “consisted of” drug trafficking. Olive argued that since medical marijuana was not the sole service offered by the Vapor Room, business tax deductions should be recognized for the other services provided because those services were a separate “trade or business.”31 The court rejected Olive’s argument and distinguished the case from CHAMP, on which Olive had relied.32 While the court accepted that Olive could have been involved in more than one “trade or business,” the court noted that his situation was different from that of the taxpayer in CHAMP because Olive “d[id] not provide counseling, caregiving, snacks, and so forth for a separate fee; the only ‘business’ in which he engages is selling medical marijuana.”33 The court proceeded to provide an analogy: comparing one bookstore that sells books and provides food for free with another bookstore that sells books and has a café area selling food.34 The court noted that the first bookstore would be in the “trade or business” of selling books only, while the latter would have two different “trade[s] or business[es]”: that of selling books and that of selling food.35
Lastly, the court rejected Olive’s argument that section 538 of the Consolidated and Further Continuing Appropriations Act of 2015,36 which provides that certain funds cannot be used to prevent states “from implementing their own State laws that authorize the use, distribution, possession, or cultivation of medical marijuana,”37 prevented the government from pursuing this litigation.38 Given that these arguments were unavailing, the court affirmed the decision of the Tax Court.39
In Olive, the Ninth Circuit seemed to suggest that dispensaries, under some circumstances, might be allowed to reduce their tax liability by tying together caregiving services with marijuana sales. The court did so by distinguishing, rather than contradicting, the Tax Court’s decision in CHAMP. Since Tax Court decisions are not binding on circuit courts,40 the Ninth Circuit did not need to carefully distinguish CHAMP from Olive. However, in not calling into question the CHAMP decision, the court implied that it would find the expenses associated with the caregiving services of a dispensary similar to the one in CHAMP to be tax deductible. Thus, the Olive court’s passive acceptance of CHAMP suggests that for dispensaries in California, tax deductions may be allowed for caregiving services if these services embody a separate “trade or business” from that of selling medical marijuana.
Therefore, marijuana dispensaries should look to both Olive and CHAMP for direction on what they would need to do to be eligible for such a tax deduction. First, dispensaries would need to ensure that their caregiving services are first and foremost a “trade or business.” Under Olive, the Ninth Circuit used the established definition of “trade or business” as something that is “entered into with the dominant hope and intent of realizing a profit.”41 Applying this definition, the court held that the Vapor Room’s caregiving services did not constitute a “trade or business” since they were free and generated no profit.42 However, CHAMP clarified that the caregiving services would not need to necessarily charge a separate fee in order to be generating a profit, since in CHAMP the dispensary charged a membership fee that covered both the medical marijuana and the caregiving services.43 Consequently, dispensaries would need to ensure that their caregiving services do realize — or at least are intended to realize — a profit, but these services would not necessarily have to be sold separately from the medical marijuana.44
Second, the caregiving services would not only need to be a “trade or business,” but also separate from the medical marijuana sales. Under CHAMP, “whether an activity is a trade or business separate from another trade or business is a question of fact that depends on . . . the degree of economic interrelationship between the two undertakings.”45 The CHAMP court determined that it was reasonable to find that the caregiving services were a separate business because they were so regular and extensive that the business “stood on its own” apart from the sale of marijuana.46 Furthermore, CHAMP cited Collins v. Commissioner,47 which found that the existence of separate records and employees was probative of whether the taxpayer had two separate businesses.48 This conclusion suggests that if a dispensary keeps separate business records for its caregiving services and also hires separate employees to provide these services, then it is likely that the caregiving services would be considered a separate business. However, CHAMP shows that separate books and records would not be necessary to find separate businesses.49 Although there is no hard and fast rule for determining whether businesses are separate, CHAMP indicates that dispensaries would probably need to establish robust and regular caregiving services, and probably have some employees tasked solely with caregiving services, to be eligible for any tax deductions.
Given that the caregiving services would have to be a separate “trade or business” in order to receive any business expense tax deductions, marijuana dispensaries would be greatly constrained in using caregiving services as a method of circumventing tax liability. Both CHAMP and Collins were concerned with whether it is possible for a court to reasonably separate out which expenses are from one business and which expenses are from the other. In Collins, separate accounting books were considered evidence in favor of the existence of two separate businesses,50 and CHAMP relied on the separately employed personnel and segregated use of the facility for the expense allocation.51 If medical marijuana dispensaries structured their operations such that a court could readily observe a separation of expenses, they would be mostly unable to artificially inflate their business-expense deductions by masking expenses associated with their medical marijuana operations as expenses associated with their caregiving services.
The Ninth Circuit, in Olive, suggested that dispensaries might be able to receive tax deductions for expenses associated with the caregiving services that are a separate “trade or business” from the marijuana sales. If the Ninth Circuit were to accept the CHAMP framework, dispensaries would benefit from the guidance CHAMP, as interpreted by Olive, would provide. For now though, the only certain result of Olive is to close one avenue by which medical marijuana dispensaries have attempted to reduce their tax liability. In the absence of certainty from the courts, the U.S. Treasury could issue either general regulations52 or rulings on particular fact situations,53 and Congress could even change § 280E or write an additional statute addressing medical marijuana in particular. Thus, there is ample opportunity for the law to change and develop in this area, especially since legal marijuana is a large and growing market.54 How tax law is applied to this industry will have profound consequences, not just on dispensaries, but also on state and federal governments.55