There is an unusual interplay between federal and state laws. While states have the ability to enact their own laws, when there is a conflict, federal laws control. For example, medical marijuana dispensaries are a completely legal business in California. However, federal law still considers marijuana a controlled substance regardless of the purpose for which it is used.
This little discrepancy comes into play in more than the criminal arena. When it comes to filing federal income taxes, the difference in the law makes a difference on dispensary owners' income tax returns. Business owners can choose to deduct certain business expenses from their tax liability. A U.S. Tax Court ruled this past month that items such as wages, advertising and supplies in relation to legal dispensaries in California were not deductible.
Section 280E of the Internal Revenue Code controls the issue at hand. The code explicitly states that "no 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."
According to the court, marijuana is still considered a controlled substance by federal definition. So while the sale of medical marijuana is completely legal in California and not considered trafficking at all, it falls under the purview of the applicable federal code section.
This decision came about due to the dispensary owner's 2004 and 2005 returns in which he claimed $10,783 and $285,349 respectively in total expenses. The returns were reviewed in relation to the closing of the dispensary after threats that it was too close to a playground in San Francisco.
Source: Reason.com, "U.S. Tax Court Says Pot Is Deductible for Medical Marijuana Suppliers, but Wages Are Not," Jacob Sullum, Aug. 6, 2012
Filing for income taxes can be a complex process for business owners. If you have been contacted for audit, our IRS Audits and Appeals page provides more information.