Generally, medical marijuana dispensaries are not allowed to deduct expenses for federal income tax purposes because buying and selling marijuana, even for medical reasons, is considered “trafficking in illegal drugs.” Such dispensaries, however, are allowed to offset income by cost of goods sold (“COGS”) if they maintain sufficiently reliable records to allow the IRS to verify their income and expenditures. Although public opinion has shifted more in favor of medical marijuana in recent years, industry culture persists so that business transactions are still primarily in cash and not formally recorded. As a result, the industry as a whole continues to struggle to maintain sufficient business records for federal income tax purposes.
A closer look at recent cases shows that the requirement to maintain business records sufficient to satisfy the IRS may not be as difficult as it initially appears. In a recent Tax Court case (Feinberg v. Commissioner, TC Memo 2017-211), the Court considered the application of the “Cohan Rule” to medical marijuana dispensaries to determine the amount of COGS. Under the Cohan Rule, a court may estimate the amount of a deductible expense if a taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount. For the Cohan Rule to apply there must be sufficient evidence in the record to provide a basis upon which an estimate can be made. The Cohan Rule has been extended to apply to COGS.
Even though the taxpayers in this Tax Court case did not succeed, the case is instructive because it shows that if dispensaries are unable (or unwilling) to maintain contemporaneous and detailed business records they may still be able to offset their income with COGS by relying on the Cohan Rule to estimate their expenses if the records maintained provide at least a basis upon which estimates of the expenses can be made.
Pauline Markey, Esq. is a Partner in the Business & Finance Department’s Tax Group at Obermayer Rebmann Maxwell & Hippel LLP. She focuses her practice on United States federal income tax – including corporate and partnership tax, tax-exempt entities, tax controversy, and executive compensation. She has significant experience translating complex tax issues for general business application and providing practical tax advice to CFOs and other stakeholders. She specifically provides tax advice and planning for small to mid-sized companies, as well as sophisticated tax memorandums, opinions, and private letter rulings.