How Legal Marijuana Sellers Can Beat a Business-Killing Tax

The law, lawyers, and the court.
Feb. 28 2013 12:02 PM

Growing the Business

How legal marijuana sellers can beat a draconian tax.

Medical marijuana
Medical marijuana

Photo by Cliff DesPeaux/Reuters

Eighteen states and the District of Columbia have now decriminalized or legalized marijuana for at least some purposes. You hear a lot about the conflict between these state laws and the federal statute criminalizing the sale and possession of marijuana. But since the Justice Department isn’t consistently coming after marijuana sellers, the more immediate problem for many of them is federal tax law. “The federal tax situation is the biggest threat to businesses and could push the entire industry underground,” the leading trade publication for the marijuana industry reports.

Here’s why: Ordinary businesses are taxed by subtracting their business expenses from their gross revenue to arrive at their net income, or profit. That amount is subject to tax. By contrast, sellers of controlled substances—in other words, drugs, including marijuana—are not permitted to deduct any ordinary business expenses other than the cost of the goods they are selling. That’s because of section 280E of the federal tax code, which Congress enacted in the 1980s to punish drug dealers. The provision was largely symbolic for decades, since few drug dealers filed income tax forms. But now, state-licensed marijuana sellers must pay federal taxes not only on their profits but also on the money they spend on salaries, rent, advertising, and all the other expenses related to running a business. In fact, it is conceivable that section 280E could require a business to pay more in tax than its total profits for the year.

I teach tax law, and I have a solution: Marijuana sellers should operate as nonprofit “social welfare organizations.” To qualify for a federal tax exemption, a social welfare organization must have as its primary purpose the promotion of the common good and general welfare of the people in its neighborhood or community. Currently, many social welfare organizations operate businesses in poor and distressed neighborhoods, providing jobs and job-training for residents and improving the conditions for economic development. For example, Homeboy Industries is a tax-exempt nonprofit that trains and employs former gang members in Los Angeles to work in a bakery, a café, and a retail store.

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If a state-licensed marijuana seller were to incorporate as a social welfare organization, it could make the case that it planned to operate primarily to improve the conditions of a neighborhood formerly blighted by illegal marijuana sales. The street sale of marijuana is associated with increased violence and property crime in a neighborhood, even if illegal marijuana markets are not as pervasively linked to drug-related violence as markets for harder drugs, An organization that sold marijuana legally at a competitive price in a clean, well-lit storefront could take business away from illicit marijuana dealers. If it also trained and employed neighborhood kids who might otherwise become drug runners, it should easily meet the definition of a social welfare organization. Which would free it from the burden of section 280E.

Some sellers of medical marijuana have tried to avoid section 280E by arguing that they are charities—exempt from income tax under section 501(c)(3)—because they promote health. But the Internal Revenue Service has denied 501(c)(3) status to marijuana sellers, arguing that because of a rule called the “public policy doctrine,” they can’t qualify as a charity because they exist for a purpose that is illegal or contrary to a well-established public policy.

The tax exemption for social welfare organizations comes from another provision of tax law, Section 501(c)(4). I know of no marijuana seller that has applied for this type of exemption yet, which is a shame, because the public policy doctrine only applies to section 501(c)(3) organizations. Groups that fall under 501(c)(4) are not charities. These social welfare organizations were in the news during the 2012 campaign because—unlike charities—they are permitted to run campaign ads. (Think Karl Rove’s Crossroads GPS, the Koch brothers’ Americans for Prosperity, and Barack Obama’s Organizing for Action.) These organizations can’t receive tax-deductible contributions the way charities can, so there are fewer restrictions on the types of activities they can engage in.

I realize that it is counterintuitive to think that an organization whose purpose is illegal under federal law could be recognized by the IRS as tax exempt. The IRS may not go for it. But for the reasons I lay out in more detail in this paper they should. There is no legal reason not to recognize a marijuana seller as tax exempt, so long as it improves a neighborhood blighted by drugs and provides economic opportunities for the kids who live there.

States that legalized marijuana presumably want the neighborhood benefits that come with cutting back on street trade. They also want to raise revenue by taxing marijuana sales. If marijuana sellers were operated as social welfare organizations, they could duck the draconian taxes of section 280E, but states and cities could still collect their own taxes. And the sellers would have a lot more money to pay them.

Eventually, it probably makes sense for Congress to repeal section 280E and treat marijuana sellers the same as any other business. If the states want to legalize and regulate marijuana, the federal government shouldn’t use the tax code to interfere. But until that question is settled, avoiding section 280E by operating as a social welfare organization will allow a neighborhood-based seller to be at the forefront of the legalization experiment—while furthering the interests of the local community. All it takes is a few visionary nonprofit entrepreneurs, and an IRS not afraid to do the right thing.

Benjamin M. Leff is a tax professor at American University Washington College of Law.

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