Are taxpayers that receive pass through income from marijuana related businesses eligible to claim the QBI deduction under Section 199A?

Qualified Business Income Deduction

The Tax Cuts and Jobs Act was enacted on December 22, 2017 and applies to tax years beginning after December 31, 2017. A major component of this legislation was to reduce the tax rate for corporations from a top rate of 35% to a flat 21%.  

The legislation also included provisions to address the interest of the non-corporate tax filers in the form of the Qualified Business Income deductions (§199A.) The QBI deduction is available to qualified trades or businesses and allows a taxpayer a deduction of up to 20% of qualified business income, subject to certain limitations.

Qualified trade or business under section 199A means a trade or business under section 162 (section 162 trade or business) other than the trade or business of performing services as an employee. With some exceptions, the deduction is also not available for a Specified Services Trade or Business (SSTB), defines as

 “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, [or owners].”

The term “qualified business income” means, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer conducted in the United States, and used in the determination of taxable income for the year.

The QBI deduction is available at the taxpayer level and may be limited based on the taxpayer’s taxable income. The limitation is based on whether, and by how much, the taxpayer’s taxable income exceeds a threshold amount. The threshold amount for 2019 is $160,700 ($321,400 for joint filers) and is adjusted annually based on cost-of-living adjustments. The deduction is reduced as the amount that taxable income exceeds the threshold amount by more than $50,000 ($100,000 for joint filers).

Section 280E

Although businesses are generally allowed to deduct “ordinary and necessary” expenses from gross receipts in determining business income, section 280E 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 (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” See 26 U.S.C. §280E

Marijuana is listed on Schedule I of the Controller Substance Act of 1970. (21 U.S.C. §812). Therefore, the manufacture, production, or sale of marijuana is considered illegal under federal law. As a result of this classification, expenses related to “trafficking” of marijuana are not deductible in determining business income for tax purposes. (Section 280E)

Trafficking is “to engage in commercial activity: buy and sell regularly”. California Helping to Alleviate Medical Problems, Inc. v. Comm’r, May 15, 2007 (CHAMP).  Dispensing or selling marijuana is considered trafficking within the meaning of section 280E. Expenses related to dispensing and selling activities cannot be deducted. Expenses that make up costs of goods sold are exclusions from gross sales, not deductions. Therefore, cost of goods sold are not subject to section 280E.    

It is currently unresolved as to whether the QBI deduction under section 199A is disallowed as a result of the section 280E. (however, recent developments provide some insight into the IRS’ position)

One argument in favor of eligibility is that the QBI deduction is not an “incurred expense” or an “amount paid” and therefore §280E does not apply. A second argument is that §280E should be applied to the entity level where the trade or business is conducted. The QBI deduction is a taxpayer level deduction, not a pass-through entity level deduction. And due to the QBI deduction being a taxpayer level deduction, the provisions of §280E should not extend to the taxpayer.

It is expected that the IRS may take a more aggressive position and present arguments supporting the application of §280E to the pass-through taxpayer. In the recent case of  Northern California Small Business Assistants, Inc v Commissioner, 153 T.C. No. 4, No. 26889-16 (Oct 23, 2019), the U.S. Tax Court emphasizes that Congress could not have been clearer in drafting section 280E of the Code. The first line of section 280E reads  “No deduction or credit shall be allowed…”. The court went on to state that the broader statutory scheme also supports the conclusion that section 280E means what it says–no deductions under any section shall be allowed for businesses that traffic in a controlled substance.

Specifically, section 261, in part IX of subchapter B of chapter 1 of the Code, provides that “no deduction shall in any case be allowed in respect of the items specified in this part.” Section 280E is in part IX. Similarly, section 161 provides that deductions found in part VI of subchapter B of chapter 1 of the Code are allowed “subject to the exceptions provided in part IX”. Part VI provides a comprehensive list of allowable deductions for taxpayers. Although the court in Northern identified Sections 162 and 165,  the list also includes section 199A.

The legislative intent of section 280E and its legislative history express a congressional intent to disallow deductions attributable to those activities associated with trafficking (buying or selling) of a controlled substance. They do not express an intent to deny the deduction of all of a taxpayer’s business expenses simply because the taxpayer may engage in some business activities that include trafficking in a controlled substance.

Multiple Businesses

Taxpayers may be involved in more than one trade or business. Whether an activity is a trade or business separate from another trade or business is a question of fact that depends on (among other things) the degree of economic interrelationship between the two undertakings.

While the fact that an individual carries on two or more enterprises that engage in identical or similar activities may be a factor suggesting that the enterprises are in reality a single trade or business, this fact may be outweighed by other considerations in any given case. These factors including, but may not be limited to:

• whether the activities are operated under different managements
• whether the activities are in different locations facing different conditions as to
  • finances,
  • currency controls,
  • labor,
  • and marketing
• whether separate books are kept adequately reflecting the operational results of each enterprise. (Davis v. Commissioner, 29 T.C.878 (T.C. 1858)

In the case of marijuana:

• a taxpayer–which operated a community center for members with debilitating diseases and charged a membership fee that covered only a fixed amount of marijuana–was engaged in two separate trades or businesses and, therefore, was entitled to an allocation of expenses. CHAMP, 128 T.C. at 183
• a taxpayer–which operated a community-center whose sole source of revenue was from the sale of marijuana–had a single trade or business and was precluded from deducting expenses pursuant to section 280E. Olive v. Commissioner, 139 T.C. at 39-42
• where the taxpayer was in the business of distributing medical marijuana and its only other source of income was its sale of books, T shirts, and other nonmarijuana items–the sale of nonmarijuana items “was an activity incident to” the taxpayer’s sole business of selling marijuana and the taxpayer was precluded from deducting expenses pursuant to section 280E). Canna Care v. Commissioner, at *12-*13
• Further, the activities of separate entities can be treated as a single trade or business if they are part of a “unified business enterprise” with a single profit motive. Patients Mutual, 151 T.C. at ___ (slip op. at 37) (quoting Morton v. United States, 98 Fed. Cl. 596, 600 (2011)).
• allocation of floor space and employee activities between two entities both show that receipt and sale of marijuana was the dominant activity and that the sale of nonmarijuana products had “a close and inseparable organizational and economic relationship” with–and was “incident to”–Alternative’s primary business of selling marijuana. Alternative Health Care v Commissioner, 151 T.C. No. 13, Patients Mutual, 151 T.C. at ___ (slip op. at 41-42) (quoting Olive v. Commissioner, 139 T.C. at 41).

Whether the cannabis business owner has multiple lines of business should be a consideration in evaluating the applicability of both §199A and §280E. Where there exist multiple businesses, the application of each section should be considered separately for each business allowing the cannabis business taxpayer, where possible, to take advantage of the benefits of §199A and avoid the pitfalls of §280E.