A fundamental rule of contract law is that “illegal” contracts are not enforceable. But what constitutes an “illegal contract”? Generally speaking, an illegal contract is one where the performance of the contract results in an illegal act. Illegal contracts are considered “void and unenforceable,” meaning neither party can sue the other party for nonperformance of the contract.
What if a tenant enters into a commercial lease that contemplates illegal activities by the tenant on the property? This is the situation for many tenants who are leasing property for cannabis operations. In many cases, the activity may be properly licensed and permitted under state recreational marijuana laws, but the activity is illegal under federal law (such as the Controlled Substances Act). A recent Arizona Court of Appeals case addressed this issue directly.
Radio talk show host Ross Reynolds, from KUOW's The Record interviews Hal Snow, member of Garvey Schubert Barer's Cannabis practice group, on the tricky landscape of the marijuana industry. Hal gives his thoughts on topical issues related to current states compliance with federal laws under the Obama administration, banking issues, rise of medicinal and recreational marijuana, and the outlook on marijuana legalization and regulation under a new president and Congress in January 2017.
In the July 9, 2015 Olive¹ decision, the Federal 9th Circuit Court of Appeals upheld a Tax Court decision that a medical marijuana dispensary was precluded from deducting any amount of ordinary and necessary business expenses associated with the operation of the business because the Vapor Room (the “business”) is a “trade or business…consist[ing] of trafficking in controlled substances…prohibited by Federal law.” I.R.C. § 280E. Deductions were limited to the “costs of goods sold.”
The Vapor Room sold only medical marijuana. It provided many other services but didn’t charge for them. The appellate court distinguished Olive¹ from the 2007 CHAMP² decision where the Tax Court determined that the taxpayer was engaged in two income generating businesses including the sale of medical marijuana and extensive counseling and caregiving services. In CHAMP², the ordinary and necessary business expenses related to the counseling and caregiving services were deductible. See I.R.C. § 162(a).
Participants in the marijuana industry should review the facts of the Olive¹ and CHAMP2 decisions carefully, and consult with their tax attorneys and accountants on the most tax efficient way to structure their marijuana businesses.
If the marijuana business owner also obtains revenue from the sale of non-marijuana goods and services then the ordinary and necessary business expenses related to the non-marijuana activity should be deductible.
Finally, on Aug. 10, 2015, the U.S. Tax Court published the Beck³ decision which, in line with the Olive¹ decision, held that a marijuana business that only sold marijuana products, could not deduct any of the ordinary and necessary business expenses related to the marijuana business. Deductions were limited to “cost of goods sold” I.R.C. § 280E. The Beck3 decision discussed the CHAMP2 decision and upheld its holding that a business may have two or more businesses and that the ordinary and necessary business expenses relating to the non-marijuana businesses were deductible.
¹ Martin Olive v. C.I.R. 139 T.C. 19
²Californians Helping to Alleviate Medical Problems, Inc. – CIR (CHAMP), 128 T.C. 173 (2007)
³Beck-v-C.I.R., T.C. Memo 2015-149 (08/10/2015)
Under Section 162(a) of the Internal Revenue Code, a business can deduct from its gross income “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” According to the United States Court of Appeals for the Ninth Circuit, however, this deduction is not extended to marijuana related businesses. Olive v. Commissioner of Internal Revenue, No. 13-70510 (9th Cir. July 9, 2015).
In 2012, the United States Tax Court assessed penalties and interest against Vapor Room Herbal Center, a California medical marijuana dispensary owned by Martin Olive, for its deduction of $654,071 as business expenses on its 2004 and 2005 income tax returns. Although IRC Section 162(a) allows businesses to deduct “ordinary and necessary expenses,” IRC Section 280E prohibits a business from deducting for any “trade or business [that] consists of trafficking in controlled substances … prohibited by Federal law.” Citing Section 280E, the Tax Court held that operating a medical marijuana dispensary constituted trafficking in controlled substances in violation of federal law, even though it was legal under California law.
Olive appealed the Tax Court’s decision to the Ninth Circuit Court of Appeals. His first claim was that for a “trade or business” to “consist of trafficking in controlled substances,” the business must consist solely of trafficking in controlled substances. Olive argued that in addition to dispensing medical marijuana, the Vapor Room also offered free caregiving services such as yoga, massage therapy, discussion of illnesses, counselling on various personal, legal or political matters related to medical marijuana and education on how to consume medical marijuana responsibly. The Ninth Circuit agreed with the Tax Court that the Vapor Room’s only “trade or business” was the sale of marijuana. It noted that the test for determining if an activity is “trade or business” is whether the activity was entered into with the intent of making a profit. As the Vapor Room’s other services were offered for free, the only activity that could raise a profit was the sale of marijuana.
Olive’s second claim was that IRC Section 280E should not apply to him because it was enacted before medical marijuana dispensaries existed, therefore Congress could not have intended for medical marijuana dispensaries to fall within the category of “items not deductible.” The Ninth Circuit stated that this argument had no bearing on its analysis.
Olive’s last claim was that Section 538 of the Consolidated and Further Continuing Appropriations Act 2015, PL 113-235 prohibits the IRS from defending his appeal as it provides that federal funds may not be used to prevent states that at the time of the Act had legalized medical marijuana, from implementing their state laws authorizing the use, distribution, possession or cultivation of medical marijuana. The Ninth Circuit held that Section 538 does not apply because the IRS is not preventing California from implementing its laws that authorize the use, distribution, possession or cultivation of marijuana. Instead, the IRS is simply enforcing a tax, which does not prevent people from using, distributing, possessing or cultivating marijuana in California.
This ruling is an obvious and a troubling set-back for the marijuana business community. It is just another example of how the inconsistencies between federal and state laws can be challenging for marijuana users, growers, processors and regulators. This problem could be resolved by revising the Internal Revenue Code to provide a further exception under 280E to allow state-sanctioned marijuana enterprises. Until then, marijuana business owners should caution taking business deductions or – alternately, consider whether other business activities are entered into with the intent of making a profit for the business.
Since its founding in 1966, Garvey Schubert Barer has counseled clients across a broad range of industry sectors. Our attorneys have deep bench experience and significant expertise in both complex legal and business matters. We value innovation and entrepreneurship, and closely monitor industry trends. It is with these values in mind that our firm established the cannabis industry group. Read More ›