In the Comprehensive Drug Abuse Prevention and Control Act of 1970, 21 U.S.C. §801–971 (1970), (“Controlled Substances Act” or “CSA”), Congress created a regime to curtail the unlawful manufacture, distribution, and abuse of dangerous drugs (“controlled substances”). Congress assigned each controlled substance to one of five lists (Schedule I through Schedule V). See §812 of the CSA. Schedule I includes: (a) opiates; (b) opium derivatives (e.g., heroin; morphine); and (c) hallucinogenic substances (e.g., LSD; marihuana (a/k/a marijuana); mescaline; peyote).
Though a medical marijuana business is illegal under federal law, it remains obligated to pay federal income tax on its taxable income because §61(a) does not differentiate between income derived from legal sources and income derived from illegal sources. See, e.g., James v. United States, 366 U.S. 213, 218 (1961). Under the Sixteenth Amendment of the United States Constitution (“Sixteenth Amendment”), Congress is authorized to lay and collect taxes on income. In a series of cases, the United States Supreme Court has held that income in the context of a reseller or producer means gross income, not gross receipts. In other words, Congress may not tax the return of capital. See, e.g., Doyle v Mitchell Bros. Co., 247 U.S. 179, 185 (“As was said in Stratton’s Independence v. Howbert, [citation omitted], ‘Income may be defined as the gain derived from capital, from labor, or from both combined.’”); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934) (“The power to tax income like that of the new corporation is plain and extends to the gross income. Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.”).
Section 61(a) defines “gross income” broadly using 15 examples of items that are includible in gross income. Consistent with the Sixteenth Amendment, §61(a)(3) provides that gross income includes net gains derived from dealings in property, which includes controlled substances produced or acquired for resale. “Gains derived from dealings in property” means gross receipts less COGS, which is the term given to the adjusted basis of merchandise sold during the taxable year. Section 1.61-3(a) of the Income Tax Regulations. See also §§1001(a); 1011(a); 1012(a). As the Tax Court explained in Reading v. Commissioner, 70 T.C. 730, 733 (1978), “[t]he ‘cost of goods sold’ concept embraces expenditures necessary to acquire, construct or extract a physical product which is to be sold; the seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold.” A taxpayer derives COGS using the following formula: beginning inventories plus current-year production costs (in the case of a producer) or current-year purchases (in the case of a reseller) less ending inventories. In general, the taxpayer first determines gross income by subtracting COGS from gross receipts, and then determines taxable income by subtracting all ordinary and necessary business expenses (e.g., §162(a)) from gross income.
In 1981, the Tax Court allowed an illegal business to recover the cost of the controlled substances (i.e., amphetamines; cocaine; marijuana) obtained on consignment and also to claim certain business deductions (a portion of the rent he paid on his apartment which was his sole place of business, the cost of a small scale, packaging expenses, telephone expenses, and automobile expenses). See Jeffrey Edmondson v. Commissioner, T.C. Memo. 1981-623.
In 1982, Congress enacted §280E, which reverses the holding in Edmondson as it relates to deductions other than the cost of the controlled substances. Section 280E reads as follows:
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 (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.