Tax deductions for medical pot biz go up in smoke, court rules

McClatchy NewspapersAugust 3, 2012 

— A once-thriving San Francisco pot shop forced to close this week is also on the hook for a serious IRS bill, following a new U.S. Tax Court decision that could complicate life for others in the medical marijuana business.

Call it a precedential bummer; or, perhaps, a rational application of tax law.

For businesses and consumers in the 17 states that permit medical marijuana use, the ruling quietly issued Thursday certainly goes well beyond the facility formally called the Vapor Room Herbal Center. In particular, the Vapor Room ruling could squeeze pot operations that claim deductions for “care-giving” services.

“The dispensing of medical marijuana, while legal in California, among other states, is illegal under federal law,” Tax Court Judge Diane L. Kroupa noted. “Congress has set an illegality under federal law as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business. This is true even if the business is legal under state law.”

The ruling means Vapor Room owner Martin Olive owes Uncle Sam a lot of money, although it is unspecified and less than the $2.1 million the Internal Revenue Service originally sought. More broadly, other medical marijuana dispensaries could have a harder time securing valuable tax deductions; particularly if, as in the case of the Vapor Room, they keep unreliable records.

“In the end, it’s going to be very important,” Las Vegas-based tax expert Russell Clayton said of the ruling in an interview Friday. “This is going to have a major impact on medical marijuana (operations).”

California alone is home to untold hundreds of medical marijuana dispensaries, although for confidentiality and other reasons the state’s Board of Equalization does not maintain records. In Washington state, media accounts estimate some 100 medical marijuana facilities can be found in and around Seattle. Missouri and Pennsylvania legislators this year have been considering their own medical marijuana bills.

Located in a comfy Victorian house on San Francisco’s storied Haight Street, the Vapor Room operated for more than eight years before closing Tuesday. Justice Department officials had advised the operators that the facility was too close to a neighborhood playground.

The shutdown order was part of the Obama administration’s generally hard line against medical marijuana operations, a policy that prompted protests in Oakland last month when Obama visited for a fundraising event. The order to close the Vapor Room, though, was not directly related to the tax court case begun several years ago.

Instead, owner Olive had gone to court to challenge the IRS’s determination that he owed more than $1.8 million in taxes, plus about $378,000 in penalties, for the years 2004 and 2005.

Olive had reported the Vapor Room had gross receipts of $1 million in 2004 and $3.1 million in 2005.

Tax investigators subsequently concluded that Olive had underreported his income, and that the Vapor Room really collected $1.9 million in 2004 and $3.3 million in 2005.

Olive sought to deduct his various business expenses, ranging from rolling papers to zip-lock bags. He also wanted to subtract the price he paid for the marijuana, as a cost of goods sold, from his total income.

Federal law is clear. It prohibits tax deductions for a trade or business that “consists of trafficking in controlled substances.” That means a medical marijuana dispensary seeking to deduct expenses must find another way to account for them.

In a previous California case, the tax court permitted a pot dispensary to deduct expenses clearly related to the separate business of medical care-giving. But though the Vapor Room provided yoga classes, movies and games, among other services, Kroupa rejected Olive’s claims that this amounted to a distinct non-drug business for which deductions were allowed.

“The Vapor Room’s dispensing of medical marijuana and its providing of services and activities . . . are one and the same business,” Kroupa declared. “(Olive) formed and operated the Vapor Room to sell medical marijuana to the patrons and to advise them on what he considered to be the best marijuana to consume and the best way to consume it.”

In a further warning sign for other dispensaries, Kroupa further dismissed Olive’s argument that formal records and receipts are rare in the medical marijuana trade.

“(Olive) chose not to keep supporting documentation for the Vapor Room’s expenditures,” Kroupa noted. “He did so at his own peril.”

Neither Olive nor his attorney could be reached to comment Friday.

Email: mdoyle@mcclatchydc.com; Twitter: @MichaelDoyle10

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