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The tax challenges of legalized marijuana

Talk about your sticky wickets. Pardon what might seem a flip remark about a sensitive issue, but it's hard to describe the situation regarding legalizing marijuana any other way. Minnesota is only at the stage of allowing the use of marijuana for a short list of specific medical conditions. Regulatory structures for that aren't in place yet and the notion of recreational marijuana isn't enjoying much support at the State Capitol.

That is not the case elsewhere, however. Twenty-nine states have legalized medical marijuana and eight allow recreational sale and use of the drug. As legalization occurs, businesses are budding. And with that comes new tax obligations and potential disputes with the IRS. One big reason is that marijuana remains an illegal controlled substance under federal law.

Business questions in the federal-state gap

What is proving to be one of the most delicate of subjects is how the IRS is choosing to apply section 280E of the tax code to deny usual business deductions to marijuana industry entrepreneurs.

Those businesses are obliged to file federal returns, and this section of the code says no deduction or credit shall be allowed a trade or business whose activity involves trafficking in a controlled substance prohibited by federal law or the law of any State in which such trade or business is conducted.

That clause in bold causes the problem. It might seem that where state law allows the trade, that the IRS should allow normal business deductions. But that's not happening. Indeed, some in the industry say the IRS is improperly leveraging the current system to bar deductions and conduct criminal investigations – a job that is outside the scope of its mission.

An effort is underway in Congress to allow legitimate marijuana operators to claim the deductions every other legal business get, but observers question whether it will see much traction in the current political environment in Washington. Meantime, some marijuana business operators in Colorado are in court seeking to curb some IRS methods for invoking the 280E provision.

The application of 280E might not be an issue in Minnesota or Wisconsin today, but given the way things are going, it seems likely that it could be one someday – unless the code changes.

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