Under Internal Revenue Code (IRC) Section 280E, no individual is permitted to take a deduction or credit on income taxes if the income resulted from carrying on any trade or business if the business consists of trafficking in controlled substances, such as marijuana, under the Controlled Substances Act (CSA). This section of the IRC was designed to prohibit individuals from taking individual tax deductions from marijuana sales. However, how does federal tax law apply to California corporations, s-corps, LLCs for the purposes of deducting expenses?
California Corporations and the Revenue and Taxation Code
The differences between federal law and California state laws have created an unique situation for California marijuana businesses due to the treatment of income and expenses for personal income tax (individuals and partnerships) versus corporation tax law (including statutory cooperatives).
For individuals and partnerships, Revenue and Taxation Code Section 17282 has prohibited taxpayers from taking deductions on any of his or her gross income as a result of income derived from illegal activities, including drug trafficking. However, the taxpayer must be found to have engaged in these activities first due to a criminal or other proceeding in which the state, county, city, or other subdivision was a party.
For corporations, including statutory cooperatives, California has enacted a stand-alone law. A statutory cooperative is a cooperative that has organized and registered as a corporation under the Corporations or Food and Agricultural Code (Id. at Section 12311(b)).
According to California tax law, an entity that is taxed as a corporation per Part 11 of the Revenue and Taxation Code and is also involved in medical marijuana activity is permitted to deduct its ordinary and necessary businesses expenses, along with the cost of goods sold, provided that the entity can substantiate any deductions that it claims with adequate records.
How California Classifies C Corporations, S Corporations, and LLCs
In California, a C corporation refers to an entity that is doing business in California, organized in California, or registered with the California Secretary of State. A C Corporation is business entity that is taxed as a separate entity from its shareholders. The C Corporation pays corporate taxes on its profits while the shareholders are not taxed on the C corporation's profits. The shareholders of a C corporation only report and pay taxes on the income that is paid to them by the corporation.
In addition, California also has specific definitions for corporations that are S corporations or LLCs:
The owners of LLCs that have not made the election for the LLC to be classified as a corporation for federal tax purposes are not required to pay a salary so they can take their earnings as distributions. Therefore, when they report the net income for the LLC, there may be no salary expenses to be disallowed under Section 280E. Additionally, if the owners are involved in the selling, marketing or delivery of marijuana and they do take a salary, this salary expense is disallowed under Section 280E.
However, if the LLC is taxed as a C corporation, the LLC owners are required to pay themselves reasonable salaries, and this salary expense may be disallowed under Section 280E.
California Tax Law Does Not Automatically Conform to Federal Tax Law
In California, individuals are bound by the provisions of Section 280-E. However, this tax law does not automatically conform for corporations. This is due to the fact that California law has not been designed to conform to changes in federal tax law, except under specific circumstances. Instead, California policy makers are required to affirmatively conform to changes in federal tax law.
However, legislative sessions in California do not systematically address nonconformity with federal law and they haven’t in sometime. In fact, the last time that California policy makers agreed to address nonconformities with federal tax laws on an annual basis occurred from the years 1982 through 1992. Beginning in 1992, the California Legislature stopped enacting annual conformity bills that were designed to require policymakers to act on federal tax law changes by a specified date each year.
As a result, several nonconformity issues, such as the nonconformity of California corporations with Section 280-E of the IRC, have gone unaddressed.