Tax Win In Oregon Reminds Cannabis Businesses To Properly Classify Expenses

• Published date: 06 December 2022
• Subject Matter: Tax, Cannabis & Hemp, Income Tax
• Law Firm: McGlinchey Stafford
• Author: Douglas W. Charnas and Heidi Urness

Tax season is nearly upon us. As cannabis businesses and the professionals who advise them can expect, navigating the variations and even direct conflicts that exist between and among the state and federal authorities that govern a cannabis business's respective tax filings can be treacherous. These complex interactions of state and federal law are highly unsettled and frequently litigated areas of law.

An interesting interaction of state and federal tax law played out in the courts this week, resulting in a nice tax victory for cannabis growers Ginger and Stephen Lessey of Oak Ponds Farm (Farm) in Stephen Lessey and Ginger Lessey v. Department of Revenue, State of Oregon, Or. T.C., No. TC-MD 210265G, 11/29/22] (Lessey). At its essence, the Lessey case involves the general question of whether a state-licensed marijuana taxpayer is entitled to deductions for the business expenses it claims.

There is nothing particularly novel in the case. However, it serves as a good reminder for taxpayers in the cannabis business to properly classify expenses as either cost of goods sold or general administrative deductions and to properly substantiate all expenses.

Many marijuana businesses may find the burden of documenting and maintaining records overwhelming. However, as the Lessey case illustrates, proper handling and submission of tax information may make or break a business' profitability. Well-advised cannabis businesses are also wise to keep abreast of decisions such as Lessey being handed down by courts, and glean insights from them to not only comply with, but also to operate strategically around, the hurdles and liabilities created by state and federal tax codes.

Applicable State And Federal Tax Laws

In 2016, Oregon codified an authorization for certain marijuana businesses to reduce their Oregon income by the amount of any federal deductions to which they would have been entitled but for Internal Revenue Code (IRC) section 280E (280E). 2016 Or Laws ch 91, § 9 (effective June 2, 2016).

IRC 280E, the notorious tax code applicable to the marijuana industry, prohibits a marijuana business from taking a deduction or credit for the vast majority of business expenses incurred in carrying on their trade (characterized by the federal government as "the business of trafficking Schedule I and II controlled substances"). Generally, businesses subject to 280E can only reduce gross receipts by the cost of goods sold (COGS), but cannot deduct other business expenses. That means traditional business expenses deductible by non-marijuana businesses, such as employee wages, lease payments, advertising expenses and more, are not deductible by marijuana businesses, which drastically increases the taxable income and resulting tax liability of marijuana businesses.

The Lesseys And Oak Pond Farm's Tax Liability

The Lesseys, unfortunately, made the common mistake of lumping all of the expenses they sought to exclude from the Farm's gross receipts in their 2016 taxable year into the "COGs" category totaling $57,654. The reason for this likely was to deduct these expenses for federal income tax purposes because federal law does allow cannabis businesses to deduct the cost of goods sold from gross income. However, following an audit, the Oregon Tax Department disallowed $26,467 of the Farm's deductions that it thought were not business related or for which the taxpayer did not provide sufficient substantiation. The Lesseys subsequently sought relief in the Oregon Tax Court (court), seeking to have the disallowed expenses either excluded or subtracted from their taxable income. The Oregon Tax Department asked the court to uphold its adjustments, disallowing the nearly $27,000 of deductions claimed by the Lesseys.

Nearly six years after the 2016 taxable...