Tax Court Denies Deduction for Business Expenses of Operating a Marijuana Dispensary

In a recent opinion, the Tax Court held that business expenses of a medical marijuana dispensary in California were not deductible for federal income tax purposes.1 Richmond Patients Group (“Richmond”) sought to deduct its business expenses including compensation to officers, wages, rent, taxes and licenses, and other business related expenses, but the Tax Court denied the deduction on the basis of §280E of the Internal Revenue Code2 which prohibits deductions “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.” To add insult to injury, the Tax Court also denied Richmond’s request to change its accounting method and upheld the accuracy related penalties assessed pursuant to §6662. As is discussed below, the opinion and the decision to deny such deductions was a little more complicated than it might seem at first glance. While marijuana is legal in California, it is classified as a controlled substance and is illegal under Federal law. However the analysis of whether Richmond was entitled to the deductions did not end at marijuana’s illegality.


Richmond operated a medical marijuana dispensary in Richmond, California. It did not offer any other services. Richmond was organized as a California nonprofit mutual benefit corporation and was a C corporation for Federal income tax purposes. All of Richmond’s operations were legal under California state law.

Richmond was a members-only operation requiring membership to buy products and supply products to Richmond for resale, with suppliers being referred to as member providers. Richmond’s facility was approximately 3,000 square feet, 50% of which was used for purchasing and processing marijuana products, 25% of which was used for reception and retail purposes, and 25% of which was occupied by administration and storage.

Richmond employed two buying managers who would purchase bulk marijuana products consisting of flowers, concentrates, and edibles, all from members of Richmond. Richmond did not provide any of its member providers with clones or seeds to grow marijuana. The buying managers were responsible for inspecting the products to be purchased, grading them, and determining the purchase price. Once purchased, as required by Richmond city law, all products had to be tested. Products that failed testing were returned to the member provider, and those that passed testing were sold to Richmond’s members. The testing was done at an independent third-party laboratory. Richmond paid all costs for the testing.

The flowers purchased by Richmond were trimmed by the member providers prior to delivery to Richmond. Richmond trimmed the flowers further when needed, and then dried them in its humidity-controlled storage facility. Once the flowers reached the optimum moisture content, Richmond broke them down into salable units based on weight. The concentrates were also broken down into salable units by weight but did not require any additional action to ready them for sale. Richmond purchased the edibles in salable form.

On the tax and accounting side, Richmond used QuickBooks to maintain its accounts and prepare financial statements and sales reports. This information was provided to Richmond’s accountant who then prepared Richmond’s federal income tax returns. Richmond used the first in, first out (referred to as FIFO) inventory method of accounting for resellers. On its 2014 Form 1120 Richmond reported $4,970,120 of gross receipts and subtracted $3,234,028 in cost of goods sold (“COGS”). The COGS consisted of inventory plus purchases and other costs less ending inventory along with the following additional costs added in: $48,881 for damage and shrinkage, $5,733 for depreciation, $149,001 for inventory security, $16,907 for packaging, $63,711 for permit fees on gross revenue, and $32,200 for testing. Richmond also claimed business expense deductions of $1,653,948 for the following: compensation to officers; salaries and wages; repairs and maintenance; rents; taxes and licenses; charitable contributions; depreciation; pension, profit sharing, etc., plans; employee benefits programs; and other expenses. Richmond’s 2014 return was selected for audit and Richmond was notified of the examination in February of 2016.

Richmond filed its 2015 Form 1120 in March of 2016 on which it reported $6,254,843 in gross receipts and subtracted $5,982,023 in COGS along with business expense deductions totaling $43,555 which included taxes and licenses and charitable contributions. In its calculation of COGS for 2015, Richmond reported $1,404,534 of other costs consisting of: $10,417 for amortization, $60,928 for damage and shrinkage, $582 for depreciation, $1,080,541 for indirect COGS, $122,205 for inventory security, $67,260 for local fees on gross revenue, $30,201 for packaging, and $32,400 for testing. Richmond also included in its calculation of COGS $1,353,705 for cost of labor, a departure from its method of calculating COGS in 2014.

In conjunction with its 2015 Form 1120, Richmond submitted a Form 3115, Application for Change in Accounting Method, which changed its method of accounting from period costs to inventoriable costs, a method referred to as indirect COGS Richmond stated on the Form 3115 that it did not have any Federal income tax returns under examination. . As discussed below, under the indirect COGS method, Richmond, if a producer, would be able to include certain business expenses as costs of production to be included in COGS. Accordingly, the indirect COGS method could provide an end around of §280E by way of §471.

In November of 2016, Richmond filed a Form 1120X Amended Return for 2014 on which it moved most of the deductions for business expenses to COGS. Richmond’s amended tax return reported other costs of $1,965,784 in its COGS calculation. Additionally, on the same date, Richmond also filed a Form 1120X for 2015 resulting in a reduction of its tax liability by $9,954. Along with the amended tax return Richmond resubmitted Form 3115 for 2015 and again reported that it did not have any Federal income tax returns under examination.

It is not clear from the opinion when the examination was expanded to Richmond’s 2015 tax year but based on the results of the assessment, the 2015 return was also audited. The IRS issued a Notice of Deficiency to Richmond in January of 2018 which covered the 2014 and 2015 tax years and made adjustments to COGS and disallowed business expense deductions pursuant to §280E for various items including rents, compensation of officers, salaries and wages, repairs and maintenance, taxes and licenses, depreciation, and other various items. In addition, the IRS assessed the accuracy related penalty under §6662 for both 2014 and 2015.

In response to the Notice of Deficiency, Richmond filed a Petition to Tax Court. The parties agreed that Richmond had properly substantiated all deductions claimed.


The Court began its analysis by stating the longstanding rule that “the Commissioner’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving those determinations erroneous.” However, under certain circumstances the burden of proof may shift from the taxpayer to the Commissioner3, but Richmond failed to meet such requirements and thus the burden of proof remained on Richmond.

Regarding the deductions, the Court began its analysis with §162 which allows a taxpayer to deduct ordinary and necessary expenses paid or incurred…in carrying on a trade or business. However, §261 limits such deductions and provides that “no deduction shall in any case be allowed in respect of the items specified in this part”, which includes §280E.4 As discussed in the opening paragraph, §280E does not allow any deductions for expenses in carrying on a trade or business that consists of trafficking a controlled substance. However, §280E disallows deductions only for business expenses and did not prohibit Richmond from reducing its gross income by its COGS.5 The Court has previously held that medical marijuana is a controlled substance6 and that the dispensing of medical marijuana, while legal under state law, is still illegal under Federal law.7 As such, §280E was applicable to Richmond’s operations and prohibited Richmond from deducting various business expenses listed as: rents, compensation of officers, salaries and wages, repairs and maintenance, taxes and licenses, charitable contributions, depreciation, pension and profit sharing plans, employee benefit programs, and other expenses. The Court denied all such deductions for Richmond.

While §280E does prohibit the deduction of business expenses by Richmond, it does not prohibit Richmond from deducting COGS. In its analysis of the COGS deduction, the Court stated that COGS “is not a deduction within the meaning of section 162(a) but is subtracted from gross receipts in determining a taxpayer’s gross income.”8 The analysis of calculating COGS and what can be included and what must be excluded is somewhat convoluted.

The starting point for COGS is §471 and the related regulations. §471 and the regulations thereunder direct taxpayers to §263A for additional rules in determining COGS.9 Pursuant to §263A, both producers and resellers are allowed to include “indirect inventory costs in determining COGS.”10 Treas. Reg. §1.263A-1(e)(3) defines indirect costs in broad manner to include all costs other than direct material costs and direct labor costs (for producers) and acquisition costs (for resellers). However, §263A specifically prohibits including any such costs in calculating COGS unless such costs are otherwise deductible.11 Since §280E disallowed the business expense deductions under §162, the Court concluded that such expenses were not otherwise deductible and thus were prohibited from being included in Richmond’s COGS by §263A(a)(2).

Richmond argued that it should be a producer for purposes of apply §263A and §471, and as a producer, was entitled to include such additional costs in COGS under the §471 Regulations. §263A and the related regulations define producers as taxpayers who “construct, build, install, manufacture, develop, improve, create, raise, or grow” and this same definition applies for §471 as well. Under Treas. Reg. §1.471-11(b)(1), “[c]osts are considered to be production costs to the extent that they are incident to and necessary for production or manufacturing operations or processes.” However, the Court concluded that Richmond was merely a purchaser and reseller and did not meet the definition of a producer. As such, Richmond was not allowed to deduct additional indirect costs included in COGS.

After denying the deductions, the Court held that Richmond was not allowed to change its accounting method. Richmond had used FIFO since inception and did not provide any evidence of change in business that would warrant a change in its accounting method. Accounting methods of a taxpayer ‘must be consistent from year to year unless the Commissioner authorizes a change.”12 The Court concluded the accounting change would not clearly reflect income and that the Commissioner had not consented, and thus Richmond’s request to change its accounting method was denied.

Additionally, the Court upheld the accuracy related penalties under §6662(a). The Court held that Richmond had not acted in good faith. In 2014, Richmond claimed deductions that were impermissible pursuant to §280E, and for 2015, Richmond moved these expenses to COGS, an action that indicated Richmond was aware when it filed its 2015 return that such expenses were not deductible due to §280E. There was relevant authority directly against Richmond’s position for 2014. Additionally, Richmond provided no evidence that it relied on its accountant for advice regarding §§ 280E, 471, and 263A.


While the business expense deductions were ultimately denied under §280E since marijuana is a controlled substance, the analysis was not quite that simple. Under a different set of facts where Richmond was engaged in additional activities that might have helped it cross the producer threshold, such costs may well have been properly included in the COGS deduction. Anyone engaging in activities related to marijuana, whether it be in production or sale, should seek the proper legal advice and aim to structure operations in a manner that avoids the issues Richmond faced whereby many of its business expenses which are necessary to operate were nevertheless held not to be deductible.

As states continue to legalize marijuana, the issues discussed in this case will continue to be relevant if marijuana remains illegal under Federal law.


  1. Richmond Patients Group v. Commissioner, TC Memo 2020-52.
  2. All references to a § or a Section are to a Section of the Internal Revenue Code.
  3. §7491(a).
  4. Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (“CHAMP”), 128 T.C. 173, 180 (2007).
  5. Id. at 178 n.4.
  6. Id.
  7. Olive v. Commissioner, 139 T.C. 19, 29 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015).
  8. Max Sobel Wholesale Liquors v. Commissioner, 69 T.C. 477 (1977), aff’d, 630 F.2d 670 (9th Cir. 1980); See also Treas. Reg. §. 1.162-1(a).
  9. §471(d).
  10. §263A(a)(2)(B), (b); Treas. Reg. § 1.263A-1(a)(3), (c)(1), (e).
  11. §263A(a)(2).
  12. Huntington Sec. Corp. v. Busey, 112 F.2d 368, 370 (6th Cir. 1940).


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