Money was pouring into Bruce Nassau’s five Colorado marijuana shops when his accountant called with the bad news: The 2014 tax season was approaching, and Mr. Nassau could not rely on the galaxy of deductions that other businesses use to reduce their tax bills. He was going to owe the Internal Revenue Service a small fortune.
“I had to write a check for $275,000,” Mr. Nassau said. “Unbelievable.”
The country’s rapidly growing marijuana industry has a tax problem. Even as more states embrace legal marijuana, shops say they are being forced to pay crippling federal income taxes because of a decades-old law aimed at preventing drug dealers from claiming their smuggling costs and couriers as business expenses on their tax returns.
Congress passed that law in 1982 after a cocaine and methamphetamine dealer in Minneapolis who had been jailed on drug charges went to tax court to argue that the money he spent on travel, phone calls, packaging and even a small scale should be considered tax write-offs. The provision, still enforced by the I.R.S., bans all tax credits and deductions from “the illegal trafficking in drugs.”
Marijuana business owners say it prevents them from deducting their rent, employee salaries or utility bills, forcing them to pay taxes on a far larger amount of income than non-marijuana businesses with the same earnings and costs. They also say the taxes, which apply to medical and recreational sellers alike, are stunting their hiring, or even threatening to drive them out of business.
The issue reveals a growing chasm between the 23 states, plus the District of Columbia, that allow medical or recreational marijuana and the federal bureaucracy, which includes national forests in Colorado where possession is a federal crime, federally regulated banks that turn away marijuana businesses and the halls of the I.R.S.
While President Obama and top federal officials have allowed states to pursue legalization, marijuana advocates say the dissonance between increasingly permissive state laws and federal prohibitions is creating a morass of complications and uncertainty.
The tax rule, an obscure provision referred to as 280E, catches many marijuana entrepreneurs by surprise, often in the form of an audit notice from the I.R.S. Some marijuana businesses in Colorado, California and other marijuana-friendly states have challenged the I.R.S. in tax court.
This year, Allgreens, a marijuana shop in Colorado, successfully challenged an I.R.S. policy that imposed about $30,000 in penalties for paying its payroll taxes in cash – common in an industry in which businesses rely on armed guards and cash-stuffed safes because they cannot get bank accounts.
“We’re talking about legal businesses, licensed businesses,” said Rachel Gillette, the executive director of Colorado’s chapter of the National Organization for the Reform of Marijuana Laws and the lawyer who represented Allgreens. “There’s no reason that they should be taxed out of existence by the federal government.”
Ms. Gillette said she represented a dispensary owner who had taken in $1.7 million last year before expenses and had received a tax bill of $866,000. They are negotiating with tax officials, she said.
Colorado and a handful of other states have changed their tax laws to let legal marijuana businesses take deductions on their state returns. And this month, Senator Ron Wyden and Representative Earl Blumenauer, both Democrats of Oregon, which legalized recreational marijuana last year, introduced legislation that would allow marijuana businesses that are following their states’ legalization laws to take regular deductions on their federal returns.
“It’s affecting thousands of businesses, and it’s doubling, tripling, quadrupling their taxes,” Mr. Blumenauer said. “It just cripples them.”
The current system, he said, encourages marijuana sellers to file tax returns that do not follow the law and simply hope the I.R.S. does not spot them.
But Kevin Sabet, president of Smart Approaches to Marijuana, a leading critic of legalization, said it made no sense to give “tax breaks to companies openly violating federal law by selling marijuana gummies and lollipops.”
Accountants and tax lawyers, who are inundated with calls from marijuana shops these days, say the rules are murky and make little sense. If marijuana retailers dedicate parts of their stores to yoga, drug education or selling non-drug merchandise, can they deduct part of their rent? If employees split their time between cleaning the store and selling marijuana, are their salaries partly deductible?
“There’s no clear direction,” said Scott Levy, an accountant in Arizona who said that marijuana sellers made up about one-fifth of his business. “You find all these weird little strategies that people use to try to parse the definitions.”