Business expense deduction goes up in smoke

Ordinary and necessary business expenses are not deductible when a trade or business consists of trafficking in controlled substances prohibited by federal law, under a recent decision by the 9th U.S. Circuit Court of Appeals.

Martin Olive owns a business called the Vapor Room, located in San Francisco, Calif.

He appealed the Tax Court’s decision to disallow the deduction of all of his business expenses for 2004 and 2005. The Vapor Room had $236,502 of business expenses in 2004 and $417,569 of business expenses in 2005.

The Internal Revenue Code (IRC) defines “gross income” and allows a business to deduct from its gross income all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on the business. The difference between the two items is the business’s net income.

The IRC also has some exceptions to what is deductible as an ordinary and necessary business expense. One exception is IRC Section 280E, which disallows the amount paid or incurred during the taxable year for the purpose of carrying on any trade or business consisting of trafficking in controlled substances.

The test for determining whether an activity constitutes a trade of business is whether the activity was entered into with the dominant hope and intent of realizing a profit.

The Tax Court in applying the profit test determined that the only business activity that was engaged in by the Vapor Room was the sale of medical marijuana. Medical marijuana, while legal to sell in the state of California, is still considered to be a controlled substance for federal government purposes.

The Tax Court found that the only income-generating activity in which the Vapor Room engaged was its sale of medical marijuana. Marijuana was the only item for which the Vapor Room charged a fee.

It offered other services and amenities for which it did not charge a fee. For example, it provided vaporizers, food, drink, yoga, games, movies and counseling. The business offered the free items hoping to lure in customers to its dispensary to buy its medical marijuana.

Because marijuana is a controlled substance, IRC Section 280E disallows the deduction of any expenses related to this activity.

Thus, the appeals court affirmed the Tax Court’s decision to deny the Vapor Room a deduction for what it had considered the ordinary and necessary business expense associated with its operation (Martin Olive v. Commissioner, U.S. Court of Appeals, Ninth Circuit, No. 13-70510, July 9, 2015).

A Higher Standard of Excellence in Everything We Do.”