On September 8, 2014, the state of Illinois begins accepting applications for medicinal marijuana dispensary and cultivation center permits. Under the state’s Compassionate Use of Medical Cannabis Pilot Program Act, passed last year, Illinois will grant one cannabis cultivation permit for each of its 22 state police districts and as many as 60 medicinal marijuana dispensary permits throughout the state.

Recipients of medicinal marijuana business licenses in Illinois should understand and plan for the difficulties they may face in deducting business expenses related to operating their cultivation centers and/or dispensaries. So far, the IRS has taken a heavy-handed approach to marijuana businesses in other states, disallowing many such deductions, maintaining that section 280E of the Internal Revenue Code precludes dispensaries from deducting business expenses related to the sale of marijuana. Section 280E provides: “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business consists of trafficking in controlled substances.” Congress enacted Section 280E in the 1980s in response to a Tax Court decision that allowed a drug dealer to deduct expenses related to his illicit narcotics business. Of course, Section 280E was enacted before any state had legalized marijuana for medicinal or recreational purposes.

Nevertheless, strictly adhering to the plain language of section 280E, the IRS takes the position that dispensing medicinal marijuana, even if legal under state law, constitutes “trafficking a controlled substance,” and has aggressively disallowed many related business expense deductions. In legal challenges by affected medicinal marijuana dispensaries, the Tax Court has agreed with the IRS, stating that “[t]he dispensing of medical marijuana, while legal in [some states], is illegal under Federal law.” By enacting section 280E, the Tax Court has noted that Congress has “preclude[d] a taxpayer from deducting expenses incurred in a medical marijuana dispensary business…even if the business is legal under State law.”

The silver lining: both the IRS and Tax Court have conceded that the “costs of goods sold” for medicinal marijuana businesses are deductible. This somewhat arbitrary distinction has resulted in creative accounting approaches that seek to mitigate the harsh application of section 280E. For instance, some dispensaries have lumped more of their operating expenses under the “costs of goods sold” umbrella, or capitalized indirect costs associated with their inventory to bulk up their costs of goods sold. Some dispensaries even offer non-marijuana related services, such as yoga and counseling, and then attribute costly overhead expenses to those legal income-producing streams. Enhanced efforts to navigate the current medicinal marijuana tax mine field will likely continue as more sophisticated entrepreneurs enter the medicinal marijuana marketplace. How the IRS and federal government will respond remains very much in flux.

In short, absent Congressional action explicitly legalizing medicinal marijuana, or removing marijuana from the list of controlled substances covered by Section 280E, medicinal marijuana business owners’ ability to deduct otherwise legitimate business expenses remains in limbo. Accordingly, those entrepreneurs applying for cultivation center and dispensary permits in Illinois should understand and plan for the potential tax pitfalls.