A recent audit is pointing up the need for additional attention from the IRS on just how taxes are collected from an emerging sector of the economy: the marijuana industry.

Ten states—Alaska, California, Colorado, Maine, Massachusetts, Michigan, Nevada, Oregon, Vermont and Washington—and the district of Columbia allow marijuana to be used for both medical and recreational use. Another 23 states allow only medical marijuana use. This means 66 percent of all the states and the District of Columbia allow for some sort of legalized use of marijuana.

In performing the audit, the Treasury Inspector General for Tax Administration (TIGTA) found that a number of  federal tax returns from marijuana-related businesses were filed with underreported income and over-reported deductions.

Part of the problem, the audit notes, is that these businesses have a foot in two different worlds, so to speak. While the marijuana industry has been legalized in various states to varying degrees, marijuana is illegal under Federal law. It remains a Schedule 1 controlled substance under the Controlled Substances Act.

This may account for the at least some of the shortcomings in federal filings from producers and retailers. The audit report explains: “Under the Controlled Substances Act, it is illegal to manufacture or distribute marijuana.  Further, Internal Revenue Code (I.R.C.) Section 280E prohibits the deduction of expenses incurred in trafficking controlled substances.  I.R.C. Section 280E does not apply to the cost of goods sold.  Consequently, businesses that sell marijuana can reduce gross receipts by the cost of goods sold but cannot deduct other business expenses.”

The Audit

TIGTA looked at statistical random samples of marijuana businesses in three states and determined some 59 percent (140 out of 237) of the tax return filings for Tax Year 2016 had likely I.R.C. Section 280E adjustments. When that percentage is spread out over the entire marijuana-business population, TIGTA said it means $48.5 million dollars went untaxed for Tax Year 2016; that grows to $242.6 million when spread over five years.

The report also looks at what impact paying additional tax would have on the marijuana industry. TIGTA estimates the industry would see some $95 million in additional taxes if I.R.C Section 280E is correctly applied to Tax Year 2016 alone.

Recommendations

The Inspector General put forth six recommendations which basically revolve around increased guidance and education for the marijuana industry. In particular, the audit report calls for a comprehensive compliance approach for the industry, including a method to identify businesses within the marijuana industry and track examination results. Other steps would be to develop and publicize guidance specific to the marijuana industry, while leveraging the information that is publicly available from the states that allow the activity.

The IRS agreed with five of the six recommendations, and said it could take another look at the sixth recommendation after completing its Priority Guidance Plan later this year.