When it comes to taxes, state-legalized marijuana companies are still having issues with the federal government, thanks to a tax code created to prevent illegal drug dealers from taking regular business deductions.

Now the IRS has opened a new round of audits on a slew of some of the biggest and most successful cannabis growers and retailers in Colorado, says James Thorburn, a Colorado-based tax attorney who represents many clients in the legal marijuana industry.

"The IRS is being very aggressive towards marijuana businesses. [They'll be auditing] pretty much everybody in the industry," he says. "It's now just a matter of time."

The new round of audits is for the taxable year of 2013 to 2014. Since marijuana is still illegal under federal law, companies must file taxes under tax code 280E, a regulation created for businesses that partake in illegal trafficking of a Schedule I or Schedule II substance (under the Controlled Substances Act). The code bans deductions besides cost of goods sold, which forces marijuana businesses to pay much higher taxes than most businesses that are allowed to take normal business deductions. (The tax code was created in 1982 after convicted drug trafficker Jeffrey Edmondson, a Minneapolis-based man who dealt amphetamines, cocaine, and marijuana, won a lawsuit against the IRS to claim business expenses. After Edmondson won the lawsuit, Congress passed tax code 280E.)

A Section 280E audit is technically civil, Thorburn explains. But in order to impose a 280E penalty, the taxpayer must be proven to have been "illegally trafficking in a controlled substance" prohibited by federal or state law. In other words, the taxpayer must have been investigated and convicted of a federal drug law for 280E to apply. While marijuana is illegal federally, the businesses being audited are operating legally within state law and have not been charged with illegal trafficking.

One of the founders of a Denver-based marijuana cultivator, who asked to remain anonymous, says his business is currently being audited for misfiling Form 8300 (cash deposits for over $10,000) and under Section 280E. He says he is not the only entrepreneur running a large-scale marijuana company in Colorado under audit. He says the number of companies being scrutinized by the IRS is astounding: "Most of the top 100 marijuana companies in Colorado are being 'randomly' audited," he says.

The entrepreneur's company has not been convicted of illegally trafficking and is currently in good standing with Colorado's Marijuana Enforcement Division, the state agency in charge of regulating the industry.

The real question remains: Why is the IRS auditing companies that are legally operating in state-legal markets?

"We don't know the reason. It could be political, it could be enforcement, but it's aggressive enforcement," says Thorburn.

The IRS' job is to make sure all income is reported, Thorburn explains. In the IRS's view, expenses beyond cost of goods sold--like employee salaries, rent, advertising--cannot be deducted.

Back in July, Inc. learned the IRS was auditing approximately 30 cannabis companies for not properly filing Form 8300, a document that businesses file when they make cash deposits over $10,000, for the tax year 2014 to 2015. Thornburn says the new round of audits is primarily focused on 280E.

When it comes to marijuana reform, the major changes have happened on the state level, creating friction between federal law, which continues to prohibit marijuana, and state laws. Last year, Congress did extend a rider in the 2016 spending bill that banned the Department of Justice from preventing states from creating their own marijuana laws. But this small federal reform did nothing to change the tax code, leaving marijuana businesses open to audit under 280E.

When reached for comment, an IRS representative said the agency doesn't comment on audit activity. Back in July, however, an IRS official said that while it cannot speak about specific taxpayers, the tax agency does not target state-legal marijuana companies for audits.

In a memo written by Kristen E. Bailey, the director of collection policy at the IRS, the state-level marijuana reforms have no impact on the way federal tax code should be enforced:

"Several state legislatures have passed laws legalizing the cultivation and sale of marijuana. These laws have created a conflict between federal law and state law. Since the Internal Revenue Service must adhere to federal law, these new state statutes do not have any impact on federal tax law when determining allowable expenses for income tax purposes."

In January 2016, a case regarding how a small dispensary in Colorado got hit with a $300,000 tax bill will go before Judge Kathleen Kerrigan, a U.S. tax court judge. Neil Feinberg, Andrea Feinberg, and Kellie McDonald started Total Health Concepts, a dispensary in Colorado, in 2009. After running at a loss and receiving a bill from the IRS for hundreds of thousands of dollars, the company closed up shop. Thorburn will argue that 280E should not apply to a state-legal marijuana company.

The outcome of this case--and others like it on the way--will be important to every entrepreneur in the industry.

"These cases [Feinberg and others] are important because if 280E is implemented the way IRS is trying, the taxes are so severe that the industry couldn't withstand the taxes that are imposed," explains Thornburn. "We are hopeful these taxes are not enforced."

Published on: Oct 24, 2016