The U.S. Tax Court recently ruled against two Colorado medical marijuana retailers who claimed deductions for the administrative expenses of selling non-marijuana merchandise. The court found that the couple did not provide adequate evidence that the non-marijuana goods were sold as part of a separate business.

Although the sale of marijuana is now legal in 30 states and the District of Columbia for medicinal purposes, and in another nine states for recreational purposes, according to Accounting Today, its sale and use are still illegal under federal law. Section 280E of the Internal Revenue Code forbids tax deductions based on the sales of illegal substances.

Laurel Alterman and William Gibson, a married couple, ran a marijuana dispensary called Altermeds, LLC in Lousiville, Colo., near Boulder. In their joint returns for the years 2010 and 2011, they claimed business-expense deductions based on the sale of non-marijuana products.  But the Tax Court held that “selling non-marijuana merchandise was not separated from the business of selling marijuana merchandise. First, Altermeds derived almost of its revenue from marijuana merchandise. Second, the types of non-marijuana products that it sold (pipes and other marijuana paraphernalia) complemented its efforts to sell marijuana."

The Tax Court noted, however that, “if selling non-marijuana merchandise were considered a second business, then the expense of that business would be deductible.” The court noted that the couple also claimed to sell non-marijuana merchandise such as hats, T-shirts and magazines. But the court found that the couple failed to identify any specific payments for, or provide records about, such a separate business, and it therefore disallowed the couple’s deductions claims.

The Tax Court also addressed the couple’s claims for costs of good sold, noting that “costs of goods sold is a reduction made in the course of computing gross income. … It is not a deduction, and therefore it is not disallowed by Section 280E.” But the Tax Court found that there was no information on the record to calculate inventory during the relevant years, nor for the cost of goods sold, so it disallowed the couple’s reductions claims that were in excess of the amounts that the IRS conceded in its brief.

As Accounting Today observed, the case illustrates the importance of good record-keeping in the cannabis industry.