Al Capone, one of the most notorious gangsters of all time, never served a day behind bars for the crimes he committed – with the exception of one crime: tax evasion. The lesson from this is to declare all of your income, even ill-gotten gains, to avoid prosecution for tax evasion. This directive will not apply to most taxpayers….hopefully.

Currently 16 states have legalized marijuana farming as a legal activity. The federal government, however, is apt to put these farmers in jail if they became aware of their activities because it is still considered a federal offense. The IRS enacted code section § 280E in 1982 in response to a tax court case that allowed a drug dealer engaged in illegal transactions to deduct as business expenses his costs for rent, automobile and telephone. In fact, legislative history indicates gross receipts can be reduced by cost of goods sold. Technically, though? Check it out. Here’s how it reads:

§ 280E. Expenditures in connection with the illegal sale of drugs

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 (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

The IRS claims it has no discretion not to apply § 280E to medical marijuana businesses because marijuana trafficking is illegal under federal law. But Congress disagrees. They have introduced the Small Business Tax Equity Act of 2011 (H.R. 1985), which would create an exception for medical marijuana businesses if it is legal under state law. On May 25, the bill was referred to the House Ways and Means Committee, where it is still being contemplated. Stay tuned to see if it passes or not.

In the mean time, the National Cannabis Industry Association (NCIA) urges medical marijuana farmers to allocate as much of their expenses as possible to cost of goods sold. Cost of goods sold would normally include the cost of clones, nutrients, labor, and supplies among other expenses. Allocations can be made for rents, utilities, and administrative overhead. In fact, I can picture an argument for including all expenses as a cost of goods sold.

If you are a medical marijuana grower, here’s what you can do:

1. Declare all of your income. Do not try to hide income from the IRS. Deposit all cash into bank accounts. If you keep some aside, make sure the income is recorded on your books.

2. Keep an accurate and complete set of books. Using QuickBooks or another software program to record income and expenses and to reconcile bank accounts is imperative.

3. Follow the law when hiring independent contractors or employees. Each worker should complete the appropriate paperwork whether it’s a W4 if he is an employee or a W9 if an independent contractor. Provide 1099s, W2s at year end and file all payroll tax returns and pay your payroll tax liabilities.

4. If you are a farmer, report your activity on Schedule F of your individual income tax return. it is not necessary to broadcast your product. On line A where principal crop or activity is indicated list “farming.” If you operate a dispensary report your income and expenses on Schedule C.

5. Be honest in your dealings. Bear in mind that the IRS and the tax court is interested only in enforcing tax law and collecting taxes. They have stated more than once that their purpose is not to punish unlawful behavior.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook

Bonnie Leehttp://global.fncstatic.com/static/v/all/img/external-link.png is an Enrolled Agent admitted to practice and representing taxpayers in all 50 states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, Calif., and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Her new e-book Taxpertise for the Creative Mind Murder, Mayem, Romance, Comedy and Tax Tips for Artists of all Kinds is available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebookhttp://global.fncstatic.com/static/v/all/img/external-link.png