The U.S. Tax Court recently ruled that because marijuana remains illegal under federal law cannabis businesses are prohibited from deducting business expenses pursuant to Section 280E of the Internal Revenue Code. According to the court, the provision is neither a penalty nor an unconstitutionally excessive fine.
While the Tax Court ultimately rejected the cannabis industry’s challenges to Section 280E in Northern California Small Business Assistants Inc. v. Commissioner of Internal Revenue, it is important to note that the decision was not unanimous. In a partial dissent, Judge David Gustafson argued that Section 280E is unconstitutional under the 16th Amendment. Judge Elizabeth A. Copeland also issued a partial dissent, rejecting the majority’s conclusion that Section 280E is not a penalty.
I.R.C. Section 280E
Marijuana remains a Schedule I controlled substance under the Controlled Substances Act. Accordingly, the IRS has relied on Section 280E to refuse to recognize tax deductions taken by state-legal cannabis businesses because of their illegal operation under federal law.
Section 280E of the Internal Revenue Code prohibits businesses from deducting otherwise valid business expenses where the business “consists of” dealing in controlled substances set forth in Schedules I or II of the Controlled Substance Act. I.R.C. § 280E expressly states:
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.
Section 280E applies only to deductions attributable to a taxpayer’s drug- related trade or business. Accordingly, the provision does not generally disallow deductions attributable to a taxpayer’s non-drug-related business.
Cannabis Business Challenges Tax Deficiency
The dispute began when the Internal Revenue Service (IRS) notified Northern California Small Business Assistants Inc. (NCSBA), a California medical marijuana company, that there was a deficiency in its 2012 income tax of $1,264,212. The IRS also assessed an accuracy-related penalty under section 6662(a) of $252,842.40.
In response, NCSBA argues that section 280E is invalid. It specifically asserts that 280E: (1) imposes a gross receipts tax as a penalty in violation of the Eighth Amendment to the Constitution; (2) eliminates only ordinary and necessary business deductions under section 162 and does not apply to other distinct sections of the Code; and (3) does not apply to marijuana businesses legally operated under State law.
Tax Court Sides With IRS
The Tax Court rejected all of NCSBA’s arguments. The court first rejected the argument that the aim of section 280E is to punish, rather than tax, and therefore it is a penalty that must be limited by the Excessive Fines Clause of the Eighth Amendment.
In support, the Tax Court emphasized that section 280E is enacted under Congress’ “unquestionable authority” to tax gross income under the Sixteenth Amendment and targets individuals who operate a business in violation of State or Federal law. “Section 280E is directly tied to Congress’ policy objective to limit and deter trafficking in illegal controlled substances, Judge Joseph Robert Goeke wrote. He added:
Petitioner does not cite, and we are not aware of, any case where the disallowance of a deduction was construed a penalty. “This is especially telling given that Congress enacted section 280E over 37 years ago in 1982, and over that 37 years it has never been held to be a penalty by any Federal court.
The Tax Court also rejected NCSBA’s argument that section 280E limits only deductions under section 162 and deductions under sections 164 and 167 are allowed notwithstanding section 280E. “[P]etitioner’s argument misses the first line of section 280E: ‘No deduction or credit shall be allowed’. (Emphasis added.) Congress could not have been clearer in drafting this section of the Code,” Judge Goeke wrote.
The Tax Court also rejected the argument that section 280E does not apply to a legally operated marijuana business because legal operations do not “traffic” in controlled substances. “Despite efforts by several states to legalize marijuana use to varying degrees, it remains a Schedule I controlled substance within the meaning of the Controlled Substances Act,” Judge Goeke wrote. “Consistent with this designation, we have held that the limitations imposed by Section 280E are applicable to the ever-increasing number of marijuana businesses operating legally under state law.”
The Tax Court’s decision in Northern California Small Business Assistants Inc. v. Commissioner of Internal Revenue was not unanimous. While Judge Gustafson and Judge Copeland joined the majority in denying NCSBA’s motion for summary judgment, they did not agree with its reasoning.
In a lengthy dissent, Judge Gustafson argued that Section 280E is unconstitutional under the Sixteenth Amendment, which gives Congress the power “to lay and collect taxes on ‘incomes, from whatever source derived…’” Under Gustafson’s reasoning, the problem with Section 280E is that it disallows all deductions and, therefore, fabricates a gain where there is none by disallowing the deduction of otherwise deductible business expenses.
“I would hold that this wholesale disallowance of all deductions transforms the ostensible income tax into something that is not an income tax at all, but rather a tax on an amount greater than a taxpayer’s ‘income’ within the meaning of the Sixteenth Amendment,” he wrote. “Accordingly, I would hold that the Sixteenth Amendment does not permit Congress to impose such a tax and that section 280E is therefore unconstitutional.”
Judge Copeland joined the majority because she found that NCSBA failed to demonstrate how the amounts were excessive. However, she also disagreed with the majority’s conclusion that Section 280E is not a penalty. "Even if Section 280E was not written as a penalty provision, it operates as such," Judge Copeland wrote. "It attacks an entire industry (in this case, cannabis businesses) and sweeps so broadly as to deny every deduction the code would otherwise allow, rather than specify a narrow range of expenses."
The dissents give cannabis businesses another argument to raise in lawsuits challenging section 280E. However, it is unclear if they will be persuasive to other members of the Tax Court. We will continue to closely monitor this evolving area of law. In the meantime, we encourage cannabis businesses to work with experienced counsel to determine the best way to reduce your liability.
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This article is a part of a series pertaining to cannabis legalization in New Jersey and the United States at large. Prior articles in this series are below:
- Five Key Cannabis Industry Legal Updates
- Federal Marijuana Legalization Bill, MORE Act, Advancing in US House
- Will Cannabis Legalization Be Decided by New Jersey Voters?
- Is United Approach the Key to Adult-Use Cannabis Legalization?
Disclaimer: Possession, use, distribution, and/or sale of cannabis is a Federal crime and is subject to related Federal policy. Legal advice provided by Scarinci Hollenbeck, LLC is designed to counsel clients regarding the validity, scope, meaning, and application of existing and/or proposed cannabis law. Scarinci Hollenbeck, LLC will not provide assistance in circumventing Federal or state cannabis law or policy, and advice provided by our office should not be construed as such.