The 16th Amendment to the U.S. Constitution provides that, “Congress shall have power to lay and collect taxes on incomes, from whatever source derived…”. According to § 162 of the Internal Revenue Code, businesses are generally allowed to deduct from their adjusted gross income the ordinary and necessary expenses they incur in carrying on their business. 26 U.S.C. § 162. One pesky provision in the Internal Revenue Code, § 280E, disallows these business expense deductions “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.” 26 U.S.C. § 280E. Because marijuana is still illegal at the federal level under the Controlled Substances Act, according to § 280E, businesses that are engaged in the growing, manufacturing, or sale of marijuana are not entitled to deduct their ordinary and necessary business expenses from their adjusted gross income under § 162.
According to The Wolters Kluwer Bouvier Law Dictionary, income may be defined as “Gain in wealth realized from one’s labor, property, commerce, or investment.” For any taxpayer, taxable income is equal to their gross income less the deductions they are entitled to. In order to lessen overall tax liability, and thus avoid higher rates of taxation, it is in the taxpayer’s best interest to utilize all available deductions. Deductions are available to taxpayers so that their taxable income more properly reflects their overall “gain in wealth”.
With the emergence of state-sanctioned marijuana businesses over the last 10 years, the application of § 280E has left many marijuana businesses with tax liabilities that do not accurately reflect the income, or “gain in wealth realized”, they are generating. Recently, a marijuana business, Harborside Health Center, which was hit with an $11 million tax liability by the U.S Tax Court, has challenged the constitutionality of § 280E, arguing that it violates the 16th Amendment’s reliance on “income”. Patients Mut. Assistance Collective Corp. v. Commissioner, Nos. 29212-11, 30851-12, 14776-14, 2018 Tax Ct. Memo LEXIS 211 (T.C. Dec. 20, 2018). The business maintains that § 280E improperly categorizes all monies generated by the business as income rather than more appropriately distinguishing those monies from “gain in wealth realized”. Harborside Health Center’s appeal will be heard in the Ninth Circuit, but remains unscheduled to this point. Patients Mut. Assistance Collective Corp. v. Commissioner, 19-73078. Per the brief that has been submitted by the appellant, the premise of their argument is that, “[b]y blocking a marijuana business from taking any deductions related to their expenses, § 280E is improperly classifying all money that passes through the business as income”. The National Cannabis Industry Association and the Marijuana Industry Group have filed amicus briefs echoing the appellant’s 16th Amendment challenge to § 280E.
In addition to attacking the constitutionality of § 280E as a whole, Harborside argues that its “cost of goods sold should include the costs of the staff and materials it uses to examine, process and package the marijuana flower, clones and edibles it buys from wholesalers and sells in its shop.” Since § 280E only applies to business deductions, cannabis businesses are still allowed to reduce taxable income by the costs associated with selling inventory. According to 26 CFR § 1.61-3, “In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold”, where the cost of goods sold is not an expense, but rather an adjustment that impacts the total amount of taxable gross income. Harborside argues that it functions like a grocery store that makes prepared food and butchers meat before putting it out for sale. Grocery stores are free to claim the cost of preparing the goods for sale as part of their costs of goods sold, so Harborside should as well.
Harborside’s tax challenge is just one in a series of lawsuits and actions aimed at reducing § 280E’s detrimental impact on legitimate, licensed marijuana businesses. Recently, the United States Tax Court acknowledged that if a business has both legal and illegal components (expenditures in connection with the illegal sale of drugs within the meaning of § 280E), the business will be permitted to take § 162 deductions for just those business-related expenses that are not in violation of § 280E. In 2007, the Tax Court, in Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner, 128 T.C. 173 (2007), held that a California marijuana dispensary which provides counseling and caregiving services in addition to selling marijuana was allowed to deduct expenses relating exclusively to the counseling and caregiving aspects of its business. The burden of distinguishing the expenses concerning marijuana-related activity from those that were related to the counseling and caregiving services fell on the dispensary taxpayer. Along those same lines, in Alterman v. Commissioner, No. 13666-14, 2018 Tax Ct. Memo LEXIS 83 (T.C. 2018), the Tax Court determined that when a marijuana business is unable to distinguish legal business-related expenses from those expenses relating to the illegal activity (those associated with the trafficking of marijuana), all business deductions will be disallowed.
Beyond the Tax Court, in Alpenglow Botanicals, LLC v. United States, 894 F.3d 1187 (10th Cir. 2018), the U.S. Court of Appeals for the Tenth Circuit ruled that the IRS has the authority to determine that a cannabis business is trafficking in a controlled substance for purposes of applying § 280E. The court stated that a criminal conviction is not a prerequisite for the IRS to apply § 280E and that the IRS has the authority to determine through an audit that a taxpayer is trafficking in a controlled substance. Furthermore, the court stated that §280E is not an unlawful penalty and disallowing a deduction is not a “punishment.” Critics condemned this decision on the grounds that it gives the IRS the power to investigate non-tax crimes for tax administration purposes and allows them to administratively determine that a crime has been committed. The plaintiff’s writ of certiorari was denied by the Supreme Court of the United States.
Cannabis businesses across the country anxiously await the Ninth Circuit’s upcoming ruling in Patients Mut. Assistance Collective Corp. v. Commissioner, 19-73078. For now, it remains obvious that as long as marijuana remains illegal under the Controlled Substances Act, § 280E will continue to act as a barrier to marijuana businesses realizing their deserved profit.
One of the most important things a cannabis enterprise can do is ensure it maintains accurate and factually detailed records of its business transactions and expenses. Making sure there are proper accounting methods in place to detail business operations and not trying to account for costs and expenses after-the-fact are all best practices. If the IRS chooses to request further documentation supporting the deductions a business claimed when filing its taxes, and the business is able to offer substantiated documentation for such claimed deductions, the court will be less likely to prohibit the deductions altogether. It is also important to structure the business in a way that clearly distinguishes the marijuana business from the non-marijuana business. Selling paraphernalia next to actual drug products—without any other activities—will probably not be enough for a company to deduct necessary and ordinary business expenses and subsequently claim that those expenses do not run afoul of § 280E’s prohibition on deductions for marijuana businesses. Proper planning and accounting are key.