Section 280E of the Internal Revenue Code has long been a thorn in the side of the cannabis industry. However, in a United States Tax Court opinion issued October 23, 2019, one judge’s partial dissent suggests that the firm ground undergirding Section 280E may be starting to weaken. At the very least, the opinion provides a potential roadmap for arguing against Section 280E’s application to marijuana-related businesses.
I.R.C. § 280E
The section of the law in question 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.
There may be no single provision in the tax code with more implications for cannabis companies—and their accountants—than the 77-word sentence making up Section 280E. Section 280E prohibits companies from deducting what would normally be deductible business expenses where the business “consists of” dealing in items found in Schedules I or II of the Controlled Substance Act. For example, a cannabis operator in California or Colorado with a legal marijuana business may be fully compliant with state law. But because the sale of marijuana is prohibited by federal law, no deductions relating to that business may be had because of the proscription of Section 280E… for now.
Potential Game Changer: Northern California Small Business Assistants, Inc. v. Commissioner of Internal Revenue
The court’s opinion in NCSBA v. Commissioner has been a long time in the making, beginning with the IRS informing NCSBA—an operator of a medical marijuana dispensary in California—that for 2012 there was an income tax deficiency of over $1.2 million and an associated penalty of over $250,000. The deficiency, the IRS informed NCSBA, resulted from the fact that NCSBA was not entitled to claim otherwise normal business deductions because of Section 280E.
Although the court as a whole rejected all of the dispensary owner’s arguments, Judge Gustafson wrote a substantive, and potentially groundbreaking, partial dissent in which he stated that Section 280E is unconstitutional because it is not permitted under the Sixteenth Amendment, which gives Congress the power “to lay and collect taxes on ‘incomes, from whatever source derived…’” What makes Section 280E unique, Judge Gustafson argues, is that it does not simply “disallow [a] deduction”—“it allows ‘no deduction’; it disallows all deductions.” (Emphasis added.)
By employing an analogy centered on a hypothetical widget business, Judge Gustafson emphasized the point that rather than imposing a tax on income resulting in a gain, Section 280E fabricates a gain where there is none by disallowing the deduction of otherwise deductible business expenses. The analogy goes like this: If one spends $600 purchasing materials; $200 on rent for the business; and $200 on payroll, that person has spent $600 on goods and $400 in typical business expenses, totaling $1,000 in expenses. If that person then sells $900 worth of finished goods, the gross receipts are $900. But since the parts cost $600 and the person is permitted to deduct the $400 in typical business expenses, there is no actual gain—there is a loss of $100. But for cannabis businesses, the result differs substantially. The business is not permitted to deduct the ordinary expenses such as rent or payroll, meaning that the $900 in revenue is no longer offset by the $400. Consequently, that cannabis business—despite experiencing the same actual “loss” as the widget company—registers a gain of $300 (the delta between the $900 in revenue and the $600 paid for the materials).
The Sixteenth Amendment permits Congress to tax “incomes’ which is “gain” realized on a transaction. According the Judge Gustafson, Section 280E’s disallowances of all deductions:
… transforms the… 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.… I would hold that the Sixteenth Amendment does not permit Congress to impose such a tax and that section 280E is therefore unconstitutional.
Whether and when Judge Gustafson’s dissent and the Sixteenth Amendment argument will be at the forefront of litigation successfully challenging Section 280E remains to be seen. In any event, the arguments raised may indicate the turning of the tide.