IRS Continues To Audit And Litigate Against Cannabis Businesses – Tax

Highlights

• Section 280E of the Internal Revenue Code (Code) prohibits the
  deduction of business expenses when the trade or business consists
  of trafficking in controlled substances.




• As cannabis continues to be legalized and regulated at the
  state level, marijuana (i.e., cannabis) remains an illegal
  controlled substance at the federal level subject to the
  prohibitions of Section 280E.




• The IRS continues to audit and litigate against businesses
  trafficking in controlled substances (within the meaning of Section
  280E).

As Congress continues to deliberate the federal legalization of
marijuana, the cannabis industry continues to face scrutiny from
the IRS under Section 280E of the Internal Revenue Code (Code).

Enacted in 1982 in response to a U.S. Tax Court case that
allowed a drug dealer to deduct expenses in connection with his
illegal activities, Section 280E provides:

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.

Thus, Section 280E prohibits any trade or business that consists
of trafficking in controlled substances from deducting or taking
credits¹ for any amounts paid or incurred during
the taxable year. The U.S. Tax Court has interpreted
“trafficking” by reference to the verb
“traffic,” denoting engagement in regular commercial
activity, which includes legal distribution of medical marijuana to
consumers under state law.²

Cannabis is a Schedule I controlled substance; thus, and despite
the fact that cannabis programs have been regulated in the majority
of U.S. states and territories as well as Washington,
D.C.,³ cannabis remains illegal under federal law
and is covered by Section 280E.

This generally means that cannabis businesses may not deduct
necessary costs (other than cost of goods sold or
COGS)⁴ in computing gross income for federal tax
purposes. For example, a cannabis business subject to Section 280E
may be unable to deduct expenses such as rent, payroll,
advertising, utilities, insurance, office equipment, legal and
accounting fees, etc. However, a cannabis business may be allowed
limited cost relief for direct and indirect costs in determining
its COGS under the relevant Code regulations, depending on whether
such business is a reseller or producer of cannabis.

The Section 280E prohibitions impose additional economic strain
on cannabis businesses that are operating in an already highly
regulated and competitive market. By denying what would ordinarily
be deductible expenses for most businesses, Section 280E may impose
a severe effective tax rate on certain cannabis businesses. For
example, a cannabis company could have a net loss on its internal
books but, by operation of Section 280E, have significant taxable
income for federal tax purposes, resulting in a challenging outcome
to the taxpayer.

In the almost 40 years since its enactment, the IRS has had
Section 280E in its back pocket to enforce against cannabis
businesses. With the relatively recent legalizations and
commercialization of cannabis at the state level, the IRS audit and
litigation activity against cannabis businesses has undoubtedly
been more active than ever before as new companies enter the
market.

As is typically the case, most federal tax disputes do not
extend beyond the audit level. However, cannabis businesses in
recent years have petitioned the U.S. Tax Court (and other courts)
challenging the IRS’ proposed audit results, often disputing
the IRS’ application of Section 280E to their business
operations under various interpretations of the law. Frequently,
the IRS has prevailed in prohibiting cannabis businesses from
taking business deductions and seems to be becoming more emboldened
in its litigation position.

That is not to say that cannabis businesses have not prevailed
in some aspects in U.S. Tax Court. In Californians Helping
to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), an
issue before the U.S. Tax Court was whether the taxpayer, a public
benefit corporation established to provide members suffering from
debilitating diseases with medical marijuana and caregiving
services, had two trades or businesses: 1) providing medical
marijuana, and 2) caregiving services.⁵ In
analyzing whether the taxpayer had two or more trades or
businesses, the court stated, “[W]hether an activity is a
trade or business separate from another trade or business is a
question of fact that depends on (among other things) the degree of
economic interrelationship between two undertakings,” noting
the IRS “generally accepts a taxpayer’s characterization
of two or more undertakings as separate activities unless the
characterization is artificial or
unreasonable.”⁶

The U.S. Tax Court found that it was not artificial or
unreasonable for the taxpayer to have characterized as separate
activities its provision of medical marijuana and its provision of
caregiving services. Consequently, the U.S. Tax Court held that,
although Section 280E prohibited business expenses attributable to
the provision of medical marijuana, it did not bar the taxpayer
from deducting the portion of the taxpayer’s expenses
attributable to its separate provision of caregiving services.

It must be stated that the CHAMP case is the
exception and not the norm, as the IRS has already prevailed in
numerous cases in the first quarter of this year
alone.⁷ For example, in San Jose Wellness
v. Commissioner, a recent U.S. Tax Court case involving a
taxpayer that operated a licensed medical cannabis dispensary
pursuant to California law, the court rejected the taxpayer’s
various nuanced textual arguments and determined that Section
280E’s broad prohibitions barred certain deductions (including
charitable contribution and depreciation deductions) and upheld a
20 percent accuracy-related penalty against the taxpayer.

Conclusion

Members of the House and Senate on both sides of the aisle have
expressed support for the federal legalization of cannabis. Unless
Section 280E is repealed or marijuana is legalized at the federal
level, businesses trafficking in cannabis (whether legally or
illegally at the state level) must still compute gross income
without the benefit of business deductions prohibited by Section
280E.

Footnotes

1 Case law on Section 280E has generally focused on the
denial of deductions and not the application of credits; thus, this
alert focuses on deductions.

2 See Californians Helping to Alleviate Med.
Problems, Inc. v. Commissioner  (CHAMP), 128 T.C. 173,
182 (2007). 

3 See State Medical Marijuana Laws, National
Conference of State Legislatures, (last accessed on April 15,
2021).

4 To avoid possible challenges to Section 280E on
constitutional grounds, the Senate Finance Committee stated in its
report that “the adjustment to gross receipts with respect to
effective costs of goods sold is not affected by this provision of
the bill.” S. Rept. 97-494 (Vol. 1), at 309
(1982).

5 CHAMP, 128 T.C. at 183-184.

6 Id. at 184.

7 See, e.g., Purple Heart Patient Center v.
Commissioner, T.C. Memo. 2021-38; Desert Organic
Solutions v. Commissioner, T.C. Memo. 2021-22; San
Jose Wellness v. Commissioner, 156 T.C. No. 4 (Feb. 17,
2021).