A byzantine legal memo of potentially disastrous implications has been released by the Internal Revenue Service, articulating a new theory of the tax code which could result in punitive audits, crippling tax bills and even federal raids for state-legal cannabis retailers — though, curiously, not necessarily for growers.

The federal memo [Warning: extremely esoteric — Ed.], released on January 23rd, poses an existential threat to state-legal dispensaries and adult-use retail stores which have heretofore operated under the largesse of US Tax Court decisions like Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner of Internal Revenue (CHAMP), a compromise decision which subjected dispensaries to higher effective tax rates than other businesses but kept the double standard sufficiently in check to avoid taxing them out of existence. But under the reasoning of the new IRS memo, the logic in CHAMP and similar decisions may be of little avail to dispensaries subject to scathing audits.

Both CHAMP and the new memo revolve around the language of Internal Revenue Code section 280E, which mandates an explicit double standard for taxing US businesses: while practically every other American business is allowed to deduct ordinary expenses like rent and utilities when calculating their taxable income, “traffickers” in a Schedule I or Schedule II substance (including cannabis) are disallowed from deducting those same expenses. The result is that many state-legal medical cannabis collectives, like CHAMP, were taxed on much more income than they actually took in after accounting for basic operating expenses, which led to crippling tax bills so high that many claimed they were being taxed to death.

Fortunately for the industry, CHAMPS sued the IRS in tax court and won — partly. Although the US Tax Court ruled that 280E did indeed forbid expenses which dispensaries may have incurred in obtaining and distributing cannabis, it also ruled that the costs of any ancillary services offered — such as acupuncture, yoga, community events, etc. — could be deducted instead.

Further decisions by the Tax Court extended similar relief through liberally interpreting 280E’s language to allow dispensaries to deduct costs of goods sold (COGS), another standard deduction for many kinds of businesses. Taken together, these decisions led to effective tax rates on dispensaries which were, although still unfairly high, manageable enough for most to stay in business. As a side benefit, many more patients gained access to affordable yoga and acupuncture.

The rules outlined in the new memo are devastating to this detente. “Read together,” the memo reads, “§280E and the flush language at the end of §263A(a)(2) [a subsequent revision of 280E by Congress] prevent a taxpayer trafficking in a Schedule I or Schedule II controlled substance from obtaining a tax benefit by capitalizing disallowed deductions… nothing in the legislative history of §263A suggests that Congress intended to permit a taxpayer to circumvent §280E by treating a disallowed deduction as an inventoriable cost or as any other kind of capitalized cost.” This reasoning directly repudiates the deduction of COGS on state-legal marijuana sales which has proven so critical to the continued operation of taxpaying dispensaries.

Lest anyone doubt the agency’s intent in promulgating this new rule, the memo’s authors conclude with a green light to IRS agents nationwide considering potentially lucrative audits against dispensaries: “In our view, Examination and Appeals have the authority under §446B to require a taxpayer to change from a method of accounting that does not clearly reflect income to a method that does clearly reflect income… When a producer or reseller of a Schedule I or Schedule II substance uses a method of accounting that causes a tax result contrary to… the legislative history of §280E, the proper exercise of the above-mentioned authority is warranted.”

This new authority could lead to devastating audits which require dispensaries to recalculate their income and expenses going back years into the past and apply a far less forgiving COGS standard under 280E than the court in CHAMP etc. articulated. The result could be bills for back taxes so massive as to effectively put scores of dispensaries out of business. And the collectives which refuse to undergo this slow death by a thousand bureaucratic cuts could simply be raided instead.

Curiously, the IRS outlined a significantly more generous interpretation for cannabis growers, noting that “a producer [i.e., grower] of a Schedule I or Schedule II controlled substance should be permitted to deduct wages, rents and repair expenses attributable to its production activities, but should not be permitted to deduct wages, rents or repair expenses attributable to its general business activities or its marketing activities.” This is apparently due to special provisions in the tax code which extend certain favorable treatment to farmers.

A word of warning to dispensary operators: the drug war is not over yet. By trading the DEA for the IRS, dispensaries may only be headed from the frying pan into the fire.