January 07, 2020

On October 23, 2019, the U.S. Tax Court published its opinion, Northern California Small Business Assistants Inc., 153 T.C. No. 4 (“Northern California”), holding that IRC Section 280E is not a penalty provision and therefore does not violate the prohibition on excessive fines under the Eighth Amendment of the U.S. Constitution. Northern California Small Business Assistants (“Northern California SBA”) operates as a state legal medical marijuana dispensary under California law.

The IRS had previously determined that Northern California SBA is subject to the limitations of Section 280E, assessing a deficiency of $1.26 million and imposing an accuracy-related penalty of approximately $253,000.

IRC Section 280E Background

Generally, the Internal Revenue Code allows a business to deduct all of its “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business,” but there are exceptions. For the cannabis industry, the primary exception is IRC Section 280E.

In 1982, Congress enacted Section 280E. With the exception of cost of goods sold (“COGS”), Section 280E denies federal tax deductions and credits from gross income if a taxpayer is engaged in the business of the manufacture, distribution or sale of certain controlled substances classified as a Schedule I or Schedule II pursuant to the 1970 Controlled Substances Act.

IRC Section 280E 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) that are prohibited by federal law or the law of any state in which such trade or business is conducted.”

Cannabis is considered a Schedule I drug. Therefore, any sales activity is considered trafficking under federal law. IRC Section 280E prevents cannabis businesses from enjoying the benefit of otherwise ordinary business deductions, dramatically increasing their effective tax rate.

Key Rulings from Northern California

The Tax Court concluded that Section 280E is not a penalty provision and therefore does not violate the prohibition on excessive fines under the Eighth Amendment, stating: “The Sixteenth Amendment does not accommodate the assertion that the disallowance of a deduction is a penalty. There is simply no way to reconcile the argument that Section 280E creates a penalty with the authority of Congress to tax gross income.”

Pursuant to the Sixteenth Amendment, Congress is granted the power to lay and collect taxes on “incomes, from whatever source derived,” and any deductions from gross income are a matter of legislative grace that can be reduced or expanded in accordance with Congress’ policy objectives.

The Tax Court further rejected the taxpayer’s argument that Section 280E limits only deductions under Section 162, citing clear language in the law that “no deduction or credit shall be allowed.”

Lastly, the Tax Court cited recent case rulings to uphold that the use of the word “trafficking” in Section 280E encompasses the taxpayer’s medical marijuana dispensary legally operating under California State law.

Takeaways from Northern California

Another loss for the cannabis industry – The Tax Court opinion has again denied deductions in the case of a cannabis dispensary operating legally under state law, reinforcing Section 280E and building upon case law precedent set by the Harborside Tax Court opinion and other previous decisions.

Section 471 costs not impacted by 280E – Generally, direct COGS (IRC Section 471 costs) are included in “gross income” and are not impacted by Section 280E. The Tax Court previously stated in Harborside that only Section 471 could be applied to calculate inventory costs for purposes of Section 280E. The Tax Court has held that the uniform capitalization rules of IRC Section 263A, which are broader in scope than those of Section 471, do not apply to cannabis businesses.

Retail cannabis dispensaries, such as Harborside and Northern California SBA, are essentially only able to include the purchase price of inventory and freight costs in COGS under Section 471. Producers, on the other hand, may still be able to capitalize certain indirect production costs into inventory under Section 471. Specifically, producers should capitalize repair and maintenance expenses, utilities, rent, indirect labor and production supervisory wages, indirect materials and supplies, tools and equipment not capitalized, and cost of quality control and inspection.

Producers should review the extent to which they may capitalize certain costs under Section 471, if they do so for financial reporting purposes:

Depreciation reported in financial reports and cost depletion.

Certain employee benefits.

Costs attributable to rework labor, scrap and spoilage, and costs attributable to strikes.

Administrative costs of production.

Salaries paid to officers for services performed incidental to and necessary for production or manufacturing operations or processes.

Insurance costs.

Partial dissent – Though the Tax Court rejected all of the taxpayer’s arguments, in a rare departure from previous cases involving Section 280E, two judges provided partial dissenting opinions. In one partial dissent, Judge Gustafson stated that Section 280E is unconstitutional and is not permitted under the Sixteenth Amendment. Judge Gustafson argued the disallowance of all deductions results in a fabricated gain and a tax on an amount greater than a taxpayer’s “income.” The second dissent, by Judge Copeland, found that Section 280E operates as a penalty provision. Further proceedings should address “excessiveness” under the Eighth Amendment.

The courts have refused to rule against the original congressional intent of Section 280E, which was to significantly limit deductions for cannabis businesses.