Cannabis Industry Faces Another Obstacle as Tax Court Upholds Section 280E

In a blow to the American cannabis industry, the United States Tax Court found that Section 280E of the Internal Revenue Code (“IRC”) did not violate the Eight Amendment to the United States Constitution. Northern California Small Business Assistance Inc. v. Commissioner, 153 T.C. 4 (2019). The Petitioner in Northern California was a legal medical marijuana dispensary in California, which challenged the application of Section 280E. 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) consist 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.

Despite legalization of marijuana use in several states, under federal law marijuana remains a Schedule I controlled substance within the meaning of the Controlled Substances Act.[1] The Petitioner’s challenge to Section 280E was based on three arguments: (1) that Section 280E is a penalty and an unconstitutional violation of the Eighth Amendment; (2) that Section 280E only limits the business deductions under IRC Section 162; and (3) that Section 280E does not apply to a legally operated marijuana business but instead only applies to illegal “trafficking” operations.

In his opinion for the Tax Court, Judge Goeke noted that Congress has the power to lay and collect income taxes under Article I, Section 8 of the Constitution and the Sixteenth Amendment. Additionally, that the United States Supreme Court has held that any deductions from gross income are a matter of “legislative grace” and can be reduced or expanded in accordance with Congress’ policy objectives. [2]  Section 280E was enacted under Congress’ unquestionable authority to tax income pursuant to the Sixteenth Amendment and is directed at persons who operate a business in violation of federal or state law. Judge Goeke stated that he was unaware—and that the Petitioner had not cited—any cases where the disallowance of a deduction was construed as a penalty. Furthermore, the overwhelming precedent holds that deductions for determining income are a matter purely left to congressional discretion and that the disallowance of a deduction is not a penalty.  Accordingly, the Tax Court held that Section 280E is not a penalty provision and consequently does not violate the Eighth Amendment.

Petitioner’s second argument was based on the fact that the language of Section 280E tracks the business deduction language of IRC Section 162, and therefore, the Petitioner argued that the restriction of Section 280E is limited only to the business expenses deducted under Section 162. Judge Goeke disagreed, finding that the broad language of Section 280E leads to the conclusion that it was written to deny all deductions under any IRC section for a business that trafficked in controlled substances. 

The Petitioner’s third argument was that Section 280E only applies to illegal marijuana activities, based on the use of the word “trafficking” in Section 280E.  Again, Judge Goeke disagreed and cited prior Tax Court precedential cases which held that the sale of medical marijuana pursuant to California law still constituted “trafficking” within the meaning of Section 280E.  Lastly, Judge Goeke advised the Petitioner that the Petitioner’s remedy lies with Congress rather than the U.S. Tax Court because of the language of Section 280E.

Most decisions of the U.S. Tax Court are written in the name of only one judge, so it is worth noting that of the 19 Tax Court judges, the Northern California decision cited: (a) the agreement of nine other Tax Court judges, (b) the non-participation of one other Tax Court judge, (c) two concurring opinions (one agreed to by three judges and the second agreed to by another judge) and (d) a concurring in part and dissenting in part opinion. The fact that this opinion was reviewed by the entire U.S. Tax Court and that there were concurring and dissenting (in part) opinions, makes this decision more significant as legal precedent and indicates the importance that the judges of the U.S. Tax Court see in the Northern California case. 

Dealing with Section 280E is a constant battle for American cannabis companies, as it precludes the ability to deduct most normal business expenses. While thoughtful tax planning may be able to mitigate some of the harms caused by Section 280E, it still undoubtedly leads to reduced profitability and lower market valuations. But all hope is not lost. Northern California will likely be appealed to the Ninth Circuit Court of Appeals, and the dissenting opinions from Judges Gustafson and Copeland may provide a roadmap to further legal challenges to Section 280E. In addition, Congress appears primed to move on significant cannabis reform, including the broad reform efforts captured in the S.T.A.T.E.S Act and more limited reform efforts to address banking and the impact of Section 280E specifically.

[1] Pub. L. No. 91-513, Sec. 202(c) and codified as amended at 21 U.S.C. Section 812(c); see also 21 C.F.R. Section 1308.11(d)(23).

[2] See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1982), and New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).