Tax Challenges Loom for New Jersey's Cannabis Industry
A 2019 U.S. Tax Court ruling involving Internal Revenue Code §280E and a California cannabis business was not a win for taxpayers, but Judge David Gustafson’s dissent, along with other arguments, may lay the groundwork for future challenges against the law.
Due to the classification of cannabis under the Controlled Substances Act (CSA), medicinal and commercial cannabis businesses are considered illicit enterprises under federal law. This introduces a range of business issues for industry operators, among the costliest being the imposition of Internal Revenue Code (IRC) Section 280E, which bars cannabis businesses from deducting business expenses in computing taxable income.
IRC §280E spans a mere single paragraph in a concise and seemingly straightforward manner. Yet the application of this law has been complicated by arguments against it, some of which challenge the technical and linguistic interpretations of the IRC while others deem the law to be unconstitutional.
Sixteenth Amendment — Right to Tax
The Sixteenth Amendment to the U.S. Constitution grants Congress the unquestionable right to tax income from whatever source derived, which includes income earned illegally. In 1981, the owner of an illicit enterprise was subject to a jeopardy assessment and resulting tax due. In computing his taxable income as any taxpayer would, he took account of deductions for ordinary and necessary business expenses such as rent, mileage and travel, among others. In realizing there was nothing to prevent the taxpayer from claiming these deductions and fearing a lack of deterrent was encouraging illegal activity, Congress enacted §280E as part of the Tax Equity and Fiscal Responsibility Act of 1982.
It is worth noting that “gross income” as defined by the Code of Federal Regulations (CFR) means total sales less the cost of goods sold. This definition has U.S. Supreme Court case law precedent supporting its application and has been held as a taxpayer’s constitutional right as it applies to cannabis businesses (see Eisner v. Macomber and Alpenglow Botanicals, LLC v. United States). It has been held that deductions from gross income above and beyond cost of goods sold are not the right of the taxpayer, rather a matter of “legislative grace” of the Congress (see New Colonial Ice Co. v. Helvering).
This theory has been relied upon by judges in affirming the application of §280E in court challenges. In the U.S. Tax Court ruling, Northern California Small Business Assistants Inc (NCSBA) v. Commissioner of Internal Revenue, Judge David Gustafson challenged his colleagues’ interpretation of “legislative grace,” citing the difference between disallowance of a certain deduction and the outright disallowance of all deductions. Judge Gustafson expressed concern that the imposition of §280E causes tax to be assessed on more income than the taxpayer may have earned, in some cases taxing income where there is none. For example, consider a taxpayer who has a net loss after considering ordinary and necessary expenses yet a net gain when only reducing income by the cost of goods sold. As a result, this taxpayer would have a tax liability but no wherewithal to pay the tax. Judge Gustafson argues this to be a distorted application of Congress’ right to tax under the Sixteenth Amendment.
Eighth Amendment — Prohibiting Excessive Fines or Penalties
In the Senate Finance Committee’s report on the Tax Equity and Fiscal Responsibility Act of 1982, they acknowledged “a sharply defined public policy against drug dealing” related to §280E’s enactment. It appears lawmakers took issue with allowing drug dealers the benefit of business expense deductions while U.S. citizens lose billions of dollars per year to the black market, stating “such deductions must be disallowed on public policy grounds.”
This serves as the basis for the argument — which has been rejected by numerous courts — that §280E is unconstitutional as it is a penalty imposed on a particular industry (see The Green Solution Retail, Inc. v. United States, Alpenglow Botanicals, LLC, v. United States and NCSBA v Commissioner). Judge Gustafson dissents from his colleagues in the NCSBA ruling, asserting that an assessment is a penalty if it is intended as a punishment for an unlawful act. To this argument, the Senate Finance Committee’s report serves to emphasize Congress’ desire to deter and punish the sale of illicit drugs. Assuming this constitutional hurdle were cleared, Judge Gustafson points out that the next issues to analyze are whether the protections of the Eighth Amendment extend to corporate taxpayers, and whether the imposition of tax under §280E is “excessive.”
Other Constitutional Protections
In his dissent, Judge Gustafson also highlights that the disallowance of deductions is limited to one industry because of the federal and state law disconnect. He compared the disallowance of all deductions for one industry to the idea of offering tax-exempt status to organizations of one religion but not another. His concern was that in Congress exercising the right to tax granted by the Sixteenth Amendment, it may be stepping on the taxpayers’ First Amendment rights.
Taxpayers have also sought protection from self-incrimination granted by the Fifth Amendment, claiming that the IRS is effectively conducting criminal investigations in enforcing the IRC (see Alpenglow Botanicals, LLC v. United States). This has not proven to be a strong Constitutional argument, and courts have held on numerous instances that the IRS may determine if the taxpayer is engaged in illegal activity as defined by the CSA in order to determine the applicability of §280E (see High Desert Relief, Inc. v. United States). In responding to this argument, one court reframed the question from whether the IRS is conducting a criminal investigation to whether the IRS has the authority to enforce the IRC. The court determined that the IRS did have this authority.
To date, none of the Constitutional arguments discussed herein have been successful in emancipating taxpayers engaged in a cannabis business from §280E, but the NCSBA case could pave the way for future arguments. The IRC is working as Congress intended when §280E was enacted, yet the legalization of state-regulated commercial cannabis markets has created a disparity between federal and state law that is unfairly impacting those businesses. §280E continues to be relevant so long as the classification of cannabis as a Schedule I substance under the CSA remains intact.
This article appeared in the Spring 2021 issue of New Jersey CPA magazine. Read the full issue.