Tax Court: No Deductions Allowed for Medical Marijuana Businesses, Including Those Operating Legally Under State Law

(Parker Tax Publishing November 2019)

The Tax Court held that Code Sec. 280E disallows all deductions, not just trade or business expense deductions, for a medical marijuana dispensary even though the dispensary operates legally under state law. The court found that (1) Code Sec. 280E does not violate the Eighth Amendment because it is not a penalty provision, and (2) the legal sale of medical marijuana under state law nevertheless constitutes trafficking within the meaning of Code Sec. 280E. Northern California Small Business Assistants Inc. v. Comm'r, 153 T.C. No. 4 (2019).

Northern California Small Business Assistants Inc. (NCSBA) is a California medical marijuana dispensary. Marijuana is a controlled substance under federal law. In 2016, the IRS issued a notice of deficiency for NCSBA's 2012 tax year stating that NCSBA was subject to Code Sec. 280E, which disallows all deductions or credits paid or incurred in carrying on a trade or business that consists of trafficking in a controlled substance. As a result, the IRS determined a deficiency of over $1.2 million and applied an accuracy-related penalty of $252,842.

NCSBA petitioned the Tax Court, contending that its operations are legal under California law. NCSBA's petition presented three arguments. First, NCSBA argued that Code Sec. 280E imposes a gross receipts tax as a penalty in violation of the Eighth Amendment. According to NCSBA, Code Sec. 280E is similar to a federal exercise tax targeting violators of state liquor laws, which the Supreme Court held was an unconstitutional penalty because there was no federal interest in punishing state law violators. Second, NCSBA argued that the text of Code Sec. 280E tracks that of Code Sec. 162, which allows for all ordinary and necessary business expense deductions, suggesting that Code Sec. 280E limits only Code Sec. 162 deductions and permits others - specifically, deductions under Code Sec. 164 (taxes) and Code Sec. 167 (depreciation). Finally, NCSBA argued that Code Sec. 280E refers to "trafficking" and therefore does not apply to marijuana businesses operating legally under state law.

The Tax Court rejected NCSBA's arguments and held that Code Sec. 280E (1) does not violate the Eighth Amendment's prohibition on excessive fines, (2) bars all deductions for businesses that traffic in a controlled substance, and (3) applies to businesses operating legally under state law notwithstanding its use of the word "trafficking."

The Tax Court rejected NCSBA's Eighth Amendment argument because it found that, unlike in other contexts where a financial burden was found to be a penalty, disallowing a deduction from gross income is not a punishment. In the court's view, Code Sec. 280E was enacted under Congress's clear authority to tax gross income and is directed at persons who operate a business in violation of state or federal law. The court reasoned that Code Sec. 280E is directly tied to Congress's policy objective to limit and deter trafficking in illegal controlled substances and is not simply an attempt by Congress to punish violators of state law with no legitimate federal objective. The court also noted that since Code Sec. 280E was enacted in 1982, no federal court has every held it to be a penalty.

Next, the Tax Court found that Code Sec. 280E is not limited to trade or business deductions because the plain language of Code Sec. 280E states that "no deduction or credit shall be allowed" to businesses that traffic in controlled substances. In the court's view, Congress could not have been clearer in drafting this section of the Code. The court also reasoned that the broader statutory scheme supported its conclusion. The court noted that Code Sec. 261 provides that "no deduction" is allowed for items specified in part IX of subchapter B, and Code Sec. 280E is in part IX. Similarly, Code Sec. 161 provides that the deductions in part VI of subchapter B, including the deductions in Code Sec. 164 and Code Sec. 167, are allowed subject to the exceptions in part IX. Thus, the court found that, clearly, Code Sec. 164 and Code Sec. 167 are limited by the exceptions in part IX, including Code Sec. 280E.

Finally, the Tax Court rejected NCSBA's argument that the word "trafficking" in Code Sec. 280E implied that the statute does not apply to a business operating legally under state law. The court noted that it has rejected that argument in several previous cases and that NCSBA offered no compelling reason to overrule those decisions. The court concluded that its precedent is unambiguous and that Congress, not the courts, would need to carve out an exception in Code Sec. 280E for businesses that operate legally under state law.

Observation: In a dissenting opinion, one judge disagreed with the court's conclusion that Code Sec. 280E is not a penalty provision but concluded that, even if it is characterized a penalty, NCSBA failed to show that it was an excessive one in violation of the Eighth Amendment.

For a discussion of the disallowance of a deduction for expenditures in connection with the sale of a controlled substance, see Parker Tax ¶96,512.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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