Tenth Circuit Affirms That Marijuana Dispensary Can't Deduct Business Expenses

(Parker Tax Publishing July 2018)

The Tenth Circuit affirmed a district court's dismissal of a tax refund suit by a medical marijuana business whose business deductions had been denied by the IRS. In so doing, the Tenth Circuit rejected the taxpayer's arguments that (1) the IRS does not have the authority to disallow deductions under Code Sec. 280E without a criminal conviction; (2) Code Sec. 280E violates the Sixteenth Amendment's definition of gross income; and (3) Code Sec. 280E is an excessive fine that violates the Eighth Amendment. Alpenglow Botanicals, LLC v. U.S., 2018 PTC 206 (10th Cir. 2018).

Background

Although 28 states and Washington, D.C. have legalized medical or recreational marijuana use, the federal government classifies marijuana as a "controlled substance" under the Controlled Substances Act (CSA). The CSA makes it unlawful to knowingly or intentionally "manufacture, distribute, or dispense . . . a controlled substance." Under former President Obama, the Justice Department had declined to enforce this provision against marijuana businesses acting in accordance with state law, but the IRS has shown no similar inclination to overlook federal marijuana distribution crimes. Instead, the IRS consistently denies business deductions to state-sanctioned marijuana dispensaries under Code Sec. 280E, which prohibits any deduction or credit for any business that consists of trafficking in controlled substances. The disallowance of deductions under Code Sec. 280E does not apply to cost of goods sold.

Alpenglow Botanicals, LLC is a Colorado company doing business in Colorado. Charles Williams and Justin Williams are owner/operators of Alpenglow. Alpenglow is a pass-through entity. It filed federal and state tax returns for the years 2010 through 2012 and its tax liability for those years passed through to Charles and Justin. The IRS audited the Williamses' returns and denied various Alpenglow deductions thus increasing Alpenglow's income. The deductions were denied because the IRS determined that Alpenglow committed the crime of trafficking in a controlled substance in violation of the CSA. Charles and Justin paid the increased tax liability under protest, and filed claims for refunds. Thereafter, the IRS either denied the claims for refunds or did not respond to the claims within 180 days, which acted as a denial.

Alpenglow sued the IRS in district court arguing that the deductions denied were: rent for where the business was conducted; costs of labor; compensation of officers; advertising; taxes and licenses for doing business; depreciation; and other wages and salaries. They alleged that the IRS exceeded its statutory and constitutional authority by denying Alpenglow's business tax deductions under Code Sec. 280E. In 2016, the district court denied Alpenglow's motion for summary judgment and granted the IRS's motion to dismiss the case (2016 PTC 527 (D. Colo. 2016)). Alpenglow then filed a motion to alter or amend that judgment which the district court rejected (2017 PTC 209 (D. Colo. 2017)) after concluding that it was not required to consider arguments not alleged in the prior complaint and Alpenglow's request to amend the prior complaint was untimely. Alpenglow appealed to the Tenth Circuit.

Alpenglow's Arguments

Before the Tenth Circuit, Alpenglow argued it had raised three legal theories that plausibly stated a claim and therefore precluded the district court's dismissal. First, Alpenglow asserted the IRS lacks the general authority to investigate and deny tax deductions under Code Sec. 280E without a criminal conviction, and that, even if it had such authority, the IRS had insufficient evidence of trafficking to apply Code Sec. 280E in Alpenglow's case. Second, Alpenglow claimed the IRS's calculation of Alpenglow's income violated the Sixteenth Amendment because it did not allow deductions for business expenses. Third, Alpenglow contended that Code Sec. 280E violates the Eighth Amendment, which prohibits excessive fines.

Tenth Circuit's Decision

The Tenth Circuit affirmed the district court's decision after finding that none of Alpenglow's arguments supported a conclusion that the district court erred in dismissing Alpenglow's complaint.

With respect to Alpenglow's claims that the IRS could not use Code Sec. 280E to deny its business deductions in the absence of a conviction from a criminal court that its owners had violated federal drug trafficking laws, the court noted that the core of this argument was an assumption that a determination that a person trafficked in controlled substances under the tax law is essentially the same as a determination the person trafficked in controlled substances under criminal law. Because Alpenglow saw the two as inextricably linked, the court said, it was contending that the IRS lacked the authority to apply Code Sec. 280E until after a federal prosecutor had investigated and charged the taxpayer with violating federal criminal law and a judge or jury in a criminal proceeding had issued a verdict of guilty. The Tenth Circuit noted that it had recently rejected this argument in Green Solution v. U.S., 2017 PTC 212 (10th Cir. 2017). In Green Solution, the Tenth Circuit concluded that Code Sec. 280E has no requirement that the Department of Justice conduct a criminal investigation or obtain a conviction before Code Sec. 280E applies. And the court noted that, under Code Sec. 6201(a), the IRS's obligation to determine whether and when to deny deductions under Code Sec. 280E "falls squarely within its authority under the Tax Code." The court also concluded in Green Solution that the Anti-Injunction Act (AIA) prevented it from exercising jurisdiction over Green Solution's "suit for the purpose of restraining the assessment or collection of any tax."

According to the Tenth Circuit, Alpenglow offered no reason why the court should conclude that the IRS has the authority to assess taxes under Code Sec. 280E, but cannot impose excess tax liability under Code Sec. 280E. There is also no evidence, the court observed, that Congress intended to limit the IRS's investigatory power. Indeed, the court said, the Tax Code contains other instances where the applicability of deductions or tax liability turns on whether illegal conduct has occurred and cited Code Sec. 162(c)(2) (denying deductions for illegal bribes, kickbacks, etc.), among other provisions. And, the court continued, other courts have upheld tax deficiencies against state-sanctioned marijuana dispensaries based on application of Code Sec. 280E, without questioning the IRS's authority on this issue.

With respect to Alpenglow's Sixteenth Amendment claim, the court noted that it consisted of two arguments: (1) under the constitutional definition of income, ordinary and necessary business expenses must be excluded from gross income calculations because they are actually exclusions that, like the cost of goods sold, must be subtracted from the calculation of a business's gross income; and (2) the IRS improperly disallowed Alpenglow's "costs of goods sold" exclusions under Code Sec. 263A. Consequently, Alpenglow was claiming that Code Sec. 280E violates the Sixteenth Amendment because it prevents the deduction of expenses that a business could not avoid incurring. The court rejected these arguments, noting that while the Tax Code has statutorily excluded certain expenses from the calculation of gross income, only the cost of goods sold is mandatorily excluded by the very definition of "gross income."

With respect to Alpenglow's Eighth Amendment claim, the court noted that the district court had held that Alpenglow did not raise a plausible Eighth Amendment claim because its complaint was entirely devoid of any allegations pertaining to the effect that Code Sec. 280E has had on a taxpayer's ability to do business. Although Alpenglow argued the district court should have allowed it to amend the complaint to allege sufficient factual allegations to support its Eighth Amendment argument, the Tenth Circuit concluded that Code Sec. 280E is not a penalty and thus does not violate the Eighth Amendment. So any amendment to the complaint, the Tenth Circuit said, would be legally futile and the district court did not abuse its discretion by denying the motion.

For a discussion of the denial of deductions under Code Sec. 280E, 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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