Is Section 280E a Tax or Penalty on Legal Cannabis Businesses?
There is an interesting appeals case that has turned into a writ of certiorari, which is a petition for the U.S. Supreme Court to hear a case, and it's something that we should pay attention to. It started in U.S. Tax Court with this case: Green Solutions Retail, Inc. v. United States.
Green Solutions is a Colorado-based cannabis dispensary that had its 2013 and 2014 tax returns audited by the IRS. Apparently, the dispensary ignored Section 280E, which 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) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
Here’s a little background to led up to the case. Section 63 defines taxable income, and this includes income derived from illegal activities. What had been common (I haven’t seen this practice used in a long time by the IRS) was a person would be convicted of a crime in which they benefited monetarily. When the person served out the prison sentence, the IRS would reconstruct the person’s income, in regards to the illegal activity, and issue a Notice of Deficiency (NOD).
A NOD can only be fought by petitioning the Tax Court. This practice by the IRS brought us the landmark 1981 case Edmondson v. Commissioner, which led to the legislative action that established Section 280E. Jeffery Edmondson served a prison sentence for dealing drugs. When he left prison the IRS reconstructed his income from drug dealing and sent him a NOD. Edmondson petitioned the Tax Court. Under the Cohen rule, which allows a taxpayer without records to introduce expenses with truthful testimony, Edmondson stated that he bought the drugs on consignment. He had some travel expenses, telephone costs, and other expenses — all of which the Tax Court gave him credit for.
In the 1980s the U.S. government was fighting the war on drugs, and Section 280E was a direct reaction by Congress to the Tax Court’s ruling.
In the appeals case for Green Solutions, and also in the writ of certiorari, the dispensary raises many objections to Section 280E. However, I think the reason the Court might hear this case is the fact that they raise the objection to the Code Section, stating that Section 280E is a penalty and not a tax.
Being that it is the penalty and not a tax argument, we should recall the Supreme Court case, National Federation of Independent Business v. Sebelius. The case challenged the constitutionality of the Affordable Care Act (ACA). The particular issue was that they government couldn’t force a person to purchase health insurance. The “penalty” the government was to charge for not having health insurance was unconstitutional. SCOTUS, in its ruling, stated that the penalty was Constitutional because it was actually a tax.
When we look at Section 280E, we notice that the law only affects the drug trade. Here is what is interesting: If you think of the most heinous of monetary crimes, we can look at something like human trafficking. When a human trafficking ring is broken up, and the people are arrested, typically the head of the ring will find themselves in the crosshairs of the IRS. These ring leaders profited financially from the kidnapping, sale, and prostitution of mostly women and children. If their income is reconstructed by the IRS, these people can deduct ALL of their expenses.
In 1982 when Section 280E was enacted, Congress would never have thought that, more than three decades later, cannabis would became legal in 29 states and the District of Columbia, in direct opposition to the federal government. That’s not to mention the entire country’s attitude has changed on cannabis.
Colorado is the self-professed hemp capital of the U.S. Since hemp only contains a trace of THC, the substance in cannabis that produces euphoria and other reactions, these hemp companies produce something called CDB oil, which is shipped across the country and is the common treatment for relief by people with several different medical conditions. It is important to point out that certain CBD oils can be made from the cannabis plant. These oils vary in the levels of THC. The question would be, if the Supreme Court hears this case, would they be legislating from the bench?
Section 280E affects a cannabis company that is legal under state law. However, it also affects cocaine, heroin, and methamphetamine dealers. The Supreme Court, if they side with the dispensary, would be overturning this law not just for the black market on the illegal sale of drugs but for cannabis companies.
Of course, Congress would either be left to fix Section 280E or not do anything at all. There are legal ways to get around Section 280E. However, it is expensive for the cannabis owner to pay someone like me to construct and watch the various companies the owner must have to avoid this tax.
White-collar businesspeople make the mistake in thinking that cannabis is a white-collar business. If you ever talk to most owners in the cannabis industry and work with them at the level that I do, you realize very quickly that 98 percent of those in the industry came from the black market. Yet, they are innately business-minded. Each knows their numbers and has connections for their supplies. When they figure out what a business plan and executive summary are, they realize that they have been doing the same in the black market. I spend a lot of time with these owners because most white-collar businesspeople want to try to take advantage of the people coming out of the black market, and into the grey market as I like to call it.
The really sad thing is I got into cannabis because I have always been a small business owner, and to think that I couldn’t deduct my expenses, didn’t set well with me. However, I spend a lot of my time forging connections and protecting these owners from what I call the “cannabis price.” The cannabis price is when an ignorant white-collar person thinks that these companies are rolling in money and grossly overcharging for their services. In fact, about 97 percent of the companies that have given us the case law on Section 280E are out of business because their legal and accounting fees were too high. That’s not to mention that most companies pay as much as 70 percent in federal taxes.
Is Section 280E a penalty? If we look at the law, realizing that it only affects the sale of drugs, then it is either a penalty or a regressive tax on a particular industry. I would suspect that the government would argue that Section 280E is some sort of excise tax, or something similar. The fact that it only affects one industry isn’t what comes to my mind when I think of an excise tax. Most excise taxes are collected on companies that don’t fund their defined benefit plan. Further, there are some excise taxes that are associated with the ACA.
The point is that prima facie evidence would state that the argument being made by Green Solutions in their write or certiorari is enough for the Supreme Court to hear the case. However, the presidential administration hasn’t come out and given their official opinion of state legal cannabis.
Jeff Sessions, the head of the Department of Justice, has stated that he will enlist the Drug Enforcement Administration (DEA) to enforce the federal cannabis laws on the legal cannabis industry. He even tried to rescind the Cole Memo, named after former US Attorney General James M. Cole, which allowed cannabis companies to open a bank account. This really made me laugh. There are about 6 million to 8 million businesses in the cannabis space, and according to Sessions, we are going back to DEA raids? We can’t even fund the IRS, much less the DEA.
This would be the right place to mention that, albeit a very slow and painful process to watch, Congress has several bills in the sponsoring and co-sponsoring stage that would take care of various issues the cannabis industry faces — one of them being Section 280E.
However, these companies are going out of business all the time. We’ve had cannabis clients for almost seven years now, and very few accountants work with these clients like we do. There are tons of cannabis companies that have never heard of Section 280E, or their accountants don’t specialize in Section 280E. The next thing you know they get schooled quickly in learning that their companies were set up incorrectly and that there have been no measures made to alleviate Section 280E. The taxes on these companies can be, effectively, as high as 70 percent. This high tax puts a lot of first-year cannabis companies out of business.
Something has to be done about Section 280E. I know that I have devised all sorts of tax plans that avoid the tax. However, these plans cost less than the tax these companies would pay without the plan but are more expensive for the business owner to implement than most other companies.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...