Cannabis Tax Frenzy

Those with an optimistic bent believe the company cracked the tax code, particularly section 280E. Section 280E generally prevents cannabis businesses from claiming tax credits and deductions for expenses they incur in the operation of their businesses. It increases the effective tax rates of cannabis businesses to rates well in excess of those incurred by businesses that do not traffick in controlled substances, to use the language of section 280E. There are some limited end runs around section 280E, and it is not clear if the company received its tax refunds because it did not fully utilize those strategies in prior years and simply amended its tax returns to take advantage of them now. It seems clear, however, that the company likely will spend years in expensive and time-consuming litigation with the IRS, as it hinted in one of its announcements. If it loses, interest will be due and penalties could be on the table.

Curiosity about the company’s tax filings is understandable, but the reason for optimism is unclear. Taxpayers have been challenging the validity of section 280E for decades, but courts have uniformly rejected those challenges and upheld its constitutionality. Moreover, nothing has changed in the federal tax law or in the application of the Controlled Substances Act (CSA) to cannabis in recent years. The only things that have changed are the makeup of the United States Supreme Court, the increasing legalization of cannabis at the state level, and the willingness of the federal government to enforce the CSA against businesses that operate in conformity with state cannabis laws.

Some taxpayers argue that the recent conservative majority on the United States Supreme Court changes the calculus in regard to section 280E. They believe the Supreme Court will overturn decades of Commerce Clause precedent, much like it did when it reversed the law regarding abortion inBrady v. Doe. This is wishful thinking, but even if they turn out to be correct in the years to come, the makeup of the Supreme Court today does not provide a basis to claim on a tax return that section 280E is invalid. Remember that taxpayers need substantial authority (about 40% or greater likelihood of success on the merits) to take a position on a tax return and avoid the imposition of penalties if they are incorrect. If they take a position based on a lower level of comfort, such as reasonable basis (about 20% or greater likelihood of success on the merits), then they need to separately disclose the position to the IRS in order to avoid penalties. Nothing about the change in the makeup of the Supreme Court provides even a reasonable basis to claim that section 280E is invalid or that it should not apply to a particular set of facts.

Other taxpayers argue that section 280E is invalid because cannabis is legal under the laws of many states. This argument is misplaced. Section 280E is federal tax law that is based on the illegality of cannabis under the CSA, which is also federal law. Nothing in section 280E hinges on the application of state law. Thus, one would be hard pressed to find a reasonable basis in this position either.

Last, some practitioners argue that there is a distinction to be made between businesses that sell cannabis for medical use and those that sell cannabis for recreational use. They argue that a 2005 Supreme Court case, which upheld the ability of Congress to pass laws prohibiting the cultivation of medical marijuana in one’s home under state law, may no longer be precedential because of limitations that Congress subsequently placed on the federal government’s ability to fund prosecutions of state-sanctioned medical marijuana. In other words, they argue that Congress’ subsequent decision to cut off funding for the enforcement of state-sanctioned medical marijuana somehow negates or undercuts the plain language of the CSA, which generally makes the manufacture, distribution, and possession of marijuana illegal, and of section 280E, which generally denies tax deductions for businesses that consist of trafficking in controlled substances that are “prohibited” by federal law. Marijuana is still prohibited by federal law, and nothing about funding the enforcement of the CSA, or the Department of Justice’s policy of non-enforcement, affects the underlying legality of cannabis at the federal level.

If a business is approached to take one of these positions on a tax return, the prudent thing to do is inquire about the advisor’s level of comfort with regard to the position. Specifically, the business should ask if the advisor believes there is a greater than 50% likelihood of success on the merits, and assuming the answer is no, whether the advisor believes there is substantial authority for the position. If the answer is yes, the business should press the advisor to list thetaxauthorities in favor of the position. The substantial authority standard is an objective one, and the tax regulations state that the treatment of an item has substantial authority “only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.”

There have been remarkable changes in the past few decades in the way society views cannabis, and various states have enacted laws to legalize its use. Cannabis, however, remains illegal at the federal level, and until that changes, taxpayers attempting to sidestep section 280E in the above manner are unlikely to prevail. Some may hope for a different result, and even applaud creative attempts to achieve one, but taxpayers must hew to the law and precedents that currently exist if they want to avoid tax penalties and years of litigation with the IRS. Having said that, it can’t hurt to hedge one’s bets and file a protective claim for refund pending the outcome of some of the pending litigation, because such protective claims are held in suspense by the IRS until the contingency is resolved and the taxpayer files a completed refund claim.

This article was originally published by Daniel Mayo in Forbes on March 4, 2024.