The U.S. Tax Court issued an opinion in Northern California Small Business Assistants, Inc. v. Commissioner of Internal Revenue, 153 TC No. 4 (No. 26889-16, October 23, 2019), disallowing all the tax deductions of a legally operating California medical marijuana dispensary.
The taxpayer in the case claimed tax deductions for ordinary and necessary business expenses on their 2012 tax return. The IRS issued a notice of deficiency to the taxpayer disallowing those expenses under IRC §280E on the basis the taxpayer’s business consists of trafficking in a controlled substance in violation of the Controlled Substances Act.
The taxpayer contested the notice on the grounds:
• IRC §280E is a penalty which violates the Constitution’s Eighth Amendment prohibition on excessive fines;
• Even if IRC §280E did not violate the Eighth Amendment, it only applies to ordinary and necessary business deductions; and
• The taxpayer legally operated its business under California law and California does not consider the taxpayer’s activity as trafficking in a controlled substance.
The court ruled against the taxpayer on all of their arguments. The court held IRC §280E is not a penalty provision or limited to ordinary and necessary business deductions, but applies to all deductions under the tax code.
The court determined “deductions from gross income do not turn on equitable considerations,” but are “pure acts of legislative grace,” where prudence is left to the discretion of Congress. Congress enacted IRC §280E under its authority to tax income under the Sixteenth Amendment and is directed towards individuals operating a business in violation of state and federal law.
The court held Congress’ intentions are clear under IRC §280E, and its application that no deductions or credits are allowable under any section for businesses trafficking in a controlled substance. The court reasoned since “Congress has not carved out an exception in IRC §280E for businesses operating lawfully under State law, then the Court is not going to allow a taxpayer to deduct expenses incurred in the operation of its drug-related business.”
The significant takeaway from the ruling is whether a taxpayer is just getting engaged in the cannabis business or is currently engaged in the cannabis business they should clearly understand there is no entitlement to any tax deductions (i.e. start-up cost expenses, licensing) for their activities.
Taxpayers already operating as a cannabis business should further consider amending their federal tax returns to not claim any deductions or face the consequence of additional assessments for inaccurately reporting income and expenses. Additionally, because most states follow the Internal Revenue Code definition for taxable income, these taxpayers should also consider amending their state tax return to reflect the change in their federal taxable income.
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