The House Judiciary Committee’s passage last week of the Marijuana Opportunity, Reinvestment, and Expungement Act to decriminalize marijuana may have been influenced by more than just the revenue the proposed excise tax will generate. A recent tax court case highlighted the need for congressional action regarding a small 77-word tax code known as Section 280E of the federal tax code.
Marijuana businesses know 280E too well. It disallows all business deductions except for the cost of the goods sold. This is because the cannabis is listed as a Schedule 1 drug (no currently accepted medical use and a high potential for abuse) under the Controlled Substances Act. The latest proposed legislation would take marijuana off this list. And Section 280E, though remaining in the tax code, would no longer affect the marijuana business — now legal in some manner in over half the states.
Section 280E’s disallowance of business expenses causes the marijuana industry to be faced with what is essentially a sales tax, as the income tax in their case is on nearly the gross sales price, like any sales tax. The only thing wrong with this picture is that the rate of tax can be anything other than what you would expect a sales tax to be, with rates up to 37 percent at the federal level.
This rather draconian tax law dates back to Nancy Reagan’s “war on drugs” and was meant to put another nail into the coffin of the illegal drug business. No one questioned it then because no legitimate business was affected. That has all changed rather quickly in the past several years with state laws legalizing the production and sale.
The clash between federal supremacy over state law was swept under the rug when President Obama put a hold on federal enforcement of state legalized businesses. This resulted in an open invitation for more states to join in the legalization movement despite no mutual recognition in Congress to change the law on their side.
This is not to say that Congress forgot about Section 280E. Several attempts have been made to pass measures to change or delete the rule, but to no avail.
However, someone forgot to tell the IRS to stop enforcing this part of the tax law and so these otherwise legitimate businesses are incurring huge tax burdens on their profits as the IRS attacks, without mercy, waiving 280E in front of tax courts to assess huge tax bills. Most recently, in NCSBA v. Commissioner, the tax court upheld a tax assessment of $1.2 million and a $250,000 penalty.
Marijuana entrepreneurs have made many arguments in tax court to combat the harshness of Section 280E, but this most recent tax court decision sent a message that there is little wiggle room.
The NCSBA v. Commissioner ruling concluded that the law is not a penalty that could be called into question as an excessive fine disallowed under the Eighth Amendment.
The decision in this case is relatively no different than the incessant stream of IRS wins on this issue, and would have been just another dead end except for a partial dissenting opinion by Judge David Gustafson. He didn’t just make a suggestion for a constitutional argument against 280E, he literally carved the opening and built the program for it to come in.
Judge Gustafson challenged a long held and oft quoted concept of our income tax code that business deductions are a matter of political grace: All income from whatever source derived is taxable and deductions against that income are allowed only if the statute so allows.
The judge centered a constitutional argument on the concept of interpreting “income” as “gain” or better yet, “economic gain” of a transaction.
For example, if you sell your Apple stock for $400 that you bought for $250 no one would think to have an “income” tax strictly on the $400. Rather, everyone would agree that the income is the difference between the sale price and the cost, or $150 in this case. Taxing the $400 is a gross receipts tax, and our Sixteenth Amendment calls only for the allowance of an “income’ tax.
Let’s take this line of reasoning and see it in the light of a typical business owner. They sell goods costing them $600 for $1,000. But they also have rent for $100, salaries for $250, and supplies for $50. Do the math and you will see that they broke even on this deal. The tax is zero since there is no net income. But in the case of a marijuana business, the tax would be $120 (30 percent of $400) — the net of the sale price less the cost of the items sold. Now the business loses money because of the tax.
When 280E is applied, the cost of good sold is an allowed deduction, because when Congress passed this law they knew that they couldn’t pass an essentially gross receipts tax on the $1,000 of total sales; they had to allow at least for the reduction of the cost of the goods sold. According to Judge Gustafson: “What differentiates the other deductions, the other costs of the sale?” Nothing.
In this light, the tax law of 280E may indeed be unconstitutional. Judge Gustafson certainly thinks so and he is personally inviting the next challenge to 280E to be made on these grounds. That is unless Congress can act first to correct the unnaturalness of the current state of affairs, which they can do in one of two ways: Eliminating Section 280E altogether or taking marijuana off the Substance 1 list, as is currently proposed. Either way would work just fine for the marijuana entrepreneurs.
Samuel Handwerger, CPA, is a full-time lecturer in the Accounting and Information Assurance Department at the University of Maryland’s Robert H. Smith School of Business.
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