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Tax Court Backs IRS in Fight Over Cannabis Business Deductions

Chris Gaetano
Published Date:
Oct 24, 2019

A federal tax court has ruled that the IRS restriction on business deductions for cannabis companies operating legally under state law is constitutional, despite a California dispensary arguing that it violates the Eighth Amendment prohibition against excessive fines.

Paying federal taxes on a product that is illegal on the federal level has long been problematic for cannabis businesses. Peter Metz, a principal at Grassi & Co., speaking at the Foundation for Accounting Education's Cannabis Conference in December 2018, said that the law does not allow cannabis industry firms to claim business expense deductions, unlike nearly every other business. A cannabis company, for example, cannot deduct advertising, insurance, marketing, rent, repairs, salaries, state taxes, utilities and many other expenses. The only item that such businesses can deduct is cost of goods sold, which is governed by Section 280E. 

The plaintiff, Northern California Small Business Assistants, ran into Section 280E when the IRS billed the firm for $1.5 million in unpaid taxes and an accuracy-related penalty for the 2012 tax year, denying that it had the right to claim business deductions outside cost of goods sold. The dispensary argued that assessing the tax on gross receipts violated the Eighth Amendment to the Constitution, as it holds that “[e]xcessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.”

The court, however, held that the Eighth Amendment applies to penalties, and that taxes are not penalties and therefore not within its purview. Further, the opinion added that Section 280E is part of Congress's authority, under the 16th Amendment, to levy taxes, which it said further bolstered the tax provision's constitutionality. Moreover, the opinion found that deductions, in and of themselves, are more a form of "legislative grace," and there's nothing that strictly requires the government to make them available. 

The dissent, written by Judge Gustafson, however, said that Section 280E does in fact impose a penalty and therefore should be considered an Eighth Amendment issue. He said that while the tax is on incomes, the section goes beyond that and, in his words, "creates something more." 

He considered a situation in which someone bought 600 widgets at $6 each, establishing a cost of goods sold of $600. Other expenses total $400, to a total of $1,000 spent. If he then sold 100 of these widgets at $9 each, he would have gross receipts of $900. Considering that he spent $1,000 to make $900, the judge argued no one would view this man as having made a gain. 

"But despite this obvious loss, section 280E would disallow any deduction for his rent and wage expenses totaling $400, leaving him with gross receipts of $900, less COGS [costs of goods sold] of $600, yielding a supposed taxable “income” of $300--despite his having incurred not gain but loss. Section 280E would fabricate gain where there was none and would impose a tax based on artificial income," he said. 

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