Tax Court deals another blow to cannabis dispensaries

BVWireIssue #223-2
April 14, 2021

federal taxation
charitable contribution, deficiency, income tax, depreciation, deduction

In recent years, numerous cannabis businesses that are legal under state law have unsuccessfully challenged section 280E of the Internal Revenue Tax Code, which prohibits tax deductions for a business that “consists of” trafficking in a controlled substance. A recent U.S. Tax Court ruling against a California medical cannabis dispensary continues the trend.

280E’s broad sweep: The taxpayer was a medical cannabis dispensary licensed by the city of San Jose, Calif. The business also sold noncannabis items such as T-shirts, pipes, and batteries. And it offered acupuncture, chiropractic, and other holistic services. The business claimed deductions for business expenses, depreciation, and charitable contributions for various tax years. The Internal Revenue Service disallowed all the deductions under I.R.C. sec. 280E. The taxpayer petitioned the Tax Court for review.

Medical cannabis, although legal in many states, under federal law, has been classified as a Schedule I controlled substance. Generally speaking, federal law preempts state law. For purposes of section 280E, dispensing cannabis qualifies as “trafficking” in a controlled substance.

The taxpayer argued that section 280E does not preclude deductions for depreciation and charitable contributions. Depreciation, the taxpayer claimed, was not “paid or incurred during the taxable year”; further, the charitable contributions were not made “in carrying on” a trade or business. Despite being aware of Tax Court precedent to the contrary, the taxpayer (for purposes of appeal) also claimed none of the expenses it deducted should be disallowed under 280E because the taxpayer’s business did not “consist of” trafficking in controlled substances.

The Tax Court rejected all the arguments. “[T]he text of section 280E sweeps broadly to preclude a deduction for ‘any amount paid or incurred during the taxable year in carrying on any trade or business … [that] consists of trafficking in controlled substances,’” it said, with emphasis. Further, it cited a number of relatively recent Tax Court decisions that found that “section 280E means what is says—no deductions under any section” of the code for businesses trafficking in a controlled substance.

The court noted it had dismissed the argument that the taxpayer’s business did not “consist of” trafficking in a controlled substance because it also sold noncannabis items and provided various services in the 2018 Patients Mutual case. There, the court ruled against another California dispensary that claimed expense deductions should not be disallowed under sec. 280E.

As for the taxpayer’s claim that depreciation is not “paid or incurred during the taxable year,” it was “foreclosed by the Code and Supreme Court precedent,” specifically the Supreme Court’s 1974 decision in Commissioner v. Idaho Power. The Tax Court said, Idaho Power “leaves no doubt” that depreciation represents an “amount paid or incurred during the taxable year.” Therefore, “section 280E applies by its express terms to [the taxpayer’s] circumstances." Also, the requirements of section 280E applied to charitable contributions, the court found.

The case is San Jose Wellness v. Commissioner, 156 T.C. No. 4 (Feb. 17, 2021).

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