All eyes in the cannabis industry will be watching an upcoming case before the Ninth Circuit Court of Appeals that could dramatically ease the tax burden of cannabis entrepreneurs, who pay tax rates many times higher than most non-marijuana businesses.
The case, Patients Mutual Assistance v. Commissioner of Internal Revenue, challenges Section 280E, a clause in the Internal Revenue Service (IRS) tax code that makes marijuana dispensaries and related enterprises ineligible for most business tax deductions. Oral arguments are scheduled for February 9. We look at the issues at stake in the case and its impact on the cannabis industry.
What is 280E?
For the unfamiliar, Section 280E of the federal tax code provides that no deduction or credit shall be allowed for amounts paid or incurred in carrying out business that constitutes “trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act).” Marijuana is a Schedule I controlled substance, and dispensing it is considered “trafficking” under Section 280E. Therefore, taxpayers that are “trafficking” in marijuana are prohibited from deducting their business-related expenses.
Challenging 280E Against the Sixteenth Amendment
There are two principal legal disputes in the pending appeal: first and foremost, the constitutionality of Section 280E under the Sixteenth Amendment, and second, the costs that appellant California dispensary Harborside Health Center (Harborside) classified as deductible “Cost of Goods Sold” (COGS) over a number of tax years, which the IRS disputed, and the Tax Court found unallowable under Section 280E. Harborside and amici also assert that Section 280E constitutes a penalty and excessive fine in violation of the Eighth Amendment, but precedent regarding “penalties” may make that assertion challenging.
The Sixteenth Amendment constitutional question is by far the most consequential and impactful of the issues. At the core of the constitutional challenge is the meaning of the word “income” in the Sixteenth Amendment, which says:
“The Congress shall have the power to lay and collect taxes on income, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” U.S. Const. Amend. XVI.
This Amendment is a specific grant of power, and neither Congress nor the Treasury Department can exceed the limit of the grant. It is solely the federal courts, and ultimately the U.S. Supreme Court that guard and interpret the Constitution. Any definition that Congress or the Treasury could give to “income” by statute or regulation cannot supplant or override the constitutional “income” reflected in the Amendment.
The IRS has sidestepped this core constitutional interpretation issue in defending Congress’s authority to tax businesses. For instance, the IRS claims the Sixteenth Amendment “does not impose any barrier at all to taxation of a business.” The plain language of the Amendment, however, provides that tax can only be collected on “income.” The IRS also claims Section 280E “does not tax more than Harborside’s income.” That begs the pending question: what is “income” under the Amendment? Indeed, the IRS’s Ninth Circuit brief ultimately concedes that the “meaning of income embodied in the Sixteenth Amendment” is an open question.
Harborside, which did not develop this issue before the Tax Court below, now has presented its strongest argument: that the Commissioner’s position and the Tax Court’s decision violate the Sixteenth Amendment by taxing more than the income of cannabis businesses, and that precedent supports that Constitutional income means gain. Eisner v. Macomber, 252 U.S. 189 (1920); Miles v. Safe Deposit & Trust Co. of Baltimore, 259 U.S. 247 (1922). So without gain, there is no “income” within the meaning of the Sixteenth Amendment. Stated differently, Constitutional “income” means gain, not gross income. If Harborside’s interpretive argument prevails, then Section 280E violates the Amendment by effectively taxing as income business expenses like rent, wages, etc., that do not represent gain.
Harborside, to sidestep precedent more in line with the IRS’s arguments for a broad reading of 280E, has suggested that because interpretation of the Constitution is not the purview of Congress, typical retorts that tax deductions are the product of “legislative grace” are beside the point. E.g., Bagnall v. Commissioner, 96 F.2d 956, 957 (9th Cir. 1938) (citations omitted).
Impact on the Cannabis Industry
If the Ninth Circuit agrees that Section 280E violates the Sixteenth Amendment, cannabis businesses will be entitled to federal income tax deductions that they have been denied for years. In effect, those businesses that have been paying federal income tax rates of 70-90 percent (which are multiples’ higher than typical rates of non-marijuana businesses) will see those rates cut in half or more.
If the Ninth Circuit declines to interpret Sixteenth Amendment “income” to invalidate Section 280E, that provision will remain a real thorn in the side of the whole cannabis industry. In the relative short history of the Sixteenth Amendment, federal income tax has become synonymous with the operation of the U.S. government, so we shouldn’t expect Congress to be chomping at the bit to acknowledge that Section 280E is arguably out of touch with current business culture and policy.
Still, if the Courts do not act through this case or a future challenge, Congress could face other lobbying initiatives to remove the increased tax burdens on cultivation facilities, medical marijuana manufacturers, and dispensaries.