TAX ISSUES AFFECTING MARIJUANA BUSINESSES.

• Author: Jensen, Erik M.

Suppose you are thinking about getting into the marijuana business--the legal marijuana business, that is--and your state has legalized that sort of activity. You assume, without legal advice, that you will be able to deduct the legitimate expenses associated with the business, just as almost any other type of business enterprise could. You might be in for quite a surprise, however, as this article will demonstrate.

A great deal of litigation in recent years has focused on Internal Revenue Code section 280E, which denies income-tax deductions and credits to taxpayers for any trade or business that involves "trafficking in controlled substances," as the section is applied to cannabis businesses. (1) Section 280E, enacted a long time ago--as part of the Tax Equity and Fiscal Responsibility Act of 1982--provides in full that, for purposes of the federal income tax:

[n]o deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consist of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted. (2) Since marijuana is a controlled substance under federal law, listed in schedule I of the Controlled Substances Act, (3) section 280E comes into play for those in the cannabisindustry even though that industry has been legalized in many states--for medical marijuana in (as of this writing) around thirty-six states and the District of Columbia and for recreational use in about eighteen states (4)--and even though the federal government plays relatively little role in enforcing marijuana laws. (5) (Federal banking law does affect marijuana businesses in a critical way in that they often have no access to the banking system. (6) At the other extreme, under what is usually called the Rohrabachcr-Farr amendment (7)--a provision that has not been codified, but that is regularly extended by Congress--the Department of Justice may not spend funds to interfere with state medical marijuana laws.) (8) In any event, state legalization does not matter under section 280E if federal law continues to characterize the activity as trafficking in a controlled substance.

This is serious stuff. A marijuana business that is totally legitimate under state law will not be able to deduct the expenses of earning income in computing its federal income tax liability. That makes creating a marijuana business a much less attractive opportunity, even (or maybe especially) in states where the business is completely legal.

Section 280E raises questions of statutory interpretation and constitutionality questions, and, when marijuana is involved, federalism concerns affect the analysis. (9) Justice Clarence Thomas recently wrote in a separate statement respecting the denial of certiorari in Standing Akimbo, LLC v. United States, (10) a case from the Tenth Circuit implicating section 280E, (11) that "[t]he federal government's current approach is a half-in, half-out regime that simultaneously tolerates and forbids local use of marijuana. This contradictory and unstable state of affairs strains basic principles of federalism and conceals traps for the unwary." (12) Justice Thomas is absolutely right, although it might be that the judiciary cannot resolve the contradictions. Ultimately Congress needs to act.

This article first addresses issues of statutory interpretation under section 280E and then moves to constitutional concerns--in particular, whether section 280E's denial of deductions for marijuana enterprises converts what would otherwise be an income tax, exempted from the direct-tax apportionment rule under the Sixteenth Amendment, into something else. As the article then discusses, however, the Sixteenth Amendment might be irrelevant to the constitutional analysis for entities that are taxable corporations. (13) Finally, the article presents a few thoughts on section 280E and marijuana businesses conducted within Indian Country, a subject of another panel at this symposium.

1. STATUTORY INTERPRETATION ISSUES

   It may be a little strong to say that there arc "issues" of statutory interpretation here in that most of the litigation about the meaning of language in section 280E has been resolved in a consistent way--to the detriment of taxpayers. One fundamental concern is that section 280E arguably conflicts with the usual understanding--one not necessarily dependent on constitutional law (14)--that taxpayers should be able to deduct the costs associated with earning income, even if illegal income is involved. A full denial of deductions converts what is purportedly an income tax into something approaching a gross receipts tax--a tax that can come into play even if a taxpayer has no net income. If you spend one hundred thousand dollars to take in fifty thousand dollars of revenue--that is, if you have lost money in a business or transaction--do you really have "income," as anybody would understand that term? A tax on the full fifty thousand dollars of revenue would be a tax on gross receipts, not a tax on income, and that is just not the way the income tax is supposed to work.

   The Supreme Court has generally acted in accordance with that understanding, permitting deductions associated with the costs of earning illegal income unless Congress has explicitly provided otherwise. (15) (Illegal income is taxable, after all.) (16) For example, in Commissioner v. Sullivan, (17) the Supreme Court concluded in 1958 that, absent clear statutory language to the contrary, an illegal bookmaker was entitled to deductions for rent and wages associated with his business. (18) Furthermore, the Court has said in other contexts that extra-statutory, public-policy limitations on deductibility should be applied only in situations "where the allowance of a deduction would 'frustrate sharply defined national or state policies proscribing particular types of conduct.'" (19) If a sufficient businessconnection can be shown, deductibility of expenses thus is the norm--even if the business is illegal.

   When Congress provides specific limitations on deductibility, however, courts almost always defer. Congress did speak directly in section 280E, providing a clear public-policy limitation on deductibility, just as it has done in several provisions in section 162. (20) Section 162 generally permits deducting ordinary and necessary expenses in carrying on a trade or business. But, for public policy reasons, no deductions are available for certain expenditures like fines and penalties--even if the connection with the business is clear. (21) You can tell your truck drivers that you will pay their traffic fines--you want deliveries made as quickly as possible--but you will not be able to deduct the fines, even though they would otherwise be considered ordinary and necessary business expenses.

   Section 280E arguably docs the same thing as the public-policy limitations in section 162--albeit with a much broader scope (including denying credits as well). (22) The recent Tax Court decision in San Jose Wellness v. Commissioner (23) is a good example of issues of statutory interpretation that are not really issues anymore. A marijuana dispensary, a taxable corporation, unsuccessfully challenged the application of section 280E with arguments focusing on statutory language.

   For one thing, San Jose Wellness had argued that section 280E docs not apply to depreciation allowances because nothing is paid during taxable years after the year of acquisition of depreciable property used in the marijuana business. Judge Emin Toro concluded, however, that argument failed because the statute refers to "paid or incurred," so "incurred" is good--or bad--enough. (24)

   San Jose Wellness also argued that section 280E is directed at the deductibility of business expenses, and the section does not preclude a charitable contribution deduction. A charitable contribution, San Jose Wellness argued, is not paid "in carrying on" a trade or business, as required by the statute if a deduction is to be denied. This argument also failed because the statute permits "[n]o deduction" at all, and, in this context, "in carrying on" should be interpreted as meaning something like "in connection with"--a less restrictive requirement than that applied in determining deductibility under section 162. (25) (Deductions for state and local taxes listed in section 164 would therefore also be disallowed for a business trafficking in controlled substances, as Judge Toro noted.) (26)

   Finally, San Jose Wellness had argued that marijuana businesses are not illegal in California, so the dispensary could not be trafficking in controlled substances--especially since it produced and sold other products as well. The Tax Court had rejected that argument three years earlier in Patients Mutual Assistance Collective Corp. v. Commissioner (Patients Mutual)- (1) and Judge Toro rejected it again. One can be trafficking in controlled substances and engage in other trades or businesses as well; the limitation of section 280E applies only to deductions associated with the trafficking trade or business. (28)

   The bottom line is that Congress intentionally drafted section 280E in a broad way to make trafficking in controlled substances, including marijuana, economically unattractive. The statute has been applied accordingly.

2. CONSTITUTIONAL ISSUES IN SECTION 280E'S APPLICATION

   The statute itself might be fairly clear, as courts have concluded, but its constitutionality is not so obvious. This part discusses three questions: whether section 280E converts what would otherwise be a "tax on incomes" within the meaning of the Sixteenth Amendment into something else; whether a cost-of-goods-sold ("COGS") adjustment is arguably necessary in the...