LEX CANNA

The Blurred Line between IRS Tax Collection and Federal Drug Laws

As California prepares for state-legal cannabis sales to begin, expectations of a robust, highly profitable market are rampant. But looming legal issues may cramp such sky-high expectations. Heavy tax burdens, for example, may strain profitability. Here we discuss Internal Revenue Code section 280E, which has a major potential effect on cannabis companies’ federal tax burden.

Cannabis companies by definition flout federal drug laws, thereby taking a calculated risk regarding enforcement of those laws. There is no similar calculated risk with respect to enforcement of federal tax law, however, and all companies should take federal taxes very seriously. After all, the IRS’s official concern is the enforcement of tax laws (i.e., ensuring that companies pay federal taxes), not whether businesses comply with laws beyond its purview.

But what happens when a company’s tax burden hinges on whether it complies with federal drug laws? That is the situation under section 280E, and it is the subject of an ongoing legal challenge.

Colorado Cannabis Companies Continue Challenging IRS

Like any company, federal income taxes are a major burden that cannabis companies must consider in their financial projections. Unlike other companies, however, cannabis businesses face the restrictions of section 280E, which prohibits deductions for business expenses associated with trafficking in federally prohibited controlled substances. That prohibition is a serious challenge to startup cannabis businesses, which, like any young company pursuing long-term profitability, would otherwise deduct as many business expenses as possible to limit federal tax liabilities.

While there are some potential legal arguments against enforcement of section 280E, courts have repeatedly upheld it and rejected arguments that it is unconstitutional or otherwise should not apply to state-legal cannabis businesses. In October, a Colorado company argued in federal court that the IRS unlawfully applied 280E to effectively conduct a criminal investigation into the company’s cannabis operations. The court rejected that and other arguments.

Another Colorado company, however, is hoping that the U.S. Supreme Court will see things differently. The company, Green Solution Retail Inc., is under audit by the IRS, which made a threshold determination under section 280E: that the company is culpable under the Controlled Substances Act. In its petition for review, the company argues that the IRS overstepped its authority by making such a determination.

The likelihood that the Supreme Court will take on this matter is not high. The Court grants review in a very small number of cases each year, and review is generally unlikely where, as here, there is no disagreement among lower courts on the issue. It is worth noting, however, that new Justice Neil Gorsuch was previously a judge on the U.S. Court of Appeals for the Tenth Circuit, which includes Colorado, where he had previously noted the “mixed messages the federal government is sending these days about the distribution of marijuana.”  Time will tell whether he seeks to send a clearer message in his new role.

For now, it is crucial that companies consult with experienced legal and tax professionals when developing business plans and making financial projections in this rapidly evolving industry.

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