“IRS cracks down with §280E”: Reviewing the latest major US Tax Court court ruling highlighting burdens for marijuana businesses

Chris Nani, a student in my Marijuana Law & Policy seminar last year, has already had articles published at the Cannabis Law Report discussing federal tax treatment of cannabis businesses (see prior posts here and here).  Thus I was not surprised to hear from Chris in the wake of a significant US Tax Court ruling earlier this month, and I imposed upon him to author a review of the decision for the blog.  He titled his review “”IRS cracks down with §280E,” and here is the account:

Altermeds, LLC, a medical marijuana dispensary near Boulder, Colorado, recently experienced the effects of § 280E after a tax audit found they had under-reported their taxes.  The ruling from the US Tax Court in Alterman v. Commisioner, TC Memo 2018-83, is already being widely discussed in the marijuana industry.

 In 2010 and 2011, Altermeds filed its taxes and applied normal tax deductions to its business.  The IRS audited Altermeds and found a deficiency of $157,821 in 2010 and $233,421 in 2011 holding Altermeds was not eligible for business expense deductions.  Additionally, the Internal Revenue Code (IRC) provides for a tax penalty of 20% the portion of the underpayment for under-reporting taxes. 

280E states:  “No 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) consists 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.”

Essentially, § 280E provides no cannabis business (because cannabis is a Schedule I drug) will receive deductions or credits for any of their business related activates. Normally, businesses can deduct their ordinary business expenses under § 162 of the IRC.  However, § 280E limits § 162 and theoretically was meant to deter drug dealers from writing off their business expenses.  (The opposite may have occurred by giving drug dealers even less incentive to report their income.)

The origins of § 280E are slightly comical.  In 1982, Jeffrey Edmondson, a drug dealer, was able to write off his business expenses under § 162.  Edmondson wrote off traveling, his scale he used to measure drugs, and his rent.  When Congress found out Edmondson was writing off his drug dealing expenses, they enacted § 280E.

The majority of businesses know when entering into the state legalized cannabis market they will still pay federal taxes without being able to deduce business expenses.    Non-cannabis related expenses such as the sale of t-shirts are eligible for § 162 tax deductions even while selling cannabis, cannabis-infused edibles, or pipes are not deductible because of their relation with cannabis.  The tax court is more likely to permit deductions the clearer the line is between a cannabis and non-cannabis business.

When Altermeds was audited, they claimed they had multiple businesses.  One of their businesses sold their non-cannabis merchandise, but the tax court did not find the business to be distinct enough from their cannabis dispensary.  To prove a business is distinct, Altermeds would have to show there is a separate bank account and business.  The tax court held that the non-cannabis products sold by Altermeds (pipes and other cannabis paraphernalia) were sold to complement selling cannabis and were not eligible for any deductions.  Lastly, the court was willing to deduct the amount for the non-cannabis business as well, but Altermeds’ brief failed to follow the court rules and the court was precluded from even contemplating the deductions.

The tax court did allow for the cost-of-goods-sold allowances that the IRS had stipulated prior in the litigation, but Altermeds was still forced to pay its overdue taxes along with the 20% penalty.  With this most recent tax decision taking a hard line approach to deductions associated with cannabis businesses, participants in the industry need to be careful about, and cognizant of the tax consequences that can result from, intermingling cannabis and non-cannabis products.

UPDATE: I just noticed that Bryan Camp over at TaxProf Blog has this long posting on the Altermeds decision under the heading “Lesson From The Tax Court: Into The Weeds on COGS.”  Here is his concluding “Lesson” concerning the case: “Get your accounting straight and be sure to hire tax counsel who have the specialized knowledge needed for the job of representing you before both the IRS and Tax Court.”