Section 280E of the Tax Code is currently being used by the federal government to “blunt” the effects of legalization of cannabis on the state level. The effects of Section 280E are crippling to the state-lawful cannabis industry with the IRS often assessing tax at a rate of more than 100% of net income in a Section 280E audit. A tax rate in excess of 100% is fatal not only to this industry, but to any business enterprise for which such a rate is imposed.
As will be discussed further below, the IRS has taken a position that the taxpayer must admit to facts constituting federal drug crimes in order for the IRS to allow any subtractions for Costs of Goods Sold.
However, there has been momentum in Congress to change the IRS’ implementation of Section 280E against cannabis. The latest attempt is Colorado Senator Cory Gardner and Senator Elizabeth Warren’s submission of a bill which would take cannabis off the Controlled Substances list for states in which cannabis has become legal – and let states regulate the plant and its derivatives. i. President Trump has indicated that he will support the bill and would sign it if the measure was passed by both houses.ii.
Nevertheless, the Cannabis industry must endure until the tax laws change. The current onerous tax rates are unsustainable. Until the tax laws change, the Cannabis industry will need funding from outside sources in order to survive.
A) Background of Section 280E.
Section 280E is very concise: 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.iii.
The elements of Section 280E are (1) person; (2) in the person’s trade or business; (3) “traffics”; (4) in a Schedule I or II controlled substance; (5) prohibited by federal or state law.iv. There is no indication that Congress intended Section 280E to apply to state legal business enterprises.
B) Background of the Illegalization of “Marihuana”.
While the illegalization of cannabis begins in the 1930s, the relevant laws begin in 1956. On or about July 18, 1956, Congress passed the Narcotics Control Act (“NCA”).v. The NCA penalized the possession and distribution of marijuana as well as taxed the possession thereof. vi. The NCA was made part of the Internal Revenue Code with the Department of Treasury/IRS being the agency in charge of its enforcement.vii.
In 1969, the Supreme Court in Leary v. United declared parts of the NCA unconstitutional.viii. The Court was especially concerned that the NCA required disclosure of a criminal act (sale/possession of marijuana) to the IRS for tax purposes but allowed for sharing of the same information for criminal prosecution purposes. ix The Leary Court discussed the Fifth Amendment “constitutional difficulty” of requiring a taxpayer to disclose facts of a federal crime for tax purposes, while allowing these same facts to be shared by the government for prosecution purposes. x.
In response to Leary, Congress repealed the NCA and adopted the Comprehensive Drug Abuse Prevention and Control Act of 1970 (“CSA”).xi Congress adopted important provisions to comply with Leary. First, the jurisdiction of the Department of Treasury/IRS to investigate federal drug crimes was removed and given to the Attorney General and, by delegation, Department of Justice.xii
As the House Report discusses:
The Commission recommends that the functions of the Bureau of Narcotics relating to the investigation of the illicit manufacture, sale, or other distribution, or possession of Narcotic Drugs and marihuana be transferred from the Department of Treasury to the Department of Justice.xiii
These recommendations were approved and codified into 21 U.S.C. §871.
At the same time, recreational drug use became a symbol of youthful rebellion and political dissent. There was also a growing heroin problem among U.S. servicemen fighting in Vietnam. In response to these problems, President Nixon announced a “war on drugs” in his famous 1971 speech to Congress.xiv. At a press conference, President Nixon identified drug abuse as "public enemy number one in the United States," and noted that “a number of young Americans have become addicts as they serve abroad.”xv. President Nixon focused on drugs that were illegally trafficked into the United States, stating that the war on drugs would be a “worldwide offensive, dealing with the problems of sources of supply.”xvi
The enactment of CSA, while being done to comply with Leary, also became the centerpiece on the war on drugs. “Marihuana” was temporarily placed as a Schedule I by Congress pending review from the Shafer Commission.xvii. The Shafer Commission recommended removing marijuana from the Controlled Substance Act, writing:
The actual and potential harm of use of the drug is not great enough to justify intrusion by the criminal law into private behavior, a step which our society takes only with the greatest reluctance. . . . Therefore, the Commission recommends . . . [that the] possession of marijuana for personal use no longer be an offense[.]xviii.
However, this recommendation was not adopted, and marijuana remains a Schedule I controlled substance, along with heroin and LSD.
In 1975, the Ford Administration released the White Paper on Drug Abuse.xix. The White Papers note that the use of marijuana has a relatively low social cost, and that “public policy should be most concerned with those drugs which have the highest social cost.”xx. The authors recommend that vigorous law enforcement be aimed at major traffickers, and indicate that sources of marijuana supply have traditionally been Mexico, the Caribbean, and South America.
President Jimmy Carter also emphasized the low social cost of marijuana in his Drug Abuse message to the Congress in 1977, stating:
Penalties against possession of a drug should not be more damaging to an individual than the use of the drug itself; and where they are, they should be changed. . . . Therefore, I support legislation amending Federal law to eliminate all Federal criminal penalties for the possession of up to one ounce of marijuana.xxi.
President Carter also noted that “immense profits made in the illicit drug traffic help support the power and influence of organized crime.” xxiii, xxii. To combat this problem, he authorized the Attorney General to investigate the link between organized crime and drug trafficking. As with the Ford and Nixon administrations, the emphasis of the federal drug policy was to eliminate organized crime and drug cartels.
C) Public Policy Regarding Drugs Changed with the Rise of Crack Cocaine Epidemic.
By the mid-1970s, there was a large amount of cocaine being trafficked into the United States. Simultaneously, there was a substantial rise in drug cartels and organized criminal organizations bringing drugs into the United States. For example, by 1976, the Medellin Cartel, led by Pablo Escobar, had become well established in Columbia.xxiv. Like the other drug cartels emerging at the time, the Medellin Cartel focused on trafficking cocaine and heroin from Central and Latin America to the United States. The Medellin Cartel alone was responsible for hundreds of deaths in Columbia.xxv. As the cocaine trade became increasingly more violent, public support for the war on drugs strengthened.xxvi.
D) Public Policy Exception to the Tax Code Began Being Employed to Unlawful Drug Traffickers.
The basic public policy of the Tax Code is to tax net income. However, there is a little used judicial doctrine of the Tax Code which allows Congress to tax gross income in cases of clearly defined violations of public policy.
Generally, the policy of the Tax Code is to tax net income:
It is clear that the Congress intended the income tax laws ‘to tax earnings and profits less expenses and losses, . . . carrying out a broad basic policy of taxing "net, not . . . gross, income . . . .’”xxvii.
To this end, both legal and illegal income are treated alike. The Supreme Court has written:
[T]he federal income tax is a tax on net income, not a sanction against wrongdoing. That principle has been firmly imbedded in the tax statute from the beginning. One familiar facet of the principle is the truism that the statute does not concern itself with the lawfulness of the income that it taxes. Income from a criminal enterprise is taxed at a rate no higher and no lower than income from more conventional sources.xxviii.
Nevertheless, when an illegal enterprise transgresses to the point that it violates sharply defined public policy, Congress may tax on gross rather than net income in order to vindicate the public policy.xxix.
The test for non-deductibility of expenses which violate public policy:
[A]lways is the severity and immediacy of the frustration resulting from allowance of the deduction. The flexibility of such a standard is necessary if we are to accommodate both the congressional intent to tax only net income, and the 6 presumption against congressional intent to encourage violation of declared public policy.xxx.
During the drug war era (pre-Section 280E), the Tax Court denied deductions based upon sharply defined public policy to convicted drug traffickers, taxing such illegal enterprise on gross rather than net income.xxxi.
However, there was a notable exception to this drug war policy in Edmondson v. Commissioner. xxxii, xxxiii, xxxiv. Jeffrey Edmondson was a convicted drug dealer who was sentenced to four years in prison for possessing cocaine with an intent to distribute. The Tax Court allowed Edmondson to take deductions for telephone, automobile, and rental expenses that were incurred in his illicit drug business, and the public policy exception was not imposed.
Congress took exception to the Tax Court’s failure to invoke the public policy exception to Edmondson’s conviction of illicit drug crimes. In response, Congress adopted IRC §280E. In the Senate Report on Section 280E, the Senate explained the reasons for the statute:
A recent U.S. Tax Court case allowed deductions for telephone, auto, and rental expenses incurred in the illegal drug trade . . . There is a sharply defined public policy against drug dealing. To allow drug dealers the benefit of business expense deductions at the same time that the U.S. and its citizens are losing billions of dollars per year to such persons is not compelled by the fact that such deductions are allowed to other, legal, enterprises. Such deductions must be disallowed on public policy grounds.xxxv.
Thus, Section 280E codified the drug-war public policy exception for illegal drug dealing.xxxvi.
E) The Enforcement of Section 280E.
Prior to the adoption of Section 280E,xxxvii xxxviii and for at least twenty-five years thereafter, the IRS waited until the taxpayer had been convicted of illegal drug trafficking to invoke the public policy exception/ section 280E.
However, in 1996, California and Arizona legalized marijuana for medical purposes. In response to this legalization, the Clinton Administration adopted a policy to destroy the developing state-legal marijuana programs through the Office of National Drug Control Policy. A memorandum to then President Clinton from Barry R. McCaffrey, then Director of the Office of National Drug Control Policy, outlined the strategy to “blunt the negative consequences of the recent ‘medicinal marijuana’ Propositions . . .” (the “Memo”). Now Justice Kagan participated in the drafting of the Memo during her tenure as Associate White House Counsel. xxxix. Part of the strategy is to use the IRS and the Tax Code to discourage the state legalization efforts. xl.
The Memo discusses a “coordinated Federal response” among various agencies including the Departments of Treasury and Justice to limit or destroy state-legal marijuana programs. A part of the policy stated in this Memo was determined to be unconstitutional in Conant v. Walters (Policy to revoke DEA physician licenses to prescribe controlled substances if physician recommends use of marijuana violative of First Amendment).xli. There is no evidence that the strategy explained in the Memo has been abandoned. Conversely, the Executive Branch apparently continues to follow the Memo using its governmental powers “to reduce use and availability of marijuana”.xlii
Also, beginning shortly after the 1996 Memo, the IRS began administratively investigating and determining that taxpayers were unlawfully trafficking in cannabis and would apply Section 280E based upon this administrative ruling. No longer did the IRS wait until the taxpayer was convicted of unlawful trafficking of drugs. Rather the IRS took it upon itself to begin its own investigations and ultimately make administrative findings that Section 280E applied to the taxpayer. This administrative change continues to focus on the state-legal marijuana industry.
F) The Politics Change in Favor of Legalization of Cannabis.
With respect to marijuana, the war on drugs became less and less of an issue. California became the first state in the nation to legalize medical marijuana when it passed the Compassionate Use Act in 1996.xliii. Since then, thirty states1 and the District of Columbia have approved the use of medical marijuana. Additionally, seven states and the District of Columbia have legalized marijuana for recreational use.
Moreover, politicians on both sides of the political spectrum advocated for ending the war on drugs, reasoning that the war on drugs has failed and resulted in the mass incarceration of American citizens.xliv. To this end, in 2010, Congress passed the Fair Sentencing Act, which reduced the criminal penalties for drug possession.xlv.
G) Changes in Federal Marijuana Enforcement.
Given the changing policies on the possession and distribution of marijuana, the Obama administration chose not to enforce federal marijuana prohibition. “[O]fficials at the Department of Justice have now twice instructed field prosecutors that they should generally decline to enforce Congress's statutory command when states like Colorado license operations like THC.”xlvi.
1 The thirty states that have passed medical marijuana laws are: Alaska (Ballot Measure 8 (1998)); Arizona (Proposition 203 (2010)); Arkansas (Ballot Measure Issue 6 (2016)); California(Proposition 215 (1996)); Colorado (Ballot Amendment 20 (2000)); Connecticut (House Bill 5389 (2012)); Delaware (Senate Bill 17 (2011)); Florida (Ballot Amendment 2 (2016)); Hawaii (Senate Bill 862 (2000)); Illinois (House Bill 1 (2013)); Maine (Ballot Question 2 (2013)); Maryland (House Bill 881 (2014)); Massachusetts (Ballot Question 3 (2012)); Michigan (Proposal 1 (2008)); Minnesota (Senate Bill 2470 (2014)); Montana (Initiative 148 (2004)); New Hampshire (House Bill 573 (2013)); New Jersey (Senate Bill 119 (2010)); New Mexico (Senate Bill 523 (2007)); New York (Assembly Bill 6357 (2014)); Nevada (Ballot Question 9 (2000)); North Dakota (Ballot Measure 5 (2016)); Ohio (House Bill 523 (2016)); Oregon (Ballot Measure 67 (1998)); Pennsylvania (Senate Bill 3 (2016)); Rhode Island (Senate Bill 0710 (2006)); Vermont (Senate Bill 76 (2004)); Washington (Initiative 692 (1998)). 2 Washington, District of Columbia (Amendment Act B18-622 (2010)). 3 Alaska (Ballot Measure 2 (2014); California (Proposition 64 (2016)); Colorado (Ballot Amendment 64 (2012)); Maine (Ballot Question 1 (2016)); Massachusetts (Ballot Question 4 (2016)); Nevada (Ballot Question 2 (2016)); Oregon (Ballot Measure 91 (2014)); Washington (Initiative 502 (2012)). 4 Washington, District of Columbia (Ballot Initiative 71 (2014)).
The memos discussed in Feinberg – David W. Ogden, Deputy Att'y Gen., U.S. Dep't of Justice to Selected U.S. Att'ys (Oct. 19, 2009), revised by Memorandum from James M. Cole, Deputy Att'y Gen., U.S. Dep't of Justice (Aug. 29, 2013) – make clear that persons who buy and sell marijuana pursuant to state law will not be prosecuted.
This determination by the Justice Department was affirmed by Congress in 2014 where it defunded the Department of Justice from prosecuting any marijuana dispensaries who are operating in accordance with state law.xlvii The Consolidated Appropriations Act states:
None of the funds made available in this Act to the Department of Justice may be used, with respect to [any of the Medical Marijuana States], to prevent them from implementing their own laws that authorize the use, distribution, possession, or cultivation of medical marijuana. xlviii.
[J]ust across 10th Street in Washington, D.C., officials at the IRS refuse to recognize business expense deductions claimed by companies . . . on the ground that their conduct violates federal criminal drug laws. See 26 U.S.C. § 280E. So it is that today prosecutors will almost always overlook federal marijuana distribution crimes in Colorado but the tax man never will.xlix.
Despite the changes in federal law, the IRS continues to consider state legal cannabis as “unlawful trafficking”, apparently still following the ONDCP mandates on “blunting” the effects of state-legal cannabis sales.
H) The Financial Effect of Section 280E on State Legal Cannabis Sales.
The financial result of Section 280E is devastating on state-legal cannabis sales. This section will compare and contrast typical business taxation versus Section 280E taxation.
The following is an example of what typical business taxation looks like using $1 million as an arbitrary gross income figure, assuming normal taxation like any other business:
Costs of Goods Sold: $ 550,000
Business Expenses: $ 250,000
Taxable Income: $ 200,000
Tax: $ 70,000
Total to Taxpayer $ 130,000
Net effective tax rate 35%
Under Section 280E, a very different scenario arises. Using the identical million-dollar gross sales and expenses, the following demonstrates the outcome of a Section 280E audit based upon our experience with numerous Section 280E audits with the IRS.
Costs of Goods Sold: $ 350,000 ($200,000 of COGS disallowed)
Business Expenses -0-(All $250,000 of business expenses disallowed)
Taxable Income: $ 650,000 (Increase of $450,000 from NI)
Tax: $ 227,500 (NI is only $200,000)
Net effective tax rate 113%
The IRS’ reasoning of limited COGS is that the DEA has previously conducted raids on unlawful trafficking organizations. The DEA did an analysis of what it believed was the cost of production of cannabis under that situation. The DEA concluded that COGS was no more than 35% of the sales price. Thus, the IRS has adopted those numbers and has effectively limited the recovery of COGS to 35% in all but undefined exceptional circumstances. Since the IRS has no published rules or regulations on Section 280E, it is unknown how the IRS analyzes COGS for cannabis outside of the above parameters.
I) Case Studies.