The recent Tenth Circuit decision of Feinberg v. Commissioner of Internal Revenue reminds cannabis businesses that as long as marijuana remains a Schedule I controlled substance under federal law, they will not be permitted to take deductions for business expenses. However, these businesses may still reduce their gross income by their cost of goods sold (COGS). This is an important distinction and can have a significant impact on a cannabis business’s tax liability.
In Feinberg, after an IRS audit of a cannabis business (which all cannabis businesses should be wary of), the IRS disallowed certain business expense deductions, citing Section 280E of the Internal Revenue Code. As discussed in our prior post, and in Feinberg, Section 280E of the Internal Revenue Code prohibits deductions for businesses engaged in unlawful trafficking of controlled substances. As a result, the taxpayers received a notice of deficiency from the IRS for the unpaid tax balance. The taxpayers challenged this determination, but the Tenth Circuit found that the taxpayers did not meet their burden of disproving the IRS’s determination that the taxpayers were unlawfully trafficking in a controlled substance. The taxpayers argued that asking them to prove they were not involved in trafficking violated their Fifth Amendment right against self-incrimination, but the Tenth Circuit disagreed and upheld the tax deficiency.
The silver lining for the taxpayer, if any, was that the IRS did reclassify many of the business deductions as COGS, which helped defray a portion of the tax liability. You may be asking yourself, why are business deductions disallowed because the business is trafficking in controlled substances, but COGS are permitted for the same “illegal” business? The answer lies in the way the Internal Revenue Code is written. Section 280E disallows tax benefits for taxpayers who traffic in controlled substances, but Section 280E concerns only deductions and credits, including regular business expense deductions. There is no corollary in the Code for COGS, which is an exclusion from gross income rather than a deduction. Said another way, Section 280E does not prohibit cannabis businesses from reducing their taxable income by excluding COGS.
The Feinberg holding further shows that courts are continuing to allow the IRS to determine if a taxpayer has violated the Controlled Substance Act, and therefore cannot take business expense deductions as a result of Section 280E. But keep an eye on Alpenglow Botanicals, LLC, where the taxpayers have asked that the United States Supreme Court reconsider the Tenth Circuit’s decision upholding the IRS’s authority to determine violations of the Controlled Substances Act without a criminal conviction.
If you have any questions about this post or any other related matters, please feel free to contact our Cannabis Law Practice Group.