IRS Authority to Determine Violations of Controlled Substances Act Challenged
A “Farm to Flame” cannabis operation in Colorado has asked a U.S. Court of Appeals to preclude the Internal Revenue Service (IRS) from disallowing income tax deductions for certain business expenses incurred by marijuana companies. The IRS had previously concluded that these business expenses were not deductible as they were incurred in business operations that violate federal law.
On Aug. 15, 2018, Alpenglow Botanicals, LLC (“Alpenglow”) filed its request with the U.S. Court of Appeals for the Tenth Circuit. Previously, a three-judge panel determined that the IRS has the authority to determine that business activities violate the federal Controlled Substances Act (“CSA”) and therefore claimed income tax deductions for certain business expenses could be disallowed on that basis.
Generally, a federal tax deduction is allowed for “ordinary and necessary” expenses incurred in carrying on a trade or business. However, Section 280E of the Internal Revenue Code (Code) prohibits any deduction (or credit) for amounts paid or incurred by a trade or business if its activities consist of “trafficking in controlled substances”. Despite permitted usage under certain state laws, marijuana remains a “Schedule I” controlled substance under the CSA.
In the Alpenglow matter, the organization claimed business expense deductions for rents, labor costs, advertising costs, taxes, licenses, depreciation allowances and certain wages and salaries on its 2010-2012 federal income tax returns. Following an audit of these tax returns, the IRS denied these deductions, concluding that Alpenglow had “committed the crime of trafficking in a controlled substance in violation of the CSA”. The owners paid the assessed tax liability under protest and filed a refund claim, which was denied by the IRS.
Alpenglow filed suit in the U.S. District Court of Colorado, arguing that the IRS could not disallow deductions under Code Section 280E without a criminal conviction and further that Code Section 280E was unconstitutional. The District Court rejected Alpenglow’s arguments, and a three-judge panel upheld the position of the IRS on appeal. The panel noted that “the IRS consistently denies business deductions to state-sanctioned marijuana dispensaries” and that “it is within the IRS’s statutory authority to determine…whether taxpayers have trafficked in controlled substances”.
While the IRS continues to disallow business deductions to cannabis operations such as those claimed in Alpenglow, the IRS permits such businesses to reduce their taxable income by deducting their cost of goods sold (COGS). COGS expenses may include both direct and indirect expenses incurred by businesses for the production and sale of inventory. Accordingly, cannabis operations may achieve significant tax benefits by properly deducting COGS expenses from their taxable income, even if certain other deductions remain impermissible under current tax law.
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