A Controversy in 77 Words

Why Section 280E of the Tax Code Is Causing Such a Stir

Nov 20, 2019
Accounting

SMITH BRAIN TRUST – The recent Congressional committee passage of the Marijuana Opportunity, Reinvestment, and Expungement Act to decriminalize marijuana may have been influenced by more than just the revenue the proposed excise tax will generate, says Maryland Smith's Samuel Handwerger, pointing to a recent tax court case that highlighted the need for Congressional action regarding Section 280E of the federal tax code. 

That section is just 77 words, he says, "but it seems like it has created 770 tax court controversies." And marijuana businesses know this all too well, he adds, because 280E disallows all their business deductions, aside from the cost of the goods sold, because cannabis is listed as a Substance 1 drug. Drugs on that list the feds deem as illegal substances. That’s despite the fact that significantly more than half of states have legalized the leaf in one way or another, he notes.

Disallowing business expenses causes the marijuana industry to be faced with what is essentially a sales tax, as the income tax in their case is on nearly the gross sales price, like any sales tax, explains Handwerger. “The only thing wrong with this picture is that the rate of tax can be anything other than what you would expect a sales tax to be…with rates up to 37% at the federal level.”

It’s a “rather draconian tax law,” dating back to Nancy Reagan’s so called war on drugs, and it was meant to serve as another tool for prosecuting drug dealers, he says. “No one questioned it then because no legitimate was business was affected. That has all changed rather quickly in the last several years with state laws legalizing the production and sale.”

The clash between federal supremacy over state law has been largely swept under the rug since President Obama put a hold on federal enforcement of state legalized businesses, he says. Over the years this has acted as an open invitation for more states to join in the legalization movement despite no mutual recognition in Congress to change the law on their side.

“This is not to say that Congress forgot about Section 280E. Several attempts have been made to pass measures to change or delete Section 280E, but to no avail,” Handwerger says. “However, someone forgot to tell the IRS to stop enforcing this part of the tax law and so these otherwise legitimate businesses are incurring huge tax burdens on their profits as the IRS attacks, without mercy, waiving 280E in front of tax courts to assess huge tax bills.”

He cites a recent case, NCSBA v. Comr (Oct 23, 2019), in which the tax court upheld a tax assessment of $1.2 million and a $250,000 penalty.

“There have been many arguments made by marijuana entrepreneurs in tax court to combat the harshness of Section 280E, but in this most recent tax court decision a line was drawn that makes it clear that there is little wiggle room,” Handwerger said.

The tax court concluded that the law is not a penalty that could be called into question as an excessive fine disallowed under the Eighth Amendment.

“Moreover,” Handwerger added, “the taxpayer tried to make the argument that not all deductions should be disallowed. The court in reply, as if talking to a child, read the first sentence of Section 280E, where it reads “No deduction…shall be allowed.” No means no…nada.”

The decision in this case is not much different than the long stream of IRS wins on this issue, Handwerger notes, and would have been just another dead end except for a partial dissenting opinion that followed the decision itself. “Here is where Judge David Gustafson didn’t make a mere suggestion for a constitutional argument against 280E, he essentially carved the opening and built the program for it to come in.

Judge Gustafson challenged a long held and oft-quoted concept of the income tax code that business deductions are a matter of political grace: All income from whatever source derived is taxable and deductions against that income are allowed only if the statute so allows.

The good judge centered a constitutional argument on this concept and definition of “income.” His argument is that “income” has to be interpreted as “gain”, perhaps better quoted as the “economic gain” of a transaction.

“For example, if you sell your Apple stock for $400 that you bought for $250 (Lucky you!), no one would think to have an ‘income’ tax strictly on the $400. Rather, everyone would agree that the income is the difference between the sale price and the cost, or $150 in this case. Taxing the $400 is a gross receipts tax, and our Sixteenth Amendment calls only for the allowance of an “income’ tax,” explains Handwerger.

He then takes that line of reasoning and applies it to a typical business owners. The owners sell goods costing them $600 for $1,000. But they also have rent for $100, salaries for $250, and supplies for $50. “Do the math and you will see that they broke even on this deal – better luck next time. The tax is zero since there is no net income. If this were a marijuana business, and the tax rate at 30%, the tax would be $120, 30% of $400 – the net of the sale price less the cost of items sold. Now the business loses money because of the tax.”

That’s what makes 280E so interesting,

“The cost of the goods sold is an allowed deduction, because when Congress passed this law they knew that they couldn’t pass an essentially gross receipts tax on the $1,000 of total sales. They had to allow at least for the reduction of the cost of the goods sold. According to Judge Gustafson, what differentiates the other deductions, the other costs of the sale? Nothing.”

Seen in this light, Handwerger says, the tax law of 280E may indeed be unconstitutional. “Judge Gustafson certainly thinks so and he is personally inviting the next challenge to 280E to be made on these grounds. That is unless Congress can act first to correct the unnaturalness of the current state of affairs.” And Handwerger says this doable in one of two ways: Eliminating Section 280E altogether or taking marijuana off the Substance 1 list, as is currently proposed.

"Either way would work just fine for the marijuana entrepreneurs," he says.  

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About the Expert(s)

Sam Handwerger, CPA, is a full-time Lecturer in the department, and is a University of Maryland undergraduate accounting alumnus. He also holds a Master of Science in Taxation degree from the University of Baltimore. Handwerger was a Senior Tax Researcher with EY in New York City and later led the Tax Planning and Preparation Departments of the CPA firm Handwerger, Cardegna, Funkhouser & Lurman. In 1996, he was awarded the Governor's Volunteer of the year award in the State of Maryland for financial and management advisement to non-profit organizations. Before joining the Smith School on a full-time basis, Handwerger held adjunct positions at the Johns Hopkins University School of Business and the University of Baltimore Law School.

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