Louis Vlahos tax Partner at Farrell Fritz writes..

Louis Vlahos

How Are You Doing?

How are you coping with social distancing? Are you working remotely? If so, has it been as “seamless” as you would have others believe? Have you snuck out to visit family or close friends, or have they asked you to stay away because they or a loved one suffer from a compromised immune system? Do you occasionally leave your home for some fresh air? Are Zoom meetings and virtual events – including weddings, and even funerals – satisfying your need for contact with other individuals, or have they lost their luster and grown tedious? Do you miss your favorite restaurant or bar? What have you done for entertainment? How have you escaped the monotony of our current environment?

As we enter the year-end holiday season – and perhaps a “dark winter” as many healthcare professionals have warned may be the case – the entire country is experiencing a second wave of the resurgent coronavirus, in reaction to which many jurisdictions are mandating reduced travel, the closure (once again) of nonessential businesses, the continued lockdown of many public venues, the suspension of in-school classes, and the observation of stricter mask-wearing and social distancing rules, among other measures.

What have you done thus far to cope with the isolation and the stress that may have accompanied the implementation of these measures? Do you plan to try anything different over the next few months?

Just What You Needed?

It appears that many Americans have turned to a well-known plant, the sale and use of which, in various forms, is permitted to varying degrees in most states, but which remains illegal under federal law: cannabis.[i]

Indeed, sales of marijuana and other cannabis-derived products (edibles, for example, such as gummy candies) have skyrocketed.[ii]

Several jurisdictions have even designated marijuana dispensaries among those “essential” businesses that may remain open in the face of stay-at-home or lockdown orders.[iii] In fact, it may not be too farfetched to say that the products and services provided by so-called “sin” businesses, generally, have probably contributed to the short-term mental health of many over the last nine months.[iv]

During the elections earlier this month, four more states acted to legalize the recreational use of cannabis.[v] Its sale and use is now “fully legal” in 24 states; there are 6 states in which it is fully illegal; and there are 20 in which its status is mixed, depending upon the use.[vi]

According to Governor Cuomo, New York will likely join the ranks of those states in which cannabis is fully legal during 2021: “I think this year it is ripe because the state is going to be desperate for funding, even with Biden, even with the stimulus. Even with everything else, we’re still going to need funding, and it’s also the right policy. So I think we get there this year.”[vii]

Keeping Up with Demand?

As we move into what is shaping up to be the next lockdown, it is reasonable to assume that the demand for cannabis products will continue unabated.

One has to wonder, however, whether the supply will keep up with the demand. For one thing, financing for the expansion of a cannabis-related business and for the purchase of inventory may present a challenge.

After all, banks are unwilling to do business with an industry that deals in a product which continues to be treated as a “controlled substance” and, therefore, is illegal under federal law. For the same reason, cannabis businesses were denied access to loans under the Paycheck Protection Program established by the CARES Act,[viii] and are likely to be shut out of any extension of the PPP under future economic stimulus legislation.[ix]

The House of Representatives sought to address this state of affairs by including in its proposed stimulus package, known as the HEROES Act,[x] a provision the stated purpose of which is to ensure “access to financial services to cannabis-related legitimate businesses and service providers.”

Among other things, the Act would protect from federal prosecution a bank that provides financial services to a cannabis-related business that operates in a state in which such activity is legal.[xi]

We all know how well the House and Senate negotiations are going – more than six months of on-and-off discussions have yielded nothing but a lot of name-calling and finger-pointing.[xii]

The Senate – Mr. McConnell – believes that the above-described provision is irrelevant to a stimulus package that is intended to at least neutralize, and hopefully reverse, the adverse effects that our attempts to contain the pandemic (by shutting down many businesses) have had on the economy. The House – Ms. Pelosi – disagrees.

The “Highest” Court

Against this backdrop, a petition for a writ of certiorari was filed with the U.S. Supreme Court on November 6, 2020, in which the petitioner (the “Taxpayer”) has asked the nation’s highest Court[xiii] to review the decision of the U.S. Court of Appeals for the Tenth Circuit in the case of Standing Akimbo v. United States.[xiv]

The petition indicates, and the IRS has conceded, that the Taxpayer operates a legal cannabis dispensary under Colorado law.

However, it is the IRS’s position, notwithstanding the Taxpayer’s compliance with state law, that the Taxpayer is an unlawful drug trafficker under federal law.[xv] On the basis of this conclusion, the IRS has argued, among other things, that Section 280E of the Code should be applied to deny the Taxpayer all deductions for expenses incurred by the Taxpayer in its purportedly unlawful drug trafficking business.

The IRS’s position – with which the Tenth Circuit has agreed – is that federal law supersedes or preempts state law when it comes to a state-legal cannabis business.

In its petition, the Taxpayer questions the IRS’s application of the preemption doctrine. Local criminal activity, the Taxpayer points out, has “traditionally been the responsibility of the States.” Citing the principles of federalism and the Tenth Amendment, the Taxpayer argues that a federal criminal statute cannot prohibit an expressly state-legal act unless “explicitly” directed by Congress.

The Taxpayer is also challenging the constitutionality of Section 280E of the Code under the Sixteenth Amendment to the Constitution, claiming that it results in the taxation of something other than “net income.”

Before considering the Taxpayer’s argument that Section 280E is unconstitutional, let’s review the application of that provision.

The Code

In computing their taxable income, a taxpayer is allowed to deduct their ordinary and necessary expenses paid or incurred in carrying on a trade or business subject, however, to certain stated exceptions (including Section 280E).[xvi]

What about a taxpayer engaged in an unlawful business which generates income, and with respect to which the taxpayer pays certain expenses?

Under federal law, cannabis is a “Schedule I” controlled substance; thus, the manufacture, distribution, dispensation, or possession of marijuana is unlawful as a matter of federal law.[xvii]

Deductions

The following phrase is sometimes attributed to mobster Al Capone: “They can’t collect legal taxes from illegal money.”

Ha! In 1931, Capone was convicted of tax evasion, just four years after the Supreme Court’s decision in U.S. v. Sullivan that “[g]ains from illicit traffic in liquor are subject to the income tax.”[xviii]

Writing for the Court in Sullivan, Justice Holmes pointed out that the definition of “gross income,” under the tax statute then in effect, did not distinguish between a lawful and an unlawful business; rather, it sought to tax income “derived from any source whatever.”

“As the defendant’s income was taxed,” Holmes continued, he was required to file a tax return.

Similarly, the Code allows a defendant who operates an illegal business to deduct, for purposes of determining its taxable income, all of “the ordinary and necessary expenses paid or incurred during the taxable year in carrying on” such business,[xix] provided the specific activity for which the expenses were incurred is not itself illegal,[xx] and subject further to certain statutory exceptions.[xxi]

One of these exceptions resides in Section 280E of the Code, which denies a “deduction” for any amount paid or incurred during the taxable year in carrying on any trade or business that consists of trafficking in certain “controlled substances”[xxii]  which is prohibited by federal law or by the law of any state in which such trade or business is conducted.[xxiii]

Cannabis/marijuana is a Schedule I controlled substance,[xxiv] and dispensing it constitutes “trafficking” within the meaning of Section 280E.

Therefore, the Code prohibits a taxpayer that is engaged in the business of “trafficking” in cannabis from deducting their related expenses.

Cost of Goods Sold

However, the fact that a taxpayer engaged in the business of trafficking in controlled substances cannot deduct its business expenses does not mean the taxpayer owes tax on the gross receipts generated by the business.

All taxpayers – including “drug traffickers” – determine their “gross income” (from which ordinary and necessary business expenses would normally be deducted[xxv] to arrive at the taxable income from a business) by reducing their gross receipts (total sales) by their cost of goods sold (“COGS”).[xxvi] Although Section 280E of the Code prohibits deductions, it says nothing about a taxpayer’s COGS.

Deduction v. COGS?

The main difference between deductions and COGS is one of timing; specifically, when does the taxpayer who incurs the cost in question benefit from the resulting reduction in their taxable income?

In general, a taxpayer can claim a deductible expense (and thereby reduce their taxable income) for the year in which the expense was incurred. However, when accounting for COGS, the taxpayer has to capitalize the cost for the item in the year of acquisition or production of the item; then the taxpayer generally waits until the year in which the item is sold to make the corresponding adjustment (i.e., reduction) to their gross income.

Recognizing that a taxpayer may be tempted to include an otherwise non-deductible expense in their COGS, the Code provides that “Any cost which . . . could not be taken into account in computing taxable income for any taxable year shall not be treated as” an adjustment to COGS.[xxvii] In this context, “cost” means expenses that would otherwise be deductible;[xxviii] thus, the taxpayer cannot circumvent the prohibition against claiming a deduction for an expense – for example, under Section 280E of the Code – by including the expense in their COGS.

With the forgoing introduction to Section 280E, let’s return to the Taxpayer’s petition.

The Sixteenth Amendment

In its petition, the Taxpayer makes the point that the power of Congress to tax under the Sixteenth Amendment is limited to taxing “income.”[xxix]

The Sixteenth Amendment reads as follows: “Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

It is the Taxpayer’s position that the reference to “income” in the Sixteenth Amendment necessarily means “taxable income,” and not gross receipts or gross income.

Thus, according to the Taxpayer, the term “income” requires, as explained above, that gross receipts from a business be reduced not only by COGS (the difference being gross income), but also by the ordinary and necessary expenses incurred by the business in generating such receipts (the difference being taxable income).[xxx]

The Taxpayer claims that, because Section 280E denies a deduction for such ordinary and necessary expenses, it creates an “income” tax on amounts in excess of “constitutional income” within the meaning of the Sixteenth Amendment.

The Taxpayer concludes, therefore, that Section 280E of the Code is unconstitutional.

Will Cert be Granted?

No.

I’m not even sure why the Taxpayer filed a petition for cert with the Supreme Court in light of the fact that, on October 13 of this year,[xxxi] the Court denied the petition of another taxpayer that challenged the constitutionality of the federal government’s treatment of cannabis.[xxxii] Among the issues presented by that petition was whether Congress, consistent with the Due Process Clause of the Fifth Amendment, could criminalize medical cannabis without exception, even for patients who require its daily administration to live.

The Taxpayer’s petition ends by explaining that only the Court can “fix” the conflict between the laws of so many states, on the one hand, and Section 280E, on the other, by declaring that Section 280E is unconstitutional and, thus, should not be enforced.

Although the Taxpayer’s statement is correct insofar as the Court’s authority is concerned, their efforts are misplaced, which may also explain why the Court will deny cert – if the state of the law is to change, it will be up to Congress to change it.

In fact, Congress has recently tried to decriminalize and de-schedule cannabis.[xxxiii] After being introduced in the House, the bill, H.R.3884, known as the Marijuana Opportunity Reinvestment and Expungement Act of 2019 (the “MORE” Act), cleared the House Judiciary Committee by a vote of 24 to 10, including two Republicans (from California and Florida), and was sent to the full chamber for consideration on November 21, 2019. After several delays, it was announced earlier this month that a vote in the House is planned for December 2020.[xxxiv] It will pass the House.

The bill was also introduced in the Senate as S.2227,[xxxv] and was referred to the Finance Committee in July of 2019. No other action has been taken[xxxvi] and, assuming a Republican-controlled Senate with Mr. McConnell at the helm, the likelihood of a vote on the Senate floor is remote.

That being said, Sen. Romney has stated that cannabis should be removed from the list of Schedule 1 controlled substances, though he opposes its legalization for recreational use.[xxxvii]

Which brings us to Georgia, with both of its Senate seats to be decided by runoff elections to be held on January 5, 2021.[xxxviii] As the Peach State goes, so the country goes?

Meanwhile, the absence of legislative change at the federal level will allow the IRS and other federal agencies to continue their enforcement of Section 280E of the Code and of the Controlled Substances Act as they relate to cannabis and its derivatives.


[i] https://www.dw.com/en/cannabis-in-high-demand-amid-coronavirus-pandemic/a-53336180 .

[ii] Did you expect me to say something about “reaching new highs?”

For those of you who follow this blog, you know that I am not shy about sharing my opinions. In this case, I side with Saruman, the Lord of Isengard, when he says to Gandalf, “your love of the halflings’ leaf has slowed your mind,” and then again, when describing Radagast the Brown as a “foolish fellow,” he says, “It’s his excessive consumption of mushrooms! They’ve addled his brain and yellowed his teeth!”

[iii] https://www.nytimes.com/article/coronavirus-weed-marijuana.html . Yep, cannabis and groceries. https://www.newyorker.com/magazine/2020/05/11/was-quarantine-made-for-cannabis

[iv] Alcohol sales have increased by 24% during the pandemic, with bipartisan support. Folks on both sides of the political aisle need their vices. https://www.npr.org/2020/09/11/908773533/hangover-from-alcohol-boom-could-last-long-after-pandemic-ends .

Query whether a grateful public will consider the current “contributions” of sin businesses in determining whether to set a place for them at the qualified opportunity zone table once society has established its new equilibrium?

[v] New Jersey, Arizona, South Dakota, and Montana.

[vi] https://disa.com/map-of-marijuana-legality-by-state . Over 40 states allow some medical use of the plant.

[vii] https://www.wamc.org/post/gov-cuomo-wamcs-roundtable-11520 ; https://www.taxlawforchb.com/2020/11/new-yorks-post-election-tax-environment-for-business-owners/ .

[viii] Public Law 116-136.

[ix] Assuming we ever see the enactment of such legislation.

[x] Health and Economic Recovery Omnibus Emergency Solutions (“HEROES”) Act, H.R. 6800, Sec. 110606.

[xi] Last year, the House Judiciary Committee approved a bill (H.R. 3884) that would decriminalize cannabis and remove it from the list of federally controlled substances.

Another bill, passed by the House (H.R. 1595), would have provided a cannabis business with greater access to banks.

[xii] According to Jamie Dimon, U.S. lawmakers are failing the country in their inability to reach a compromise on fiscal stimulus. At a virtual NYT conference last week, he stated “We have this big debate: Is it $2.2 trillion, $1.5 trillion? You’ve got to be kidding me.” Dimon added that the lawmakers should “Just split the baby and move on. This is childish behavior on the part of our politicians.” https://www.bloomberg.com/news/articles/2020-11-18/jpmorgan-s-dimon-says-congress-is-being-childish-on-stimulus

[xiii] No, the Justices are not on drugs.

[xiv] Standing Akimbo, Ltd. Liab. Co. v. United States, 955 F.3d 1146 (10th Cir. 2020), which affirmed the District Court (2018 WL 6791104 United States District Court, D. Colorado).

https://www.supremecourt.gov/search.aspx?filename=/docket/docketfiles/html/public/20-645.html . The case was docketed on November 12, 2020. The Government’s response is due December 14, 2020.

[xv] Specifically, the Controlled Substances Act.

[xvi] IRC Sec. 161 and Sec. 162.

[xvii] See Controlled Substances Act, P.L. 91-513, Sec. 202.

[xviii] 274 U.S. 259 (1927).

[xix] For example, rent or compensation.

[xx] For example, bribery, or an illegal kickback.

In response to the defendant’s argument in Sullivan, that “if a return were made, the defendant would be entitled to deduct illegal expenses, such as bribery,” Holmes responded, “This by no means follows, but it will be time enough to consider the question when a taxpayer has the temerity to raise it.”

[xxi] IRC Sec. 161 and Sec. 162.

[xxii] Within the meaning of schedule I and II of the Controlled Substances Act.

[xxiii] Cannabis, Business Expenses, and the Code | Tax Law for the Closely Held Business (taxlawforchb.com) .

[xxiv] https://www.dea.gov/controlled-substances-act .

[xxv] IRC Sec. 63(a).

[xxvi] Reg. Sec. 1.61-3(a); Reg. Sec. 1.162-1(a). Basically, the cost of acquiring inventory, either through purchase or production.

[xxvii] IRC Sec. 263A(a)(2).

[xxviii] Reg. Sec. 1.263A-1(c)(2).

[xxix] The Sixteenth Amendment reads as follows: “Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

[xxx] IRC Sec. 162 business expenses.

[xxxi] After the passing of Justice Ginsberg and before the appointment of Justice Barrett.

[xxxii] Washington v. Barr, which sought review of a decision rendered by the Courts of Appeals for the Second Circuit. https://www.marijuanamoment.net/supreme-court-declines-to-hear-marijuana-case-challenging-deas-restrictive-classification/ ; https://www.supremecourt.gov/search.aspx?filename=/docket/docketfiles/html/public/20-148.html .

[xxxiii] https://www.congress.gov/bill/116th-congress/house-bill/3884/text.

[xxxiv] https://www.cannabisdispensarymag.com/article/us-house-plans-december-vote-on-more-act/ .

[xxxv] By Sen. Kamala Harris. https://www.congress.gov/bill/116th-congress/senate-bill/2227 .

[xxxvi] Ah, the power of the majority leader.

[xxxvii] https://www.sltrib.com/news/politics/2018/09/24/romney-wilson-split-utahs/ ; https://www.isidewith.com/candidates/mitt-romney/policies/healthcare/marijuana .

[xxxviii] https://www.taxlawforchb.com/2020/11/the-2020-elections-are-almost-over-what-now/ .

https://www.jdsupra.com/legalnews/taxing-cannabis-during-the-pandemic-69206/