Medical Marijuana Facility Found Not to Have Other Business, All General Expenses Disallowed Under §280E

The taxation of medical marijuana clinics came back into the Tax Court in the case of Olive v. Commissioner, 139 TC No. 2, later appealed to the Ninth Circuit who affirmed the lower court.  In this case, in addition to reminding us of the Tax Court’s previous holding that IRC §280E holds to prevent the deduction of expenses other than costs of sales related to the operation of such a clinic (a position the Court put forward in the 2007 case of Californians Helping to Alleviate Med. Problems, Inc., 128 TC 173), the Court dealt with some additional items.

First among these was the taxpayer’s assertion that he should be allowed to retain less formal documentation than other businesses because the industry tends to operate in cash and shuns formal documentation.  Thus he should be allowed to use his rather informal ledgers to support his deductions.

As you might expect, the Tax Court wasn’t terribly impressed with that view.  As the Court noted

Neither Congress nor the Commissioner has prescribed a rule stating that a medical marijuana dispensary may meet that substantiation requirement merely by maintaining a self-prepared ledger listing the amounts and general categories of its expenditures. It is not this Court's role to prescribe the special substantiation rule that petitioner desires for medical marijuana dispensaries and we decline to do so.

The Court did decide that it had sufficient information to compute an estimated cost of sales pursuant to the Cohan rule.  The taxpayer’s expert had testified, based on his experience, to a percentage of sales that generally represented the cost of sales in the medical marijuana industry.  The Court used that as its starting point to estimate a cost of sales.

However, the Court found that all of the other expenses would be disallowed under the provisions of IRC §280E.  IRC §280E provides:

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.

Although the sale of medical marijuana was legal under the state law in question (California), federal law still prohibits the sale of marijuana.  In Californians Helping to Alleviate Med. Problems, Inc. the Tax Court had found that the fact the business might be considered legal under state law did not impact the application of §280E in determining the federal tax status

In the Californians Helping to Alleviate Med. Problems, Inc. case the Court had found that taxpayer had other business operations in addition to its medical marijuana dispensing operation and thus only disallowed a portion of the general expenses.  However, in this case the Court found that the other real business being operated was the medical marijuana operation and thus no deduction should be allowed.

Specifically, the fact that the taxpayer operated a lounge of sorts and had a social area was deemed primarily to support the marijuana operation.  The Court specifically noted that the name of the business (the Vapor Room) certainly indicated a primary emphasis on the medical marijuana operation, as well the source of revenue for the operation.

The Court did find that only a portion of the tax would be subject to the accuracy related penalty under §6662.  The portions of the assessments where adjustments were made due to sloppy documentation were found to be items of a type where a penalty was justified. 

However, the IRS had agreed the taxpayer had documentation for some of the claimed business expenses that the Court disallowed under §280E.  The Court noted that the tax years in question were before 2007 when the Court had first ruled on the question of the deductibility of such expenses for medical marijuana operations.  As that was an unsettled area of the law when the returns were filed, the Court found it was not appropriate to impose an accuracy related penalty on the portion of the tax due that related to substantiated general business expenses.

The taxpayer, not happy with the decision appealed to the Ninth Circuit Court of Appeals (Case No. 13-70510, 2015 TNT 132-13), arguing the Tax Court had erred in not looking at whether the entity’s entire business consisted of trafficking in controlled substances.  He argued that since the organization provided other services §280E could not apply at all to him.

And, the taxpayer pointed out, in the interim Congress had spoken on the issue and, in any event, his business wasn’t what Congress was looking to control. 

The Ninth Circuit didn’t accept any of this.  First, the Court pointed out that the phrasing of the statute properly allows for an entity to have more than one trade or business.  But, the Court noted, the Vapor Room provided other services at no cost to the individuals there.  The Court likened this to a bookstore that allowed individuals to sit in a relaxing area and provided coffee at no cost—in that case the sole trade or business of the entity would be selling books and the provision of coffee and seating served solely to support the book sales. 

It would be different, the Court noted, if the bookstore also contained a full service coffee shop where coffee and pastries were consumed in a café like setting and the items were not provided at cost, that bookstore would have more than one trade or business.  But that was not the case here.

The panel also rejected the taxpayer’s view that since state legal marijuana dispensaries did not exist when Congress passed §280E that it should only apply to street dealers.  The opinion notes:

That Congress might not have imagined what some states would do in future years has no bearing on our analysis. It is common for statutes to apply to new situations. And here, application of the statute is clear. See Chamber of Commerce of U.S. v. Whiting, 131 S. Ct. 1968, 1980 (2011) (stating that “Congress’s authoritative statement is the statutory text” (internal quotation marks omitted)). Application of the statute does not depend on the illegality of marijuana sales under state law; the only question Congress allows us to ask is whether marijuana is a controlled substance “prohibited by Federal law.” I.R.C. § 280E. If Congress now thinks that the policy embodied in § 280E is unwise as applied to medical marijuana sold in conformance with state law, it can change the statute. We may not.

But, the taxpayer argued, Congress had prohibited the use of funds to prevent states from implementing such laws.  Clearly that indicated that Congress did not intend for the law to apply to him and, in fact, the government was prohibited from doing so.

The Court disagreed, noting:

Finally, for three reasons, we are not persuaded by Petitioner’s argument that section 538 of the Consolidated and Further Continuing Appropriations Act, 2015, Pub. L. No. 113-235, 128 Stat. 2130, precludes the government from continuing to defend Petitioner’s appeal. First, statements by a later Congress do not inform us about the intent of a previous Congress. See Mackey v. Lanier Collection Agency & Serv., Inc., 486 U.S. 825, 840 (1988) (“The views of a subsequent Congress form a hazardous basis for inferring the intent of an earlier one.” (internal quotation marks and brackets omitted)). Second, a decision not to expend funds to enforce a particular statute says nothing about the meaning of that statute. “What one house of Congress thinks, in the 2010s, about enforcement priorities for the agency is entirely uninformative about the intent of Congress when it enacted a statute in [an earlier year].” Navarro v. Encino Motorcars, LLC, 780 F.3d 1267, 1277 n.5 (9th Cir. 2015). Third, section 538 does not apply. It provides that certain funds may not be used to prevent states, such as California, “from implementing their own State laws that authorize the use, distribution, possession, or cultivation of medical marijuana.” Pub. L. No. 113-235, § 538 (emphasis added). Here, the government is enforcing only a tax, which does not prevent people from using, distributing, possessing, or cultivating marijuana in California. Enforcing these laws might make it more costly to run a dispensary, but it does not change whether these activities are authorized in the state.