In a significant ruling for the cannabis industry and tax practitioners representing clients in the sector, the United States Court of Federal Claims has issued a memorandum and order in Gravenstein 116, LLC v. The United States. The decision provides a strict statutory interpretation of Internal Revenue Code (I.R.C.) § 280E, rejecting the taxpayer’s novel argument that the refundable portion of the Employee Retention Credit (ERC) constitutes a "non-tax refund" rather than a credit subject to the 280E disallowance.

Factual Background

The plaintiff, Gravenstein 116, LLC, operates cannabis dispensaries in California under the name "Solful". The plaintiff’s business activities consist of selling marijuana, which remains a controlled substance listed on Schedule I of the Controlled Substances Act. During the COVID-19 pandemic, specifically throughout 2020 and 2021, the plaintiff was subject to state and local health orders that restricted commerce, forcing a transition to "almost exclusively" curbside pickup operations and increasing operational costs.

The plaintiff contended that it met the statutory requirements for the ERC for the first and second quarters of 2021, asserting it paid qualifying wages of $215,408.84 and $244,614.37, respectively. Consequently, the plaintiff filed Forms 941-X claiming a total refundable ERC of $322,016.25. When the IRS failed to adjudicate the refund claims within six months, the plaintiff filed suit in the Court of Federal Claims.

The Taxpayer’s Argument for Relief

The plaintiff acknowledged the general applicability of I.R.C. § 280E, which disallows any "deduction or credit" for businesses trafficking in controlled substances. However, the plaintiff attempted to bifurcate the ERC, arguing that "the refundable portion of the Employee Retention Credit is not a tax credit subject to Section 280E".

The core of the plaintiff’s argument was structural. They asserted that "while the form of the ERC is that of a tax credit, the substance of the amounts in excess of an employer’s tax liabilities is that of a non-tax refund of wages paid". By characterizing the refundable portion as a subsidy for employment rather than a traditional tax credit, the taxpayer argued it fell outside the specific prohibition of § 280E.

The Court’s Analysis of the Law

The government moved to dismiss the complaint under Rule 12(b)(6), arguing that § 280E’s prohibition applies to the entirety of the ERC. Judge Eleni M. Roumel granted the motion, relying on a strict textualist interpretation of the Code and established Supreme Court precedent regarding refundable credits.

Statutory Construction

The court began with the plain text of the statutes. I.R.C. § 280E explicitly states that "[n]o deduction or credit shall be allowed" for trafficking businesses. Simultaneously, I.R.C. § 3134, which established the ERC, explicitly labels the incentive as "a credit against applicable employment taxes".

The court applied the canon of statutory construction that assumes identical words used in different parts of the same act have the same meaning. The court noted that "the Code unequivocally labels the ERC as ‘a credit’" and that the plaintiff failed to provide evidence that the term "credit" in § 280E differs in meaning from the term in § 3134. Consequently, "Section 280E’s bar on eligibility for tax credits must be read to encompass the ERC".

Refundability and Precedent

The court dismantled the plaintiff’s argument that the refundable nature of the ERC alters its classification as a credit. The court relied heavily on Sorenson v. Secretary of Treasury, 475 U.S. 851 (1986). In Sorenson, the Supreme Court held that refundable credits (specifically the Earned Income Credit) are treated as overpayments of tax, but this structure does not change the definitions of words within the Code.

Judge Roumel wrote that "the Internal Revenue Code does not discriminate between a refundable credit and other credits". Citing the Second Circuit’s decision in Israel v. United States, the court reaffirmed that even when a refundable credit acts as an antipoverty mechanism or subsidy, terms used elsewhere in the Code retain their meaning. Therefore, the plaintiff’s assertion that the ERC is a "non-tax refund" was rejected as having no authority in the Code.

Rejection of Policy Arguments

The plaintiff also argued that the remedial purpose of the CARES Act—"keeping Americans employed and paid"—should override the § 280E bar. The taxpayer sought to distinguish its legal state operations from "illegal cocaine dealer[s]".

The court declined to engage in this "purposivist analysis" where the statutory text was clear. The opinion noted that "Section 280E does not distinguish between different types of drug traffickers but rather applies equally to any business that ‘consists of trafficking in controlled substances’".

In a pointed footnote, the court addressed the plaintiff’s comparison to cocaine dealers, observing that "the distinction does not reflect well upon Plaintiff" because marijuana remains a Schedule I drug, which is statistically more restrictive than Schedule II, where cocaine is listed. The court concluded that "Congress did not grant this Court the authority to weed through different types of trafficking and determine that only some are subject to Section 280E’s bar based on policy rationales".

Conclusion

The court held that I.R.C. § 280E unambiguously applies to the Employee Retention Credit. The court stated definitively: "Section 280E’s anti-trafficking bar squarely applies to the Employee Retention Credit, including the refundable portion of the credit". Because the plaintiff acknowledged its business consisted of trafficking in controlled substances, it was ineligible for the credit as a matter of law.

The Motion to Dismiss was granted, and the complaint was dismissed. This decision reinforces the broad scope of § 280E and suggests that arguments attempting to reclassify refundable credits as subsidies to avoid 280E limitations are unlikely to succeed in the Court of Federal Claims.

Prepared with assistance from NotebookLM.