Cannabis Businesses’ Tax Litigation: The Lessons Learned

July 6, 2018Articles Law360

Internal Revenue Code Section 280E creates incredibly harsh tax treatment for state legal cannabis companies. Why? During the War on Drugs of the 1980s, the U.S. Congress determined that in addition to punishing drug dealers under the criminal statutes, they would increase their taxes. So, drug dealers are not allowed deductions for ordinary and necessary business expenses in determining their tax liabilities. While the definition of drug dealer has evolved under state law, because federal law has not changed, the 1980s War on Drugs continues through the Internal Revenue Code.[1] To avoid constitutional limitations, Section 280E does allow cannabis businesses to deduct their cost of goods sold.[2] 

Given this harsh tax regime, after taxes are paid, cannabis businesses operate at very low margins and, as a result, are fighting for every last dollar of inventory cost. The Internal Revenue Service audit rate of the cannabis industry is extremely high. My clients report that all the business owners they know are under audit. Cannabis businesses are struggling for relief from the harsh consequences of Section 280E and the lack of clarity in determining exactly which costs can be included as inventory costs.[3] In the past month, the courts have issued opinions that give cannabis businesses some additional guidance on tax issues. The cases include Alterman v. Commissioner of Internal Revenue, Loughman v. Commissioner of Internal Revenue and Alpenglow Botanicals LLC v. U.S.[4]

Alterman: Keep Good Records, Hire Competent Professionals, Apply Section 280E

Due to the fact that most cannabis businesses have banking challenges and, due to the lack of sound credit card processing options, are required to accept only cash from customers, cannabis businesses conduct countless transactions in cash. Cannabis businesses need to have tight internal controls over that cash to substantiate to the IRS that they have properly reported their sales. In addition, when cash is used to pay costs, reliable controls must be in place so that those payments can substantiate inventory costs during the audit. Cannabis businesses also need to maintain meticulous inventory records. A failure to properly maintain inventories creates further exposure. 

That’s what happened in the Alterman case.[5] When the Altermans filed their tax returns, they appropriately reduced gross receipts by cost of goods sold. However, they also deducted business expenses. It does not appear based on the findings of fact that the taxpayer disallowed any expenses pursuant to Section 280E on the original return. It also appears that the amount of cost of goods sold claimed on the return was, for the most part, only amounts paid for purchases of inventory and did not include indirect production costs. At trial, the taxpayer asserted that it incurred over $100,000 of production costs each year in addition to the amounts paid for purchases of inventory. 

However, even though the court concluded that Section 471 entitles taxpayers to a deduction for indirect production costs, the court denied a deduction for additional production costs not conceded by the IRS because the taxpayer failed to maintain proper beginning and ending inventories. The problem here was that the tax returns for most of the years in question reported beginning and ending inventories as zero. The court found it “implausible” that beginning or ending inventories would be zero. Further, there was no information, such as physical counts and per item cost information, in the record allowing the court to compute beginning and ending inventories. 

The even greater danger of failing to keep good records and hire competent professionals is that, in addition to denying reductions from gross income for cost of goods sold, the court will impose penalties. Here, the court found that the Altermans were negligent because they did not keep adequate records to compute beginning and ending inventories. Further, there was no reasonable cause because the taxpayers did not seek advice regarding inventory accounting or the application of Section 280E.

Loughman: Be Prepared for an Unsympathetic Ear

Section 280E often creates double taxation. For example, this happens when an owner of a cannabis business owns property leased to the business or performs services for the business. Unless these items are inventory costs — i.e. if the property leased is solely a grow or production facility — they are not included in cost of goods sold. However, when paid to the taxpayer or owner, they must be included in income as wages, guaranteed payments or rent. 

This was the primary issue in the Loughman case. Here, the operators of a Colorado cannabis dispensary argued that Section 280E discriminates against Subchapter S corporation shareholders by double taxing income when shareholder salary is disallowed pursuant to Section 280E as a deduction from flow-through S corporation income and is also included on the shareholder’s individual tax return as W-2 wages. The U.S. Tax Court concluded that the regime was not discriminatory because Section 280E disallows a deduction for salaries not attributable to inventory costs whether or not the salaries are paid to the shareholder.

The only way to avoid this outcome is if the owner’s sole responsibility is activities related to the production of inventory. However, it is unlikely that, except in certain circumstances, an officer/owner’s responsibilities do not include some sort of management and oversight. While making an election to be taxed as a C corporation can minimize the cost of double taxation in this situation, it won’t eliminate it.

The inequitable nature of Section 280E is unlikely to gain sympathy in the courts. In 1950, in addressing the penal nature of the Marihuana Tax Act, the U.S. Supreme Court held that “a tax does not cease to be valid merely because it regulates, discourages, or even definitely deters the activities taxed.”[6] In Loughman, the court noted that taxpayers have the option to elect to be taxed as any type of entity and to operate in any line of business. Simply, in order to avoid double taxation and profit-draining tax effective tax rates caused by Section 280E, you are advised to operate a business not subject to Section 280E. 

Alpenglow Botanicals: IRS Can Determine That Section 280E Applies Without a Criminal Investigation

The term “eggshell audit” is a term of art in the tax world. An eggshell audit is one where there is concern that the government may have a position that a criminal statute was violated or that there has been a violation of criminal tax laws. When this is the case, there is always a concern that continuing to cooperate in an IRS civil audit will result in the taxpayer providing self-incriminating evidence to the IRS that law enforcement agencies could use in a criminal proceeding. However, the courts have held that if the IRS asked about whether there is a criminal proceeding or a potential criminal proceeding, the IRS official must be honest in answering this question. If they aren’t, the criminal investigation can be tainted and indictments and convictions can be overturned.[7] In fact, the U.S. attorneys’ manual provides that: “attorneys and agents must take care not to affirmatively mislead targets about a criminal prosecution in order to obtain information from them, nor use a civil or administrative proceeding as a stalking horse to develop evidence for the criminal case.”[8] Given this backdrop, it is unlikely that a criminal investigation will be going on without the taxpayer’s knowledge. 

Alpenglow Botanicals and several other taxpayers have sought injunctions to stop IRS audits of cannabis businesses based on the basic notion that providing information about their — federally — criminal enterprise violates their Fifth Amendment rights and creates exposure to criminal prosecution. The Tax Court, the district courts, and the Tenth Circuit have all determined that: (1) civil audits are not criminal investigations, (2) when it is conducting a civil audit of a business to determine that it properly reported and paid its taxes, the IRS is not required to initiate a criminal investigation to determine whether a taxpayer is subject to Section 280E and (3) taxpayers bear the burden of proving an IRS finding of trafficking is wrong.[9] When he was still on the Tenth Circuit, now Justice Gorsuch illuminated that “[i]n tax court, after all, it’s the petitioners who carry the burden of showing the IRS erred in denying their deductions — and by invoking the privilege and refusing to produce the materials that might support their deductions the petitioners no doubt made their task just that much harder.”[10]

To be sure, there are instances where tax laws violated Fifth Amendment rights by requiring disclosure of information that invoked a substantial hazard of incrimination. For example, in 1969, Timothy Leary was successful in overturning the Marihuana Tax Act because it required a buyer of marijuana to complete and file with the IRS a form that disclosed the name and address of the transferor, name and address of the transferee, and the amount of marijuana involved.[11] Then, the IRS regularly provided the forms to law enforcement who used the forms to bring criminal charges for violations of drug laws. In that case, the court found that “the Act was clearly aimed at bringing to light violations of the marihuana laws.”[12] In contrast, in Alpenglow Botanicals, the Tenth Circuit determined that Section 280E is different because statutes, such as the Marihuana Tax Act, “involve the imposition of a tax for specific illegal conduct, not the denial of a tax deduction.”[13] Further, “Alpenglow has failed to cite a single case in which the government relied on a denial of deductions under Section 280E as evidence of guilt in a criminal trial.”[14] Without evidence that the IRS is using information gathered in IRS civil audits to initiate criminal proceedings or inform other law enforcement agencies of criminal activity, the courts have been unwilling to intervene in IRS civil exams. 

Where Do We Go From Here?

Complying with Section 280E is an onerous burden for businesses already subject to complex regulatory regimes. Taxes will drive some businesses into the red and perhaps out of business. The STATES Act[15] proposes to remove state legal businesses from the Controlled Substances Act which would remove the Section 280E burden. However, cannabis businesses that operate during years when Section 280E applies should be prepared to deal with burdensome tax liabilities and the close scrutiny associated with IRS examinations.

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