Wither the Weed?

It has been one month since Mr. Biden’s inauguration as President of the United States. Among the many questions being asked of President Biden is whether he will seek the decriminalization[i] of cannabis. During the campaign, the Democratic Party’s official position (part of the party’s platform) regarding cannabis was as follows:[ii]

Democrats believe no one should be in prison solely because they use drugs. Democrats will decriminalize marijuana use and reschedule it through executive action on the federal level. We will support legalization of medical marijuana, and believe states should be able to make their own decisions about recreational use. The Justice Department should not launch federal prosecutions of conduct that is legal at the state level. All past criminal convictions for cannabis use should be automatically expunged.

The Democratic Party’s interest in decriminalizing and rescheduling cannabis ostensibly stems from a stated desire to redress the “legacy of racial and ethnic injustices, compounded by the disproportionate collateral consequences of 80 years of cannabis prohibition enforcement,” yet it concludes by calling for “proactive steps to mitigate inequalities in the legal cannabis marketplace and ensure equal participation in the industry.”[iii]

Of course, those businesses that already operate in the “legal cannabis marketplace,”[iv] and many others who would like to enter the industry, have long waited for Federal legislation to clear their path toward a “normal” commercial existence.[v]

Fast forward.

“Mass Pardon?”

Of the approximately fifty-six Executive Orders, Directives and Memoranda (“executive actions” within the meaning of the platform, quoted above) issued by the President since January 20, 2021, none address the issue of cannabis.[vi]

Last week, on February 18, 2021, thirty-seven Members of Congress sent a letter[vii] to President Biden in which they reminded him that, during his campaign for the White House, he committed to expunging all past marijuana convictions for use and possession.

The letter indicated that 36 states have legalized medicinal cannabis, and fifteen states have enacted adult use policies. “Following the lead of voters,” the letter explained, the House passed the Marijuana Opportunity, Reinvestment and Expungement (“MORE”) Act[viii] “to ensure that these programs work as intended.” The MORE Act would also decriminalize cannabis under Federal law.

The letter concluded by urging the President to exercise his power to “to grant executive clemency for all non-violent cannabis offenders.”

Opposition to Writ

One week earlier, on February 12, 2021, the U.S. Department of Justice[ix] filed a brief with the U.S. Supreme Court in opposition to a taxpayer’s petition for a writ of certiorari[x] to the Federal Court of Appeals for the Tenth Circuit.[xi]

The taxpayer is a medical marijuana dispensary that was operated in accordance with Colorado law. The IRS investigated the taxpayer’s returns and, when the taxpayer was not forthcoming with information, the IRS issued a third-party summons to the Marijuana Enforcement Division of the Colorado Department of Revenue. The taxpayer sought to quash the summons, claiming that it lacked a legitimate purpose. The lower courts disagreed with the taxpayer.

In the process, the taxpayer questioned the IRS’s application of the preemption doctrine, pointing out that local criminal activity has “traditionally been the responsibility of the States.” Citing the principles of Federalism and the Tenth Amendment, the taxpayer argued that a Federal criminal statute cannot prohibit an expressly state-legal act unless “explicitly” directed by Congress. The taxpayer also challenged the constitutionality[xii] of Section 280E of the Code – which disallows deductions for expenses paid or incurred in carrying on a trade or business that consists of trafficking in controlled substances – claiming that it results in the taxation of something other than “net income.”

The Justice Department’s brief rejected the taxpayer’s arguments. “The IRS,” it stated, “seeks to obtain information about [the taxpayer’s] marijuana dispensary as part of an investigation into the accuracy of [the taxpayer’s] federal income tax returns, including whether [the taxpayer] claimed any business expense deductions disallowed by” Section 280E of the Code.[xiii] It also rejected the taxpayer’s other assertions.

Another One Bites the Dust

No sooner had the Justice Department responded to the taxpayer in the Standing Akimbo matter, than the U.S. Tax Court issued yet another adverse opinion to yet another medical cannabis dispensary (“Taxpayer”), this time in California.[xiv]

Taxpayer was licensed to sell cannabis to individuals who held a valid doctor’s recommendation to use cannabis. Taxpayer also sold non-cannabis items, including T-shirts, pipes, and batteries. In addition, Taxpayer offered acupuncture and chiropractic services, as well as other “holistic” services.[xv] It did not charge a separate fee for membership, acupuncture, chiropractic services, or any other services.

Taxpayer incurred certain expenses in connection with its operations, which it reported on its Form 1120, U.S. Corporation Income Tax Returns for the years at issue. Among the expenses reported, Taxpayer claimed deductions for depreciation and for charitable contributions.

The IRS disallowed all of Taxpayer’s deductions pursuant to Section 280E of the Code. Taxpayer maintained that Section 280E did not foreclose its deductions for depreciation and charitable contributions because (1) depreciation is not “paid or incurred during the taxable year” and (2) its charitable contributions were not made “in carrying on” a trade or business. Taxpayer also argued that none of its expenses should be disallowed by Section 280E because its business did not “consist of” trafficking in controlled substances.[xvi]

The IRS disputed Taxpayer’s contentions, and issued notices of deficiency that disallowed the deductions claimed. Taxpayer timely filed petitions with the Tax Court seeking redetermination of the income tax deficiencies set forth in the IRS’s notices.

The Court’s Opinion

The question before the Court was whether the deductions for depreciation and for charitable contributions[xvii] fell within the broad prohibition of Section 280E of the Code.

The Court explained that the Code imposes a tax “on the taxable income of every corporation” for each taxable year.[xviii] “Taxable income,” it continued, “is defined as ‘gross income minus the deductions allowed by this chapter.’ ”[xix] The Code further provides that, “[i]n computing taxable income * * *, there shall be allowed as deductions the items specified in this part.”[xx] According to the Court, the referenced “part” includes the deductions for depreciation and for charitable contributions. The “deductions specified in Part VI of Subchapter B of the Income Tax Subtitle of the Code [which includes the deductions for depreciation and for charitable contributions] are ‘subject to the exceptions provided in part IX.’” One of these exceptions is Section 280E.

Section 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.

In other words, a deduction will be disallowed if each of the following conditions is satisfied: (1) the deduction is for an amount paid or incurred during the taxable year; (2) that amount was paid or incurred in carrying on any trade or business; and (3) that trade or business (or the activities that comprise the trade or business) consisted of trafficking in certain defined controlled substances.

In deciding whether the depreciation and charitable contribution deductions claimed by Taxpayer met each of the statutory conditions summarized above – and are therefore disallowed under Section 280E – the Court first addressed Taxpayer’s argument that, because its trade or business included more than the sale of cannabis items, that trade or business did not “consist of” (that is, does not comprise exclusively) trafficking in controlled substances. The Court rejected Taxpayer’s position, stating that it reads “Section 280E to deny business-expense deductions to any trade or business that involves trafficking in controlled substances, even if that trade or business also engages in other activities.”


The Court turned next to Taxpayer’s argument that the depreciation deduction falls outside the scope of Section 280E because depreciation is not “paid or incurred during the taxable year.”[xxi] Taxpayer argued that the meaning of Section 280E is “unambiguous” and that its reach is limited to “deductions and credits for business expenditures.” In Taxpayer’s view, the business expenditures covered by Section 280E included (but were not limited to) the ordinary and necessary business expenses described in Section 162 of the Code.[xxii] But they do not include depreciation because depreciation is not described in Section 162 and is not an amount “paid or incurred during the taxable year.” The Court disagreed with Taxpayer’s contention that depreciation was not “paid or incurred during the taxable year.”[xxiii] When the asset is used to further the taxpayer’s day-to-day business operations, the periods of benefit usually correlate with the production of income, the Court stated. Thus, to the extent that equipment is used in such operations, a current depreciation deduction is an appropriate offset to gross income currently produced. The Court noted, however, that when the consumption of the asset takes place in the construction of other assets that, in the future, will produce income themselves, the cost represented by depreciation does not correlate with production of current income; rather, the cost, although presently incurred, is related to the future and is appropriately allocated as part of the cost of acquiring an income-producing capital asset. In light of the foregoing, the Court concluded that Section 280E applied by its terms to Taxpayer’s circumstances.

Charitable Contribution

Taxpayer next argued that its charitable contributions should be deductible because they were not paid “in carrying on” a trade or business as required by section 280E.

The Court disagreed. Section 280E, it explained, applies to disallow a deduction for “any amount paid or incurred * * * in carrying on any trade or business.” Taxpayer was a corporation that was engaged in a trade or business when it made the relevant charitable contributions. California State law, the Court explained, specifically authorizes a corporation to make charitable contributions, and courts have long permitted corporations to decide whether a charitable gift is consistent with their financial and operational goals. Taxpayer chose to contribute the amounts at issue, and the Court saw no reason to conclude that this action was somehow separate from, or outside the scope of, Taxpayer’s business activities. The Court observed that many other courts have acknowledged the potential benefits to a corporation of making a charitable gift where the so-called gift tends reasonably to promote the goodwill of the business of the contributing corporation. In the view of the Court, Taxpayer contributed the amounts at issue “in carrying on” its trade or business.

Finally, Taxpayer argued that Section 280E should not apply to charitable contributions as a matter of policy, because to decide otherwise could produce unfavorable outcomes for taxpayers who contribute capital property or inventory to charities. These arguments, the Court stated, were beside the point.

Based on the foregoing, the Court concluded that Section 280E applied to Taxpayer’s charitable contributions for the years at issue, and thus that the corresponding deductions were disallowed.

What’s Next?

It appears, notwithstanding the House’s passage of the MORE Act in 2020, that there is no sense of urgency in the Senate to act on that bill.

Moreover, it appears that Mr. Biden is in no hurry to decriminalize cannabis by executive order, let alone push for its legalization.[xxiv] Query whether he even has an appetite for granting a mass pardon of convictions for past marijuana possession and use?

Without any movement by Congress or the President, the Courts – including the Tax Court – have no choice but to continue applying the existing Federal laws under which cannabis is treated as a controlled substance. This means that a cannabis business, operated in a State in which such operation is legal, will be denied a deduction, for purposes of determining its Federal income tax liability, for any expenses paid or incurred in carrying out its business.[xxv]

In the meantime, States like New York – which is hoping to legalize cannabis this year – view the cannabis business as a significant source of future tax revenues. Indeed, if cannabis legislation were passed as proposed by Governor Cuomo, New York’s effective tax rate on cannabis (including its sales tax) would be 20 percent.[xxvi] That’s pretty high, but it’s also on par with other States in which cannabis is legal.[xxvii] It is also another reason why the inability to deduct the expenses paid or incurred by such a business (for income tax purposes) may give pause to anyone who may be considering entering in the industry – just think of the effective Federal income tax rate in the absence of such deductions.[xxviii]

Stay tuned.

[i] Not the same as legalization. If cannabis is decriminalized, an individual would not be prosecuted for possession of up to a specific amount. Legalization, however, would remove all legal prohibitions, as a result of which cannabis would be available for purchase and use by all adults.

[ii] https://alabamapolicy.org/2020/09/08/2020-election-comparing-the-democratic-and-republican-platforms/ .

[iii] See Section 2 of H. Rept. 116-604, which accompanied the MORE Act (see below). https://www.congress.gov/congressional-report/116th-congress/house-report/604/1?overview=closed .

Confused? Me too.

[iv] Legal under the law of the particular State.

[v] Because of its status as a controlled substance, banks are unwilling to make loans to cannabis businesses. For the same reason, these businesses are denied bankruptcy protection. They do not qualify for PPP loans. Although not identified as a “sin business” under the Qualified Opportunity Zone rules, the fact remains that “trafficking in” cannabis is illegal under federal law; thus, it is doubtful that such a business would qualify as a qualified opportunity zone business. Until recently, attorneys were concerned about advising cannabis businesses, lest they are found to be in violation of Federal criminal law and State ethics rules. Many States have addressed this last issue; for example, last year the California Bar Association issued an advisory opinion which stated that attorneys may advise clients on compliance with the State’s cannabis laws. https://calawyers.org/california-lawyers-association/spotlight-on-ethics-california-bar-issues-opinion-on-advising-cannabis-industry-clients/ .

[vi] https://www.marketwatch.com/story/all-of-president-bidens-key-executive-orders-in-one-chart-2021-01-21 .

You may recall that then-candidate Bernie Sanders promised to legalize cannabis in the first hundred days of his administration with “executive action.” Could the President Legalize Marijuana Through Executive Action? – Marijuana Law, Policy, and Authority (vanderbilt.edu).

[vii] https://www.marijuanamoment.net/37-members-of-congress-ask-biden-to-issue-mass-marijuana-pardons-ahead-of-legalization/ .

[viii] H.R. 3848 was passed by the House on December 4, 2020, and was received in the Senate on December 7, 2020, following which it was referred to the Committee on Finance, https://www.congress.gov/bill/116th-congress/house-bill/3884/all-actions?overview=closed#tabs, which is where it remains.

[ix] Now controlled by the Biden Administration.

Interestingly, and in contrast, the Justice Department, on February 10, 2021, withdrew the Federal government’s (i.e., the Trump Administration’s) support in favor of striking down the Affordable Care Act. California v. Texas. Query why its position toward cannabis cases has not changed? I guess the Administration is waiting for Congress to send it a bill.

[x] Basically, an order to the lower court to send up its record of the case to the Supreme Court for its review. Traditionally, four of the nine Justices must vote to accept a case. (Presumably to prevent a majority from dictating which cases the Court will entertain. Good luck finding that in the Supreme Court’s Rules.)

[xi] Standing Akimbo, LLC v. United States, Docket No. 20-645. 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 was originally due December 14, 2020.

We discussed the taxpayer’s petition here: https://www.taxlawforchb.com/2020/11/taxing-cannabis-during-the-pandemic/#_edn14 .

[xii] Under the Sixteenth Amendment to the Constitution.

[xiii] https://www.law.cornell.edu/uscode/text/26/280E .

[xiv] San Jose Wellness v. Comm’r., 156 T.C. No. 4 (Feb. 2021).

[xv] My firm regularly provides such services to stressed-out attorneys – NOT. J

[xvi] Taxpayer must have been under the influence when preparing its arguments.

[xvii] Allowed by Section 167 and Section 170 of the Code, respectively.

[xviii] Section 11(a).

[xix] Section 63(a).

[xx] Section 161.

[xxi] Taxpayer conceded that the depreciation was incurred “in carrying on” a trade or business.

[xxii] Section 162 of the Code allows as a deduction all the ordinary and necessary expenses paid or incurred by a taxpayer during the taxable year in carrying on any trade or business.

[xxiii] According to the Court, Taxpayer’s contention is foreclosed by the Code and Supreme Court precedent. Section 7701(a)(25) of the Code provides that, “[w]hen used in this title, where not otherwise distinctly expressed or manifestly incompatible with the intent thereof,” “[t]he terms ‘paid or incurred’ * * * shall be construed according to the method of accounting upon the basis of which * * * taxable income is computed under subtitle A.” Generally, “[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” Sec. 446(a).

During the taxable years at issue, Taxpayer used the accrual method of accounting, a permissible method under Section 446 of the Code. Focusing on the concept of depreciation, the Court noted that over a period of time a capital asset is consumed and, correspondingly over that period, its theoretical value and utility are thereby reduced. Depreciation is an accounting device which recognizes that the physical consumption of a capital asset is a true cost, since the asset is being depleted. As the process of consumption continues, and depreciation is claimed and allowed, the asset’s adjusted income tax basis is reduced to reflect the distribution of its cost over the accounting periods affected. The Court stated “[T]he purpose of depreciation accounting is to allocate the expense of using an asset to the various periods which are benefited by that asset.”

[xxiv] Yes, I know, it has been only one month, and folks are preoccupied with the proposed $1.9 trillion relief package. By the same token, such an environment may have been perfect for such executive action, and would have been welcomed by the Party’s more liberal wing.

[xxv] This may be of general interest: https://www.taxlawforchb.com/2018/06/cannabis-business-expenses-and-the-code/ .

[xxvi] https://taxfoundation.org/new-york-marijuana-tax/.

[xxvii] For other states’ taxes, see: https://taxfoundation.org/state-excise-taxes-on-recreational-marijuana-2020/ .

[xxviii] The power to tax . . .