By: Allen Todd Paxton, Associate
It was business as usual for the ten member majority, but three dissenting judges of the United States Tax Court (“Tax Court”) broke new ground in Northern California Small Business Assistants Inc. [1] finding section 280E of the Internal Revenue Code unconstitutional.
The petitioner in the case is a California medical marijuana dispensary organized as a C corporation. The respondent, the Internal Revenue Service (“IRS”), issued the petitioner a Notice of Deficiency, claiming “a deficiency in petitioner’s 2012 income tax of $1,264,212 and an accuracy-related penalty under section 6662(a) of $252,842.40.”[2] After receiving that notice, the petitioner filed for review in the Tax Court.
Once before the Tax Court, the petitioner filed a motion for partial summary judgment, in which it argued section 280E: (1) imposes a gross receipts tax as a penalty in violation of the Eighth Amendment to the Constitution; (2) eliminates only ordinary and necessary business deductions under section 162 and does not apply to other distinct sections of the code; and (3) does not apply to marijuana businesses legally operated under State law.[3]
The majority rejected all of these arguments and denied the motion for partial summary judgment. Addressing the petitioner’s arguments in order, the majority held (1) “that section 280E is not a penalty provision”[4] that could violate the Eighth Amendment; (2) “that section 280E means what it says–no deductions under any section shall be allowed for businesses that traffic in a controlled substance;”[5] and (3) that “[p]etitioner has offered us no compelling reason to overrule our caselaw”[6] applying section 280E to cannabis businesses operating in compliance with state law.
Despite agreeing with majority’s denial of the motion for partial summary judgment (insofar as the denial rested on procedural grounds), Judge Gustafson authored a robust dissent. Joined by Judges Copeland and Gale, Judge Gustafson disagreed with the majority’s handling of the taxpayer’s arguments that section 280E is unconstitutional. The dissenters argued that section 280E, which denies all deductions to cannabis businesses, is unconstitutional, as “the Sixteenth Amendment does not permit Congress to impose such a tax.”[7]
The Sixteenth Amendment permits Congress to “collect taxes on incomes.”[8] Taxable income under the Sixteenth Amendment “may be defined as the gain derived from capital, from labor, or from both combined.”[9] To compute gain (and therefore income), certain items, such as basis and cost of goods sold, are constitutionally “mandatory exclusion[s]”[10] from income.
According to the dissenters, business expense deductions, to an extent, are also constitutionally mandatory exclusions. While acknowledging that Congress has “wide latitude” to disallow particular business expense deductions,[11] the dissenters think section 280E goes too far, as it does not “simply deny ‘a deduction’ . . . . Rather, . . . [w]here section 280E applies, it allows “no deduction”; it disallows all deductions. The result of section 280E is that the determination of the supposed ‘income tax’ liability of a taxpayer trafficking in illegal drugs bypasses altogether any inquiry as to his gain.”[12] As a result, “this wholesale disallowance of all deductions transforms the ostensible income tax into something that is not an income tax at all, but rather a tax on an amount greater than a taxpayer’s ‘income’ within the meaning of the Sixteenth Amendment.”[13]
On the other hand, the majority saw section 280E’s denial of deductions to be a congressional exercise of “legislative grace.”[14] In their view, “any deductions from gross income are a matter of legislative grace and can be reduced or expanded in accordance with Congress’s policy objectives.”[15] As a result, the majority did not find that section 280E runs afoul of the Sixteenth Amendment. Responding to this argument, Judge Gustafson offered this critique:
If this “legislative grace” adage denotes something true, it unfortunately seems to connote that the Government exercises largesse when it lets the taxpayer keep some of his income; and the opinion of the Court illustrates the way in which the adage can be invoked to distort or exaggerate Congress’s discretion under the Sixteenth Amendment.[16]
Ultimately, the majority did nothing new here, following a long line of precedent subjecting cannabis businesses to section 280E. The significance of this case, however, lies with the dissent and cannot be understated. This is the first time a judge has declared section 280E unconstitutional; further, it was not just one judge who advanced this view, but three.
This case is complex, with five different opinions addressing several different issues. For example, most of the majority opinion is devoted to rejecting the taxpayer’s Eighth Amendment argument. That, along with other facets of the case, will be discussed in later blog posts.
[1] N. Calif. Small Bus. Assistants Inc. v. C.I.R., 153 T.C. No. 4 (2019).
[2] Id . at 2.
[3] Id . at 4.
[4] Id. at 6.
[5] Id. at 14.
[6] Id. at 15.
[7] Id. at 33.
[8] U.S. Const. amend. XVI.
[9] Eisner v. Macomber, 252 U.S. 189, 206–207 (1920) (emphasis added).
[10] 153 T.C. No. 4 at 28 (Gustafson, J., dissenting).
[11] Id. at 31.
[12] Id. at 32.
[13] Id. at 33.
[14] N. Calif. Small Bus. Assistants Inc. v. C.I.R., 153 T.C. No. 4 at 8.
[15] Id.
[16] Id . at 24 n.1 (Gustafson, J., dissenting).
