Challenging IRS authority to deny “ordinary and necessary” business expense deductions

By Tosin Hassan, CPA, CohnReznick

In the words of Lauryn Hill, “It’s funny how money changes a situation, miscommunication leads to complication.” With the explosion of cannabis businesses across the country, many business owners are not profitable because of significant tax bills impacting cannabis providers’ bottom line. Internal Revenue Code (IRC) Section 280E prohibits plant-touching cannabis businesses from deducting “ordinary and necessary” business expenses from their gross income, because marijuana is classified as a Schedule I controlled substance under the Controlled Substance Act (CSA).

Does the IRS have statutory and constitutional authority to deny cannabis businesses ordinary and necessary business deductions? Alpenglow Botanicals, LLC, along with owners Charles William and Justin Williams, challenged this argument with the United States Court of Appeals for the Tenth Circuit (seeAlpenglow Botanicals, LLC V. United States, July 2018).

Alpenglow is a medical marijuana business operating in Colorado. After an audit of their 2010, 2011 and 2012 tax returns, the IRS denied a variety of ordinary and necessary business expenses claimed by Alpenglow under §280E. The IRS concluded that Alpenglow had, “committed a crime of trafficking a controlled substance in violation of the CSA”.

Alpenglow challenged the IRS’ decision and asserted the following claims in its lawsuit:

• They were not criminal convicted of a crime
• The IRS did not have adequate evidence that they were trafficking controlled substances
• The IRS did not have statutory authority to disallow the deductions under § 280E
• The IRS’s calculation of their income violates the 16^thAmendment by disallowing cost of goods sold under § 263A
• That § 280E is a penalty and violates the Eighth Amendment

Alpenglow management alleged they were entitled to the business deductions they claimed when filing their tax returns, because they had not been investigated, charged or found guilty of violating a federal law by a judge.

The Alpenglow case was dismissed “for failure to state a claim upon which relief can be granted” under the Civil Procedure Rule 12(b)(6).

The courts concluded that under§6201(a), The IRS has the authority to determine whether and when to deny deduction under § 280E. Also, per the courts, § 280E, “Has no requirements that the Department of Justice conduct a criminal investigation or obtain a conviction before § 280E applies.”

The court’s decision resulted in additional taxes due to the higher taxable income after § 280E was applied to the 2010, 2011 and 2012 tax returns filed by Alpenglow. The additional taxes were passed on to the owners Charles Williams and Justin Williams, because of the flow-through structure of Alpenglow.

To avoid costly legal bills and enormous tax penalties that will trickle down to individual owners based on their entity’s structure, cannabis businesses must adhere to § 280E when preparing their tax returns. Properly identifying expenses related to cost of goods sold and disallowing ordinary and necessary business expenses will reduce additional tax penalties assessed by the IRS.

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