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Tax Court Decides Whether A Tax on Marijuana Sales Is An Unconstitutionally Excessive Fine

The Tax Court's majority decision dealt another blow to marijuana advocates trying to fight Section 280E.

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Current tax laws are killing the buzz for legal marijuana sales dispensaries. Section 280E disallows any business-related expenses connected to the trafficking of Schedule I controlled substances, which includes marijuana. The IRS and the courts have consistently held that Section 280E is clear on its face when they mean all expenses are nondeductible. However, this next case takes an interesting twist as the taxpayer and its lawyers try to show the U.S. Tax Court that Section 280E is unconstitutional.

Last month, the U.S. Tax Court decided Northern California Small Business Assistants, Inc. v. Commissioner. There, the Court considered whether Section 280E of the Internal Revenue Code is an excessive fine in violation of the Eighth Amendment.

The facts are typical. The taxpayer was a corporation operating a marijuana dispensary business in California where it is legal. The IRS audits the taxpayer and disallows all of the taxpayer’s business expenses citing Section 280E. The IRS then proposes $1.5 million dollars in taxes and penalties for one year. The taxpayer disagrees and petitions the U.S. Tax Court.

The case was interesting enough to warrant a decision from all 15 judges. While all of them ruled that the IRS’s disallowance was proper, the judges were split on whether Section 280E implicates the Eighth Amendment of the Constitution. To do so, the court had to determine whether Section 280E had the effect of a penalty.

In the majority opinion, 10 of the judges held that Section 280E’s disallowance of marijuana-related business expenses was not a penalty. The majority acknowledged that Congress had the unquestionable Constitutional right to create tax laws. Furthermore, they also noted that the Supreme Court has held that tax deductions are granted only by Congress.

In the dissenting opinions, three of the judges ruled that Section 280E was a fine, although they joined the majority siding with the IRS because there was no finding of excessiveness. Judge Gustafson starts by stating that the Constitution allows Congress to tax income. The Constitution does not define income but Judge Gustafson states that income is defined as gain which is only determined after all relevant businesses expenses are deducted from gross income. To tax solely on gross income could lead to an unfair situation where the taxpayer may not have any money to pay the tax.

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For example, if a taxpayer earned $100 but his business expenses totaled $150, he would realize a loss of $50 and under normal circumstances he would not be taxed because it would add insult to his financial injury. If only his gross income was taxed he would have to pay income tax on the $100 even though he has no money after expenses.

Judge Gustafson states that for a payment to be a penalty, it must be imposed as punishment for an unlawful act. It does not matter whether a payment is labeled differently, like a tax, a tariff, or a fee. In this case, according to the legislative history, Section 280E was enacted with the explicit goal of deterring and penalizing marijuana trafficking. By disallowing deductions, income taxes will increase and the profit motive will decrease. He believes this has the effect of punishment even though it is not explicitly stated as such.

Two judges had no opinion on whether Section 280E was a fine since there was no determination on excessiveness.

So while the majority of the Tax Court judges ruled that Section 280E was not a fine, three held that it was a fine and could be excessive in violation the Eighth Amendment of the Constitution. And two are on the fence. If they can disagree, so could other judges and even other circuits.

Professor Bryan Camp over at the TaxProf Blog believes that the majority got it right.

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He believes that Congress has the Constitutional right to tax gross income even if business deductions are disallowed. Why? Because if Section 280E can be a penalty, then so can Section 163(h) which allows the ever-popular home mortgage deduction. In other words, the home mortgage interest deduction punishes renters for not owning a home. Also, since hobby losses are nondeductible, he believes that this would open the doors for tax protestor hobbyists to argue that they are being penalized.

In short, he’s arguing that this can open Pandora’s Box.

Should Congress have the “unquestionable” power to tax as the majority of the Tax Court judges believe? Most believe that it is better for the legislature to pass tax laws as they are directly accountable to the people. But what if Congress wanted to pass a law that taxes a certain group of people differently? For example, some believed that the Tax Cuts and Jobs Act’s $10,000 limitation on state tax deductions unfairly targeted high tax states where the residents predominately voted Democratic. It was so bad that it got to the point where New York and other blue states sued. That lawsuit was recently dismissed.

While any tax law can treat people differently, when does it get to a point of being a penalty that can implicate the Eighth Amendment? Perhaps a good place to start is to determine whether a tax punishes or subsidizes behavior. Some taxes are known to be penalties. For example, “sin taxes” are taxes imposed on certain goods (such as alcohol and cigarettes) that are known to be harmful to society.

But some tax laws act as subsidies. For example, the federal government provides tax credits for the purchase of alternative fuel cars in order to boost sales and promote use of alternative fuel. These credits do not covertly penalize those who purchase gasoline engine cars assuming the prices of the cars were fairly steady before the tax and will continue to remain that way.

Some tax laws can be neither subsidies nor penalties. It can just be a means to raise revenue. Or to curb abusive transactions.

Of course, the line can be difficult to draw. Reasonable people will have different opinions.

While the Tax Court’s majority decision dealt another blow to marijuana advocates trying to fight Section 280E, the split decision opened the door for courts to consider whether the Section may be unconstitutional. If enough judges disagree, the issue may end up being decided in the high court.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at [email protected]. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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