Court Denies ERC Refund to Cannabis Dispensary Under IRC 280E

On January 30, 2026, the U.S. Court of Federal Claims issued its decision in Gravenstein 116, LLC v. United States, holding that a cannabis dispensary cannot claim the Employee Retention Credit (ERC), including its refundable portion. The court held that IRC Sec. 280E disallows “any deduction or credit” for businesses trafficking controlled substances under federal law, and refundability does not change a credit’s characterization under IRC Sec. 280E.  

Background of Gravenstein  

The taxpayer operates three cannabis dispensaries in California under state law. While legal under California law, on the federal level cannabis remains a Schedule I controlled substance. IRC Sec. 280E disallows any deduction or credit of business engaged in trafficking federally prohibited substances.  This includes any substance that is classified as Schedule I or Schedule II under the Controlled Substances Act, including cannabis. 

The taxpayer filed amended employment tax returns seeking ERC refunds for the first and second quarters of 2021. Congress enacted the ERC under the CARES Act in 2020 as a refundable payroll tax credit to incentivize employers to retain their employees during COVID-19. If the credit exceeds an employer’s payroll tax liability, the taxpayer may still receive the excess amount as a cash refund. 

The question before the court was whether the refundable portion of the ERC qualifies as a credit under IRC Sec. 280E. The taxpayer argued that once the ERC becomes refundable, it functions as a non-tax subsidy rather than a tax credit and therefore falls outside the scope of IRC Sec. 280E. 

The Court’s Approach: Statutory Text Controls 

The court rejected this argument. Applying the plain language of the statute, the court noted that IRC Sec. 280E disallows “any deduction or credit” under the Code. The court held that refundability does not change the credit’s legal character. Even if the ERC produces a cash payment exceeding the taxpayer’s payroll tax liability, the law still treats it as a credit for federal tax purposes. Furthermore, the court rejected policy-based arguments related to the ERC’s pandemic-relief purposes and emphasized that statutory texts governs. As a result, the court denied the taxpayer’s refund claim as a matter of law. 

Ongoing Federal Developments 

This result aligns with how courts have treated the interaction between IRC Sec. 280E and other provisions in other instances. In the recent case Ayla A. Savage et al. v. Commissioner, the Tax Court applied IRC Sec. 280E to disallow the deduction of W-2 wages for purposes of IRC Sec. 199A.   

Federal policymakers are reviewing changing cannabis’s classification under the Controlled Substances Act. If finalized, this change should eliminate IRC Sec. 280E’s application to state-legal cannabis businesses. Until that change occurs, courts will continue to enforce IRC Sec. 280E according to its plain language. 

Key Takeaways for Cannabis Businesses 

Gravenstein reinforces three key points: 

• For purposes of IRC Section 280E, refundable credits continue to be treated as disallowed, regardless of their classification. This includes the ERC, even though it functions as a payroll tax credit rather than an income tax credit. Courts continue to enforce IRC Sec. 280E according to its plain terms. 
• State legalization does not alter federal tax treatment. Businesses that operate legally under state law dealing with Schedule I substances under federal law are subject to IRC Sec. 280E’s limitations for federal tax purposes. 
• If you have questions about how this decision affects your cannabis business or pending refund claims, contact our tax professionals below.