Tax Court Upholds $4.2M Assessment Against California-Based Cannabis Dispensary

On February 17, 2021, the U.S. Tax Court published its opinion, San Jose Wellness (“SJW”) v. Commissioner¹. SJW operates as a medical cannabis dispensary under California law. As a result of the Tax Court’s opinion, SJW was ordered to pay tax deficiencies plus penalties of approximately $4.2 million on business deductions improperly claimed for tax years 2010-2012, 2014 and 2015.

IRC Sec. 280E – Background

In 1982, Congress enacted IRC Sec. 280E. With the exception of cost of goods sold (“COGS”), which is treated as a reduction from gross income, IRC Sec. 280E denies all federal tax deductions and credits from gross income if a taxpayer is engaged in the business of the manufacture, distribution or sale of certain controlled substances classified as a Schedule I or Schedule II substance pursuant to the 1970 Controlled Substances Act.

Under the Federal Controlled Substances Act, cannabis is labeled as a Schedule I drug. Therefore, any cannabis sales activity is considered trafficking under federal law. IRC Sec. 280E prevents cannabis businesses from enjoying the benefit of otherwise ordinary business deductions, clearly making it the most significant tax issue affecting the industry.

Key Rulings from San Jose Wellness

• The Tax Court referenced several of its previous rulings disallowing deductions under IRC Sec. 280E.

• • Judge Toro wrote in the opinion: “The requirements of Section 280E are clear and the hypotheticals posited by SJW are not relevant to these cases,”
• The Tax Court disallowed SJW’s deductions for depreciation and charitable contributions claimed under IRC Sec. 280E.

• • SJW was unsuccessful in arguing depreciation and charitable contributions are not “paid or incurred in carrying on a business”, and hence are allowable deductions.
• The Tax Court held SJW liable for a 2015 accuracy-related penalty of $181,423 due to the previous rulings that rejected arguments similar to SJW’s.

• • SJW could have avoided the penalty if it demonstrated it acted with reasonable cause and in good faith.
• SJW’s argument to avoid IRC Sec. 280E because its business sold items other than cannabis was denied by the Tax Court.

The Tax Court’s ruling against SJW dealt yet another blow to the cannabis industry in its struggle to claim as many deductions as possible. The Tax Court continues to deny non-COGS deductions in the case of a cannabis dispensary operating legally under state law, reinforcing IRC Sec. 280E and building upon prior case law precedent and the original congressional intent of IRC Sec. 280E.

With the mounting court losses for cannabis businesses, calls are growing louder for Congress to either downgrade the cannabis drug classification or remove it entirely from the Controlled Substances Act to release it from the shackles of IRC Sec. 280E. An attempt to do this was made through the MORE Act right after the November election, but was not taken up by the Senate. Therefore, if it is to be addressed, it must be taken up anew by both chambers in the new Congress. With pandemic relief taking all the spotlight recently, the status of a new vote on cannabis decriminalization is unknown right now.

¹ 156 T.C. No. 4