United States: Denver-Based Court Of Appeals Issues Two Important Cannabis Rulings

In the last few week, the Denver-based United States Court of Appeals has issued two decisions important to Colorado's burgeoning cannabis industry.
Both cases relate to the applicability of section 280E of the Internal Revenue Code. Section 280E denies a taxpayer all deductions and credits for any amount paid or incurred by a business that traffics in controlled substances, as defined under federal law. This provision has been a thorn in the side of cannabis companies operating lawfully under state law, significantly increasing their cost of doing business, as they generally must report more income and pay more tax than they otherwise should under general tax principles.

In both cases, the Court evidences a hostility to arguments centered around the criminal element of 280E. In determining that section 280E applies, the IRS is essentially determining as a matter of fact that a taxpayer is (in the eyes of federal law) engaging in an illegal business. The Court has not been sympathetic to the underlying concern that the federal government could use the IRS's auditing and summons authority as a back-door to building a criminal case against cannabis companies. In both cases, the criminal element has not swayed the court. Each case is described in more detail below.

Feinberg v. Commissioner:

In Feinberg, the Tenth Circuit affirmed the Tax Court's determination that the taxpayer was not entitled to deductions and credits for its medical marijuana dispensary pursuant to section 280E.
Much of the opinion focuses on the Tax Court's insertion of a substantiation issue not raised by the IRS in its notice of deficiency, but ultimately the Court affirmed the Tax Court on the basis that the taxpayers had not introduced any evidence to show that the IRS erred in determining they were in the medical marijuana business. As such, the opinion does not address the scope of the section 280E bar, but it does reaffirm two important points. First, it held that the taxpayer, not the IRS, bears the burden on section 280E. Also, it rejects an argument many cannabis companies appear to be making in 280E cases — that requiring them to prove that 280E does not apply violates the Fifth Amendment privilege against self-incrimination. Most cases in the 280E space involve corporations, which have otherwise have no fifth amendment rights. Here, the taxpayers were faced with the Hobsonian choice of either providing evidence that they are not engaged in the trafficking of a controlled substance or forgoing the tax deductions available by the grace of Congress. This did not sway the court and it refused to see that placing the taxpayer in such a position constituted a violation of their fifth amendment privileges.

High Desert Relief, Inc. v. United States:

In High Desert Relief, the Tenth Circuit affirmed district courts' denials of the taxpayer's motions to quash summons issued to third-party banks. High Desert Relief ("HDR") is a cannabis company that had refused to comply with IRS's Information Document Requests ("IDRs") unless the IRS assured HDR that it would not use that information in a subsequent criminal investigation. The IRS refused and it issued summons to third-party banks. In several district courts, HDR sought to quash the summons, which the courts rejected.

On appeal, HDR put forth two arguments: First, it argued that the district court erred when it determines that the IRS satisfied its burden under the Powell factors and that the IRS's investigation did not proceed in good faith. Second, it argued that the district courts erred in not applying a "dead letter rule" to the IRS's motion to enforce. Each will be described in more detail below.

As to the first, under United States v. Powell, 379 U.S. 48, 57 (1964), the IRS demonstrates it issued a summons in good faith when it meets four factors: (1) the investigation will be conducted pursuant to a legitimate purpose"; (2) "the inquiry may be relevant to the purpose"; (3) "the information sought is not already within the Commissioner's possession"; and (4) "the administrative steps required by the [Internal Revenue] Code have been followed. Once the IRS satisfies this "slight" burden, the taxpayer must demonstrate that enforcement would constitute an abuse of the court's process.

The IRS must also demonstrate that it has not referred the matter to the Department of Justice for criminal prosecution. Here, the IRS satisfied this burden by putting forth an affidavit from an IRS agent that stated no referral had been made. It did not matter that the IRS indicated that it was investigating whether section 280E applied. As to the second factor, HDR argued that the investigation did not have a legitimate purpose because it is essentially a disguised criminal investigation. In examining 280E, the IRS would be determining that HDR would be engaging in criminal activity, which is outside of the bounds of its statutory authority. The Court rejected this argument for lack of evidence. The Court continued to find that the remaining factors were satisfied.

As to the second, HDR argued that the IRS cannot deny it deductions pursuant to 280E because "the underlying public policy that § 280E purports to vindicate as to marijuana trafficking–that is, the policy regarding marijuana trafficking embodied in the [Controlled Substances Act]–is a 'dead letter.'" There is a limited exception to the general deductibility of ordinary and necessary business expenses if it would be otherwise against public policy, which HDR characterizes as the very purpose that 280E serves. The Court easily rejected this argument because this exception only applies when Congress has not directly spoken on an issue. Since Congress specifically denied the deductions in 280E, this argument has no applicability here.

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