A recent Treasury Department review of IRS practices showed that auditing marijuana businesses pays off, and cannabis industry attorneys say they expect more scrutiny and enforcement to come.
According to the March 30 report from the Treasury Inspector General for Tax Administration, marijuana industry audits in fiscal year 2019 resulted in more than $145,000 in federal tax adjustments per return on average. For tax returns flagged for auditing by the IRS’ standard algorithm, the average adjustment was only around $43,000. TIGTA estimated the IRS was missing out on $48.5 million in tax revenues annually from marijuana businesses in Washington, Oregon and California and recommended the agency increase compliance efforts targeting the industry.
“The TIGTA report pretty much said, ‘Hey, IRS, you get a lot more bang for the buck here. And these cannabis audits, you should do a lot more of them,’” said Nick Richards, a partner at Greenspoon Marder and a former trial lawyer for the IRS.
It’s not clear how much future compliance efforts will focus on Colorado companies. Almost every marijuana business in the state has been audited already, according to Richards, while retail marijuana operations in states like California, Nevada and Massachusetts now have a few years of tax returns on file, making them ripe for review by the revenue agency.
“One of the things that the IRS wants to do with its audit power is educate the taxpayer public. And the Colorado cannabis industry has been educated,” he said. But TIGTA recommended the IRS increase audits across the board, Richards added, so Colorado won’t necessarily be spared.
The marijuana industry’s tax woes are rooted in Section 280E of the Internal Revenue Code, which prohibits businesses from deducting expenses incurred in the production, distribution and sale of controlled substances. The inability to deduct business expenses has resulted in an effective federal tax rate of up to 90% for marijuana companies.
While the TIGTA report mostly addresses the IRS’ efforts in 280E compliance, Hall Estill shareholder Jennifer Benda said she also expects to see an increase in audits of Form 8300, which businesses need to file when they collect more than $10,000 in cash.
A change to the tax code under the Tax Cuts and Jobs Act of 2018 has left some cannabis tax experts wondering whether one new provision, Section 471(c), created a loophole to escape the troubles caused by 280E. “Under this new provision, marijuana businesses could argue they are entitled to use a method of accounting that includes all expenses in cost of goods sold to potentially avoid the impact of I.R.C. section 280E,” said the TIGTA report, which recommended the IRS provide guidance on the question. Richards said there is debate around whether 471(c) does away with 280E and called the possibility “very intriguing” and “almost too good to be true.”
Marijuana businesses have fought 280E and its enforcement in court, with little success. In October, the Tax Court rejected a California medical marijuana dispensary’s argument that 280E is an excessive fine under the Eighth Amendment.
One of the best-known cases to come out of Colorado was brought by Breckenridge-based Alpenglow Botanicals, whose owners had filed a refund suit to recover deductions banned by 280E. Alpenglow argued the tax provision was unconstitutional under the Eighth and 16th Amendments and the IRS lacks the authority to prohibit deductions under 280E without a criminal conviction.
The case was dismissed by the district court, and the 10th Circuit affirmed the lower court’s decision. In June 2019, the U.S. Supreme Court announced it would not hear Alpenglow’s appeal.
Most recently, the 10th Circuit on April 7 ruled against Denver medical marijuana dispensary Standing Akimbo, which had petitioned to quash summonses the IRS had issued as part of a 280E investigation. The decision offered few surprises, according to attorneys. Tom Downey, director at Ireland Stapleton Pryor & Pascoe, said the appellate court’s decision “merely affirmed what we had known before.” Benda said the court had already opined on the same issues, “and those arguments are continuing to get very little traction.”
Richards said some of the “misinformed arguments” about 280E that have been raised in courts have only hurt the industry, adding he has gotten good results for clients by settling cases, rather than going to trial.
“The cases that have been tried are uniformly misinformed,” Richards said. “The principles that are being advocated, particularly in the 10th Circuit, are based on flawed knowledge of the tax system, frankly.”
While the courts have offered little relief to the marijuana industry so far, Benda said there are a couple cases she is paying attention to. One deals with whether marijuana dispensary Harborside Health Center should be able to include indirect inventory costs to increase its costs of goods sold and lower its tax burden.
The second is about whether an employee leasing company set up by a licensed marijuana company is also subject to 280E. The Tax Court ruled against the taxpayers in both cases, but they are now on appeal in the 9th Circuit.
The attorneys weren’t optimistic a legislative solution to the industry’s heavy tax burden would come soon, either. “Congress doesn’t have to legalize marijuana. It can simply amend 280E,” Downey said, but “it’s certainly not going to happen this year.”
Even changing 280E might be a hard sell politically. “With all the spending that’s going on and the fact that tax rates have been lowered over the past couple of years,” Benda said, “it would be very hard to repeal 280E because they would need to plug that hole in the budget.”
—Jessica Folker