Alert

Podcast: Denial of Tax Deductions for Marijuana Businesses – Who is this Inter-Loper to Section 280E?

November 7, 2024

Read Time: 12 mins

Has the Supreme Court’s opinion overturning the Chevron doctrine altered the landscape for the denial of tax deductions for marijuana businesses under Section 280E of the Internal Revenue Code?  We explore that question in this podcast.

Douglas Charnas: Welcome to our podcast on the effect of the Supreme Court’s decision in Loper Bright Enterprises, which overturned the Chevron doctrine on Section 280E of the Internal Revenue Code.

I’m Douglas Charnas, a member of McGlinchey’s Washington, DC office. I practice corporate and tax law. I’m joined today by my colleague Perry Salzhauer, the co-chair of McGlinchey’s Cannabis Industry group.

Perry is located in McGlinchey’s, Seattle, Washington, office. He represents clients on a broad range of corporate and environmental matters. His years of working on business processes, SEC, and environmental compliance have made him uniquely qualified in the emerging cannabis space, where navigating complex compliance and regulatory implementation is a major barrier to entry and ultimate success.

I think we need to set the stage for our discussion. Perry, let me briefly review the relevant Internal Revenue Code provisions that affect whether a marijuana business can reduce its gross receipts by its business costs, and then turn it over to you to briefly review the Supreme Court’s decision in Loper. Section 162 of the Internal Revenue Code allows most businesses to deduct business expenses, such as wages, rent, utilities, advertising, and insurance. Anyone in the marijuana business, however, is well aware of the crushing effect Section 280E of the Internal Revenue Code has on profitability. It substantially increases the cost of doing business because it disallows deductions for expenses related to “trafficking” in marijuana. It overrides Section 162 by disallowing businesses expenses that otherwise are deductible.

Section 162 of the Internal Revenue Code allows most businesses to deduct business expenses, such as wages, rent, utilities, advertising, and insurance. Anyone in the marijuana business, however, is well aware of the crushing effect Section 280E of the Internal Revenue Code has on profitability.

While Section 162 generally allows a deduction for business expenses, Section 263A of the Internal Revenue Code contains the uniform capitalization rules. These rules require certain direct and indirect costs allocable to real or tangible personal property produced by the taxpayer to be included in either inventory or capitalized into the basis of such property, as applicable. For real or personal property acquired by the taxpayer for resale, Section 263A generally requires certain direct and indirect costs allocable to such property to be included in inventory.

The Internal Revenue Code giveth and the Internal Revenue Code taketh away. While Section 162 generally allows deductions for business expenses, Section 263A takes those deductions away for some expenses and requires them to be capitalized.

Perry, I suspect you may be asking yourself why Doug is boring me with this tax talk and what does it have to do with Section 280E and a marijuana business’s expenses. The answer lies in the United States Constitution.

Under the Constitution, direct taxes must be apportioned among the states on the basis of population. The Sixteenth Amendment removed the apportionment requirement for “taxes on income,” thereby making an unapportioned income tax possible. There is some question as to what the Sixteenth Amendment means when it uses the term “income.” Does it mean gross receipts or gross income or net income? Congress was aware of this issue when it enacted Section 280E in 1982 and was careful to make clear that the reduction to gross receipts for the cost of goods sold was not affected by Section 280E. What this means is that a marijuana business can reduce its gross receipts by the cost of goods, but it cannot deduct its ordinary and necessary business expenses.

Congress was aware of this issue when it enacted Section 280E in 1982 and was careful to make clear that the reduction to gross receipts for the cost of goods sold was not affected by Section 280E. What this means is that a marijuana business can reduce its gross receipts by the cost of goods, but it cannot deduct its ordinary and necessary business expenses.

Perry Salzhauer: Doug, let’s take a breather here so that we can all understand this. The application of Section 280E means that a marijuana business can reduce its gross receipts, that is, all the money it collects from its marijuana business activities for the cost of its goods sold, but it cannot deduct its ordinary and necessary business expenses, such as wages, rent, utilities, advertising, and insurance.

Douglas: You got it.

Perry: You also said that Section 263A requires taxpayers to include some expenses in the cost of goods sold for their inventory. Let me see if I follow this. Section 162 generally allows a deduction for ordinary and necessary business expenses, but for a marijuana business, Section 280E disallows the deduction for those expenses. However, Section 280E does not disallow gross receipts to be reduced by the cost of goods sold. That is, marijuana businesses can reduce gross receipts by the cost of goods sold.

Douglas: You got it so far.

Perry: But then you said Section 263A requires some ordinary and necessary business expenses to be capitalized and added to the cost of goods sold for inventory. So, if that is the case, doesn’t Section 263A allow a marijuana business to essentially deduct business expenses for which Section 280E disallows a deduction?

Douglas: That is certainly a logical argument. So logical, in fact, that Congress decided it needed to amend Section 263A to prevent taxpayers from adding expenses to inventory for which a deduction is disallowed under Section 280E. It added language to Section 263A that says no cost can be added to the cost of inventory sold if such cost is disallowed in computing taxable income.

Perry: You were not kidding when you said the Code giveth and the Code taketh away. Let’s go through this again to make sure that everyone understands this:

• Section 162 generally allows a deduction for ordinary and necessary business expenses.
• Section 280E disallows a deduction for ordinary and necessary business expenses for marijuana businesses.
• However, Section 280E does not disallow a marijuana business from reducing its gross receipts by the cost of goods sold.
• The uniform capitalization rules of Section 263A require some ordinary and necessary business expenses to be capitalized and added to the cost of goods sold for inventory.
• This looks like it might allow marijuana businesses to add to the cost of goods sold some expenses disallowed under Section 280E.
• But Congress amended Section 263A to make clear that expenses denied under Section 280E could not be added to inventory.

Douglas: Could not have said it better myself.

Perry: Are we ready to move on to the Supreme Court’s decision in Loper?

Douglas: Not yet. Hang in there Perry. Just one more Code provision to cover.

The Tax Cuts and Jobs Act added Section 471(c) to the Code. It exempts small businesses – those generating average annual gross receipts of $25 million or less – from the general rule for valuing inventory and, thus, cost of goods sold. A qualifying business is not required to use the uniform capitalization rules under Section 263A. Instead, it can elect to conform to its internal accounting procedures as the basis for valuing inventories on its tax return.

So what does this accounting provision have to do with whether a marijuana business can add to the cost of goods sold expenses disallowed under Section 280E? Well, certain qualifying marijuana businesses, that otherwise would be subject to business expenses being disallowed under Section 280E, could potentially account for their inventory under Section 471(c) using a method that would classify most or all of their expenses as inventoriable costs, thereby avoiding Section 280E’s disallowance of such expenses. Because all costs would be capitalized into inventory, the marijuana businesses would reduce taxable income as the inventory was sold. Is this an end run around Section 280E?

Perry: That certainly would be a good result, but didn’t Congress add language to Section 471(c) like it did with Section 263A to disallow any expenses from being added to the cost of goods sold that are otherwise disallowed in computing taxable income?

Douglas: That is precisely the question that is at the heart of this podcast. Congress did not add language to Section 471(c) like it did with Section 263A. Clearly, Congress is aware of the issue. By not providing such language, you could argue that it is reasonable to assume that Congress intended to allow marijuana-related expenses to be added to the cost of goods sold if doing so conforms to its internal accounting procedures.

By not providing such language, you could argue that it is reasonable to assume that Congress intended to allow marijuana-related expenses to be added to the cost of goods sold if doing so conforms to its internal accounting procedures.

Perry: I know that Treasury issued final regulations under Section 471(c), and I am assuming the regulations address this issue.

Douglas: Final regulations have been issued. And you are right, the final regulations do include language that an inventory cost does not include a cost that is neither deductible nor otherwise recoverable but for Section 471(c). Arguably, this language would exclude from an inventory cost a cost that is disallowed as a deduction under Section 280E. Without language like that in Section 263A, the authority of this argument is questionable.

Perry: Well, that certainly was a long windup, but that is often the case when you are talking tax. Hopefully, we can now move on to a discussion of the interplay between Section 471(c) and the Supreme Court’s decision in Loper overruling the Chevron doctrine. The Supreme Court’s decision in the Chevron case in 1984 involved the level of deference that a court must give an agency’s interpretation of a statute that agency administers. The Supreme Court’s decision in Chevron required courts to defer to “permissible” agency interpretations of the statutes the agency administers, even when a reviewing court reads the statute differently.

The Supreme Court’s decision in Chevron required courts to defer to “permissible” agency interpretations of the statutes the agency administers, even when a reviewing court reads the statute differently.

This principle of deference to administrative agency interpretation has been a cornerstone of administrative law for nearly four decades and one that Chevron opponents had looked to overturn for years. In fact, I would say that around 2/3rds of my Environmental Law LLM coursework revolved to some extent around the application of what lawyers have called “Chevron Deference.”

Enter Loper Bright Enterprises, Inc. v. Raimondo and Relentless, Inc. v. Dep’t of Commerce, a pair of cases that sought to overturn the Chevron deference. In these jointly reviewed cases, the Supreme Court overturned Chevron (a six to three decision) and held that the Administrative Procedures Act requires courts to exercise their independent judgment in deciding whether an agency acted within its statutory authority, and courts may not defer to an agency interpretation of the law simply because the law is ambiguous.

Douglas: Does this mean that now courts have to ignore an agency’s interpretation of its enabling or authorizing statutes?

Perry: Like with 471(c), it’s not that simple, Doug. In holding that the APA requires courts to exercise their independent judgment in deciding whether an agency has acted within its statutory authority in interpreting a statute, the Supreme Court is not saying that agency interpretations should be ignored. It acknowledges that a statute may delegate authority to an agency. On this point, the opinion makes the following statement, which I am quoting: “Careful attention to the judgment of the Executive Branch may help inform that inquiry. And when a particular statute delegates authority to an agency consistent with constitutional limits, courts must respect the delegation, while ensuring that the agency acts within it. But courts need not and under the APA may not defer to an agency interpretation of the law simply because a statute is ambiguous.”

“Careful attention to the judgment of the Executive Branch may help inform that inquiry. And when a particular statute delegates authority to an agency consistent with constitutional limits, courts must respect the delegation, while ensuring that the agency acts within it. But courts need not and under the APA may not defer to an agency interpretation of the law simply because a statute is ambiguous.”

Douglas: Perry, it seems like the Supreme Court left open the door for Congress to delegate to agencies the authority to exercise discretion in certain cases. The Court’s opinion provides that when a statute “delegates authority to an agency consistent with constitutional limits,” that courts fulfill their obligation “to independently interpret the statute and effectuate the will of Congress” by “ensuring the agency has engaged in ‘reasoned-decision-making.’” I interpret this language to mean that if Congress delegates authority to an agency and if a court finds that the agency engaged in reasoned decision-making, then the count should defer to the agency rule.

Perry: Well, Doug, in my opinion, this aspect of the Loper Bright decision is fairly consistent with the established precedent under the “Chevron Doctrine.” Historically, the “Chevron Doctrine” dictates that courts use sort of a sliding scale, if you will, based on the text of a particular statute, to determine the extent to which a court may substitute its reasoning and interpretation for that of the agency. Viewed in this light, these decisions more or less move that sliding scale somewhat by making it clear that even when a statute is ambiguous, the court can’t be forced to simply defer to the agency interpretation.

Douglas: If the Supreme Court left open the door for Congress to delegate to agencies the authority to exercise discretion, does the Congressional delegation of authority have to be expressed, or can it be implied?

Perry: Scholars and practitioners have offered differing views on this question, and I don’t think we will know the answer until the courts have settled this issue. What the Supreme Court’s decision does make clear is that there is no implied delegation if a statute is ambiguous. There must be something more than just ambiguity.

Douglas: Let’s turn back now to Section 471(c). I mentioned earlier that Section 471(c) is unlike Section 263A in that it does not contain a provision stating that an expense cannot be added to the cost of goods sold of inventory if it is otherwise disallowed in computing taxable income. The final regulations under Section 471(c) try to remedy the absence of such language in Section 471(c) by including language that an inventory cost does not include a cost that is neither deductible nor otherwise recoverable but for Section 471(c).

In adding this provision, did Congress delegate to the Department of Treasury, whether expressly or impliedly, the authority to exercise its discretion?

Perry: Section 471(c) does not contain any provision expressly or impliedly delegating authority to Treasury to interpret this section. Nor is there any delegation in the legislative history. Section 471(c) contains a cross-reference to Section 263A for rules relating to the capitalization of direct and indirect costs, but this appears to be for informational purposes only.

Section-specific delegations of regulatory authority are quite common in the Internal Revenue Code. The Code also contains Section 7805(a), which is a general grant of authority to Treasury to “prescribe all needful rules and regulations for the enforcement of this [Code].” It is unlikely that the Supreme Court considers this general grant of authority to be the type of delegation that requires deference if the agency has engaged in reasoned decision-making. Thus, there is no expressed or implied delegation of authority to Treasury for Section 471(c).

Douglas: Where does this leave us, Perry, with respect to Section 471(c)?

Perry: We have an IRS regulation that says you cannot use Section 471(c) to account for inventory in a manner that allows you to include in the cost of the inventory expenses that could not be deducted under Section 280E. That is, you cannot use Section 471(c) as an end-around of Section 280E. The authority for this position in the regulations is now questionable because there is no language in Section 471(c) comparable to that in Section 263A that disallows an expense to be added to the cost of inventory if the expense cannot be deducted under Section 280E. A court interpreting Section 471(c) would not be required to defer to the regulations. I want to say that another way: after Loper Bright, the IRS cannot argue to a court that it must accept its interpretation that a business cannot use 471(c) to include inventoriable costs that would otherwise be disallowed under 280E simply because 471(c) is ambiguous on that point; that is, the statutes say absolutely nothing about it. But, of course, that doesn’t mean that the IRS couldn’t argue that its interpretation should be enforced for some other reason.

After Loper Bright, the IRS cannot argue to a court that it must accept its interpretation that a business cannot use 471(c) to include inventoriable costs that would otherwise be disallowed under 280E simply because 471(c) is ambiguous on that point; that is, the statutes say absolutely nothing about it. But, of course, that doesn’t mean that the IRS couldn’t argue that its interpretation should be enforced for some other reason.

In addition, while the authority for the rule in the final regulations may be questionable, and a court is not required to defer to the regulations when interpreting Section 471(c), the final regulations present two problems. First, taxpayers are potentially subject to penalties for failing to follow tax regulations. The regulations are sufficiently clear so that including inventory expenses that cannot be deducted under Section 280E likely would be viewed by a court as failing to follow the tax regulations, assuming the court found the regulations valid.

The second problem is more of a practical problem. If a marijuana business uses a professional tax preparer to prepare its tax returns, the tax preparer may not sign the return if it contains a position that conflicts with the regulations.

Douglas: This is going to be something that marijuana businesses will need to discuss with their tax lawyers and accountants. What the Supreme Court’s decision in Loper has done is take away the upper hand that the IRS has in a tax case by removing the requirement that the court defer to the regulations. It increases the likelihood of success in challenging a regulation, but taking a tax return position contrary to regulations remains risky. Is there anything a marijuana business can do now?

Perry: As you noted, this is something that a marijuana business should discuss with its tax lawyer and accountant. Because we do not know how the courts will interpret Section 471(c), it may be advisable for a marijuana business to position itself so that it can benefit from Section 471(c) should the courts conclude that expenses that cannot be deducted under Section 280E can be added to inventory (or production) costs under Section 471(c). If a marijuana business is inclined to litigate this issue, it might consider filing its return following the regulations but then filing an amended return claiming a refund by taking the position that expenses disallowed under Section 280E can be added to inventory (or production) costs under Section 471(c). The IRS likely would deny the refund claim, thereby giving the marijuana business the right to sue for a refund.

If a marijuana business is inclined to litigate this issue, it might consider filing its return following the regulations but then filing an amended return claiming a refund by taking the position that expenses disallowed under Section 280E can be added to inventory (or production) costs under Section 471(c). The IRS likely would deny the refund claim, thereby giving the marijuana business the right to sue for a refund.

Douglas: Perry, this has been a very interesting discussion. We will be seeing the effects of the Supreme Court’s decision in Loper for many years to come. While the Loper decision doesn’t fix the Section 280E problem the way rescheduling marijuana would, it gets the camel’s nose under the tent for challenging the regulations under Section 471(c) to allow taxpayers to add to inventory (or production) costs expenses that could not be deducted under Section 280E.

I wanted to thank our listeners for joining us today. The cannabis team at McGlinchey is ready to assist you with any cannabis-related issues that you may have.