A majority of the Tax Court concluded in the case of Northern California Small Business Assistants Inc. v. Commissioner, 153 TC No. 4,[1] that the denial of deductions for those operating businesses trafficking in cannabis is not a fine. Therefore, the provision could not be found to be an excessive fine.

The Eighth Amendment to the U.S. Constitution provides:

Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.

The taxpayer, a medical marijuana dispensary operating under California law that allows such operations, argued that IRC §280E served as an excessive fine under the Eighth Amendment and thus should be disregarded by the Court.

IRC §280E provides:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Marijuana is defined by statute to be a controlled substance, and thus all deductions or credits related to the operations are denied by the statute aside from those properly deducted as a cost of sale.

The majority opinion finds that the denial of a deduction is not a fine under this provision of the Constitution. First, the Court notes that the 16th Amendment gives the Congress the absolute right to tax income and that deductions are also left to Congress’ discretion.

Congress has the power to lay and collect income taxes under Article I, Section 8 of the Constitution. The Sixteenth Amendment grants Congress the power to lay and collect taxes on “incomes, from whatever source derived” without requiring apportionment among the States as required by Article I. The Supreme Court has held that any deductions from gross income are a matter of legislative grace and can be reduced or expanded in accordance with Congress’ policy objectives. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); see Keeler v. Commissioner, 70 T.C. 279, 284-285 (1978). Under the Sixteenth Amendment, “[t]he power of Congress to tax gross income is unquestionable.” Bagnall v. Commissioner, 96 F.2d 956, 957 (9th Cir. 1938), aff’g 35 B.T.A. 1 (1936).

… Deductions from gross income do not turn on equitable considerations; rather they are pure acts of legislative grace, the prudence of which is left to Congress. Deputy v. du Pont, 308 U.S. 488, 493 (1940); White v. United States, 305 U.S. 281, 292 (1938); Hokanson v. Commissioner, 730 F.2d 1245, 1250 (9th Cir. 1984), aff’g T.C. Memo. 1982-414; United States v. Akin, 248 F.2d 742, 743 (10th Cir. 1957); Gen. Fin. Co. v. Commissioner, 32 B.T.A. 949, 954 (1935), aff’d, 85 F.2d 846 (3d Cir. 1936). Congress is free to grant, restrict, and deny deductions as it sees fit. J.E. Riley Inv. Co. v. Commissioner, 110 F.2d 655, 658 (9th Cir. 1940), aff’d, 311 U.S. 55 (1940); Barbour Coal Co. v. Commissioner, 74 F.2d 163 (10th Cir. 1934).[2]

The majority opinion therefore concludes:

Petitioner does not cite, and we are not aware of, any case where the disallowance of a deduction was construed a penalty. This is especially telling given that Congress enacted section 280E over 37 years ago in 1982, and over that 37 years it has never been held to be a penalty by any Federal court. See Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, sec. 351(a), 96 Stat. at 640. The overwhelming precedent establishing that deductions from gross income are a matter purely left to congressional discretion by the Sixteenth Amendment explains why over the last 37 years an Eighth Amendment attack on any section of the Code that limits deductions from gross income has been a nonstarter. … The Sixteenth Amendment does not accommodate the assertion that the disallowance of a deduction is a penalty. There is simply no way to reconcile the argument that section 280E creates a penalty with the authority of Congress to tax gross income. Therefore, we hold that section 280E is not a penalty provision and, consequently, the Eighth Amendment's Excessive Fines Clause does not apply.[3]

While all Tax Court judges agreed in the result of this case (the taxpayer should not prevail in its claim that §280E represented an excessive fine), five judges held that the taxpayer failed to show the amount was excessive. Two judges specifically declined to rule on whether §280E was a fine or not (finding it wasn’t relevant if there was no evidence of it being excessive),[4] while three held that §280E did operate as a fine but since there was no evidence presented that it was excessive, the taxpayer could not prevail.[5]

The taxpayer advanced other theories, one of which deserves some additional comment. The taxpayer argued that §280E’s bar on deductions only applied to those allowed under IRC §162 (for ordinary and necessary business expenses). As the majority opinion notes:

Petitioner would have us find that section 280E applies only to section 162 deductions. According to petitioner, the text of section 280E “tracks” that of section 162, which allows for all ordinary and necessary business expense deductions, suggesting that section 280E should apply only to limit section 162 deductions.[6]

IRC §164 allows a deduction for taxes paid by the taxpayer, while §167 allows the deduction for depreciation. Applying the taxpayer’s logic, the dispensary would also apparently be allowed deductions under §179 (for expensing equipment purchases) and §199A (the qualified business income deduction).

But the Tax Court determined that §280E broadly denies any deduction aside from cost of sales, ruling:

However, petitioner's argument misses the first line of section 280E: “No deduction or credit shall be allowed”. (Emphasis added.) Congress could not have been clearer in drafting this section of the Code.

The broader statutory scheme also supports our conclusion that section 280E means what it says — no deductions under any section shall be allowed for businesses that traffic in a controlled substance. Section 261, in part IX of subchapter B of chapter 1 of the Code, provides that “no deduction shall in any case be allowed in respect of the items specified in this part.” Section 280E is in part IX. Similarly, section 161 provides that deductions found in part VI of subchapter B of chapter 1 of the Code are allowed “subject to the exceptions provided in part IX”. Part VI provides a comprehensive list of allowable deductions for taxpayers. This list includes section 162 and section 165 deductions, which we have previously disallowed pursuant to section 280E. See CHAMP, 128 T.C. at 180-181 (disallowing section 162 deductions under section 280E); Beck v. Commissioner, T.C. Memo. 2015-149, at *18 (disallowing a section 165 loss deduction under section 280E). As relevant here, part VI also includes sections 164 and 167, two additional sections petitioner believes would allow it a deduction. Clearly, sections 164 and 167 are limited by the exceptions in part IX, including section 280E. Thus, section 280E precluded petitioner from taking any deductions under sections 164 and 167 that are tied to its medical marijuana dispensary.[7]

Note IRC §199A is also found in part VI of subchapter B of chapter 1 of the Code, so the reference in §161 limiting such deductions to those not barred by part IX would also appear to apply to that provision. As well, IRC §164 would be the provision under which state income taxes are deducted, so the decisions also appears to bar the deduction for corporate income taxes paid by a dispensary organized as a C corporation.

[1] Northern California Small Business Assistants Inc. v. Commissioner, 153 TC No. 4, October 23, 2019, https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12102, retrieved October 23, 2019

[2] Northern California Small Business Assistants Inc. v. Commissioner, 153 TC No. 4, pp. 7-8

[3] Northern California Small Business Assistants Inc. v. Commissioner, 153 TC No. 4, pp. 11-13

[4] Northern California Small Business Assistants Inc. v. Commissioner, 153 TC No. 4, p. 21

[5] Northern California Small Business Assistants Inc. v. Commissioner, 153 TC No. 4, pp. 22, 44

[6] Northern California Small Business Assistants Inc. v. Commissioner, 153 TC No. 4, pp. 11-13

[7] Northern California Small Business Assistants Inc. v. Commissioner, 153 TC No. 4, pp. 14-15