In the case of San Jose Wellness v. Commissioner, 156 TC No. 4[1] the Tax Court again looked at the question of whether the bar on deductions other than cost of sales for marijuana dispensaries goes beyond just those allowed by IRC §162, and extends to deductions allowed under IRC §171 (charitable contributions) and §167 (depreciation). But the opinion looks at some interesting interpretations of language that may find application outside of cannabis industry cases.

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.

The opinion provides that a deduction will be disallowed under this provision if three conditions are satisfied:

The deduction is for an amount paid or incurred during the taxable year;
That amount was paid or incurred in carrying on any trade or business; and
That trade or business (or the activities that comprise the trade or business) consisted of trafficking in certain defined controlled substances.

Prior Decision – Bar is Not Limited to Only §162 Expenses

The opinion notes that in 2019 the Tax Court decided a case on this particular issue in the case of N. Cal. Small Bus. Assistants Inc. v. Commissioner (“NCSBA”), 153 T.C. 65 (2019). The opinion summarizes this ruling as follows:

There, NCSBA — also a medical marijuana dispensary — sought to save from disallowance the deductions it claimed for taxes (under section 164) and depreciation (under section 167). In support of its position, NCSBA argued that “section 280E limits only deductions under section 162,” such that “deductions under sections 164 and 167 are allowed notwithstanding section 280E.” NCSBA, 153 T.C. at 72. In an Opinion reviewed by the full Court, we rejected the argument, stating in relevant part: NCSBA’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.” Id. at 73.

We found support for this conclusion in the Code’s text and structure:

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.

Id. (emphasis added).[2]

So why is this case being put forward as a published decision if the issue had already been decided? The Court notes that the taxpayer in this case “has advanced more nuanced textual arguments” than those raised in the earlier case—and the Court decided to deal with those issues in this opinion. But it turns out the result is the same as it was for the taxpayer in NCSBA.

Is Depreciation Paid or Incurred During the Year

The taxpayer first offers the argument that the depreciation deduction is not one that is “paid or incurred” during the year—the purchase of the item generating a depreciation deduction may have taken place years earlier. As §280E only applies to deductions paid or incurred during the year, the taxpayer argues that the depreciation deduction is not affected by IRC §280E and a full deduction should be allowed.

The Court cited a Supreme Court decision (Commissioner v. Idaho Power, 418 US 1 (1974)) for support of the view that depreciation is a cost incurred in the year in which the deduction is allowed. The Court analyzes the Supreme Court ruling as follows:

In Idaho Power, the Court considered whether a taxpayer that used its own equipment in the construction of its own capital facilities was entitled under section 167(a) to a depreciation deduction for the current year with respect to the use of that equipment, or whether the deduction was barred by section 263(a)(1). If the deduction was barred by section 263(a)(1), the amount of the deduction would be capitalized and recovered over the useful life of the constructed facilities.

Focusing on the concept of depreciation, the Court noted:

Over a period of time a capital asset is consumed and, correspondingly over that period, its theoretical value and utility are thereby reduced. Depreciation is an accounting device which recognizes that the physical consumption of a capital asset is a true cost, since the asset is being depleted. As the process of consumption continues, and depreciation is claimed and allowed, the asset’s adjusted income tax basis is reduced to reflect the distribution of its cost over the accounting periods affected. The Court stated in Hertz Corp. v. United States, 364 U.S. 122, 126 (1960): “[T]he purpose of depreciation accounting is to allocate the expense of using an asset to the various periods which are benefited by that asset.” See also United States v. Ludey, 274 U.S. 295, 300-301 (1927); Massey Motors, Inc. v. United States, 364 U.S. 92, 96 (1960); Fribourg Navigation Co. v. Commissioner, 383 U.S. 272, 276-277 (1966). When the asset is used to further the taxpayer’s day-to-day business operations, the periods of benefit usually correlate with the production of income. Thus, to the extent that equipment is used in such operations, a current depreciation deduction is an appropriate offset to gross income currently produced. It is clear, however, that different principles are implicated when the consumption of the asset takes place in the construction of other assets that, in the future, will produce income themselves. In this latter situation, the cost represented by depreciation does not correlate with production of current income. Rather, the cost, although certainly presently incurred, is related to the future and is appropriately allocated as part of the cost of acquiring an income-producing capital asset. [Fn. ref. omitted.]

Commissioner v. Idaho Power Co., 418 U.S. at 10-11 (emphasis added).

Idaho Power leaves no doubt that, as a “cost * * * certainly presently incurred,” id. at 11, depreciation constitutes an “amount paid or incurred during the taxable year,” sec. 280E. Given that conclusion, section 280E applies by its express terms to SJW’s circumstances.[3]

The holding that depreciation is an expense paid or incurred by the taxpayer may help ease the minds of some employers who were nervous about including depreciation amounts as part of an accountable reimbursement plan under IRC §62(a)(2)(A). The ruling clearly holds such depreciation is incurred by the taxpayer, and thus should qualify for reimbursement to an employee without having to treat the amount as payroll.

Charitable Deductions Were Incurred in Carrying on a Trade or Business

Next, the taxpayer argued that it should be allowed charitable deductions that the IRS disallowed, arguing that they were not paid or incurred “in carrying on any trade or business” as required for the deduction to be covered by IRC §280E. The taxpayer argues that while the charitable contribution might be in connection with the trade or business, §280E only impacts what the taxpayer argues is a narrower category of expenses paid in carrying on a trade or business.

The opinion notes:

In support of this view, SJW compares the text of section 280E with that of section 162(a). The latter provides a deduction for “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” (Emphasis added.) SJW contends that the phrase “in carrying on” significantly limits the universe of expenditures to which section 162 applies and that a similar analysis of section 280E confirms that the section does not apply to SJW’s charitable contributions.[4]

The Court did not accept this argument:

SJW is correct that courts have construed section 162(a) as inapplicable to certain categories of expenditures — for example, distributions of profits, loans, and capital expenditures. But courts typically do not ground these exclusions in the phrase “in carrying on.” Rather, they rely on other requirements of section 162(a), such as the condition that an expenditure must be an “expense” that is both “ordinary” and “necessary.” Section 280E, which applies to “any amount paid or incurred,” has no analogous requirements.[5]

The Court also found that these charitable contributions, even though arguably not deductible under IRC §162, are still incurred in carrying on the trade or business and fall under IRC §280E’s coverage:

SJW’s argument that its charitable contributions by definition are not “business expenditures” misses the mark for similar reasons. Failing to qualify as a business expenditure may well be fatal under section 162, although the phrase does not appear in that section. The concept, however, has no relevance under section 280E, which applies to “any amount paid or incurred * * * in carrying on any trade or business.” (Emphasis added.) The fact that the two provisions share one phrase (“in carrying on”) does not import the other requirements of section 162 into section 280E.[6]

This part of the ruling might arguably give support to the position the IRS previously posited in instructions on the computation of qualified business income (QBI) under IRC §199A—that there does exist a class of charitable contributions that, while not allowed as a deduction under IRC §162(a), are still a deduction related to carrying on the trade or business.

Since removing the item from the instructions was not accompanied by any IRS discussion of why charitable contributions were not deductions related to the trade or business under IRC §199A, it is possible if the agency wants to again assert that QBI is reduced by such deductions it would cite this case to support that position.

[1] San Jose Wellness v. Commissioner, 156 TC No. 4, February 17, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/cannabis-dispensary-can%e2%80%99t-deduct-depreciation%2c-charitable-gifts/2zdsp (retrieved February 20, 2021)

[2] San Jose Wellness v. Commissioner, 156 TC No. 4

[3] San Jose Wellness v. Commissioner, 156 TC No. 4

[4] San Jose Wellness v. Commissioner, 156 TC No. 4

[5] San Jose Wellness v. Commissioner, 156 TC No. 4

[6] San Jose Wellness v. Commissioner, 156 TC No. 4