Conflict between liberalized state marijuana laws and IRC 280E
In the past few years, more than twenty states and the District of Columbia have adopted legislation either decriminalizing or legalizing cannabis, giving rise to numerous for-profit businesses. Congress, however, has not seen fit to join this movement toward liberalized controlled substance laws, which means that while growing and distributing cannabis is lawful in certain states, individuals engaged in such conduct remain subject to prosecution under federal laws.
Proponents frequently argue that legalization will, among other things, transform the cannabis industry into a legitimate, regulated business sector, thereby generating significant state tax revenues, however the Internal Revenue Service has consistently applied a provision of the Internal Revenue Code that precludes the deductibility of expenses associated with operating an illegal drug trade. This conflict between state laws legalizing the cannabis industry and federal tax law precluding participants in that industry from deducting business expenses disadvantages cannabis businesses from a federal tax perspective, and has given rise to a series of cases exploring the Fifth Amendment implications of the disallowance of business deductions for state sanctioned businesses.
In response to the Tax Court's decision in Edmondson v. Commissioner, 42 T.C.M. (CCH) 1553 (1981), which allowed a taxpayer to deduct expenses incurred in an illegal drug trade, Congress enacted §280E of the Internal Revenue Code, which disallows tax deductions for expenses incurred "in carrying on any trade or business if such trade or business... consists of trafficking in controlled substances." As a result of §280E, in cases such as Feinberg v. Commissioner, 916 F.3d 1330 (10th Cir. 2019), the court found that taxpayers faced with §280E disallowances could be required to choose between proving that they are not engaged in trafficking or simply foregoing their federal tax deductions. Furthermore, the Tenth Circuit concluded that losing a deduction afforded through "legislative grace" is not sufficiently punitive to trigger Fifth Amendment privileges and that "deductions 'are matters of legislative grace...and Congress has unquestioned power to condition, limit, or deny deductions from gross income in arriving at the net which is to be taxed."
In High Desert Relief, the entity at issue (HDR) sought to quash summonses for business records contending, in part, that they had been "issued for an improper purpose-specifically, that the IRS in seeking to determine the applicability of [§280E], was mounting a de facto criminal investigation pursuant to the Controlled Substances Act." High Desert Relief, Inc. v. United States, 917 F.3d 1170 (2019). However, in its ruling, the court noted that HDR "is not a natural-person taxpayer and, consequently, has no Fifth Amendment privilege that it can properly invoke.".
High Desert Relief was initiated before the Trump Justice Department resumed enforcement of the federal laws regarding marijuana, and the taxpayer in that case highlighted the inconsistency between the IRS's rejection of deductions under §280E and the Obama Administration's then-existing policy of declining to enforce the federal laws criminalizing the distribution of cannabis in arguing that §280E should not be enforced because the Justice Department's policy rendered it a "dead letter." In theory, if the criminal law in question were truly a dead letter and no longer a valid reason to fear prosecution, the taxpayer may well lack a reasonable fear of prosecution, thereby negating any basis to assert the privilege against self-incrimination. See, e.g., United States v. Luck, 852 F.3d 615, 629 (6th Cir. 2017). Although the Tenth Circuit did not address this point in any of its dispensary cases, a court could conclude that a defendant's use of the dead letter argument undermines his or her right to assert the privilege.
Legislation has since been introduced precluding application of §280E to businesses engaged in the sale of marijuana that is lawful under state law. While such legislation, if passed, would moot the specific dispute that prompted the Tenth Circuit's decisions in Feinberg and High Desert Relief, those decisions will nevertheless remain important reminders of the limitations of the Fifth Amendment privilege in litigation over disputed deductions.
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