10th Circuit Smokes Marijuana Tax Challenge

Experts say a solution to the industry’s longstanding federal tax code dilemma will likely have to come from Washington

10th Circuit Court of Appeals rams
The 10th Circuit Court of Appeals recently allowed two cases alleging violations of prisoners’ religious rights to proceed. / Law Week File

Nobody enjoys tax season; but likely few people dread the weeks preceding April 15 more than pot shop owners. 

Ever since Colorado voters kicked off the grand experiment of legalizing recreational marijuana statewide, local cannabis company owners have routinely had to navigate the challenges of operating a business that deals with a product considered lawful locally but illegal by the federal government. The most financially painful of those conflicts remains a discrepancy in the federal tax code that prohibits marijuana companies from taking the standard deductions available to most businesses — and a July 3 ruling by the 10th Circuit Court of Appeals continued to suggest there is no judicial remedy for the problem. 

“This has been one of those legal issues that has really plagued the industry for a number of reasons,” said Zane Gilmer, partner at Stinson Leonard Street. “Primarily, it’s a problem for the industry because it really results in effectively a higher tax on the cannabis industry than a non-cannabis business operating next door.” 

The issue pertains specifically to section 280e of the federal tax code, which states “no deduction or credit shall be allowed … if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances.” Since the Drug Enforcement Agency still considers marijuana a Schedule 1 controlled substance, no federal tax deductions are available to state-legal cannabis businesses. As a result, pot companies pay an effective tax rate upward of 80 percent. 

“It’s really simple,” said Dean Heizer, an attorney for LiveWell, one of the state’s largest marijuana companies, “280e operates exactly the way it was designed to operate; it strips the profit out of businesses selling drugs that the [federal government] has on Schedule 1. What that means from the business perspective is we’re a very high volume, low margin business — and that’s the only way to make a profit.” 

The recent 10th Circuit case dealt with a Breckenridge-based medical marijuana company, Alpenglow Botanicals, which is owned and operated by Charles and Justin Williams. The government audited Alpenglow’s 2010, 2011 and 2012, tax returns — cannabis companies are audited at a much higher rate than other businesses—and subsequently the IRS issued the company a “Notice of Deficiency concluding that Alpenglow had ‘committed the crime of trafficking in a controlled substance in violation of the [Controlled Substances Act]’ and denying a variety of Alpenglow’s claimed business deductions under 280e.” 

According to the 10th Circuit opinion, the determination from the audit resulted in Charles Williams owing the IRS an additional $24,133 and Justin Williams owing and additional $28,961. (The owners had attempted to take deductions for things such as rent for their business, labor costs, advertising, business taxes and licenses, and wages and salaries.) Williams and Williams both paid up and then filed for a refund, which was denied; the pair then filed suit in U.S. District Court for the District of Colorado hoping to topple the decision by the IRS.  

In the complaint, the plaintiffs argued, among other things, “the IRS’ decision to apply 280e was arbitrary because it had no evidence Alpenglow trafficked in a controlled substance.” Siding with the IRS, the 10th Circuit affirmed the lower court ruling.

“Practically, it’s a fascinating opinion, although it is legally unremarkable” said Tom Downey, a director at Ireland Stapleton Pryor & Pascoe. “The 10th Circuit has confirmed what we have known for years, which is that these state-legal, federally-illegal businesses are in a tough tax jam because of the federal illegality of marijuana.” Downey said the only thing that’s likely to help state cannabis businesses is either federal legislation declassifying marijuana as a controlled substance or an amendment to the tax code. 

Gilmer agreed. “At least as we’re seeing it now, this case kind of affirms what most of us have been operating under — it’s a known dilemma,” he said. “Can we interpret how a different set of facts might play out? No. That’s sort of the beauty of the law, right?” 

Last month, Sens. Cory Gardner of Colorado and Elizabeth Warren of Massachusetts, two strange political bedfellows, introduced the STATES Act, which would give states the freedom to regulate marijuana without interface from the federal government, including access to banking. Importantly, one aspect of the bill would carve out a new space in the tax code so that marijuana businesses were not impacted by 280e.  

Heizer favors the bill’s proposed solution to the 280e problem. “I have been a primary advocate of not trying to fight the fundamental questions at issue in Alpenglow in court,” he said. “You’re not going to win an argument about the application of 280e.” 

Tax attorney Nick Richards of Dill Dill Carr Stonbraker & Hutchings thinks it’s a bit unfortunate cases like Alpenglow have landed in the courts. “It’s not good for the industry and doesn’t show that the industry wants to be a good citizen taxpayer,” Richards said. “[This case] was a losing proposition from the start.” 

Judicial challenges aside, the STATES Act is not the industry’s only hope; according to Richards, there are more bills pending to change 280e now than ever before. They’re just all stuck in committee. Problem is, said attorney Pat Oglesby, founder of the Center for New Revenue, a tax policy nonprofit base in North Carolina, fixing the 280e dilemma is a revenue loser; he said the federal government pulls in an estimated $5 billion over a 10-year period in money not lost to these would-be deductions. “The money itself is not huge,” Oglesby said. “There’s just a reluctance to pass tax cuts for anybody.” 

Nevertheless, Heizer said he remains hopeful. “We pay our taxes and use a substantial amount of what’s leftover, which isn’t a lot, to petition our government,” he said. “The net margin in this business, if you’re paying your taxes, is between 3 and 5 percent. If anyone tells you they’re making more money than that they’re either lying—or not paying your taxes.” He added: “[The STATES Act] is a potentially history making piece of legislation; we just have to get it past Mitch McConnell.” 

— Chris Outcalt

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