Tax I OCTOBER 14, 2016

Substance Over Form & Medical Marijuana Income Taxes

substance

Tax law stresses the doctrine of “substance over form.”  See Frank Lyon Co. V. United States, 435 U.S. 561 (1978).  When applying this doctrine, the Supreme Court looked to the “objective economic realities of a transaction” because tax courts “are concerned with substance and realities.”  Id. at 573.

On the heels of the case of the United States v. McIntosh, a question arises about the objective economic realities medical marijuana businesses face.  Have medical marijuana businesses been paying too much to the federal government on their taxes?  First, some background on the three pieces of federal law at issue here.

According to the Controlled Substances Act (CSA), “it shall be unlawful for any person knowingly or intentionally… to manufacture, distribute, or dispense, or possess with intent to manufacture, distribute, or dispense, a controlled substance.” 21 U.S.C. 841(a)(1).  Marijuana is a controlled substance included in the most dangerous classification, schedule I. 21 U.S.C. 812(c)(c)(10).

In 1982, Congress passed Section 280E of the Internal Revenue Code (IRC) that prohibits deducting the cost of carrying on trafficking in schedule I substances “which is prohibited by Federal law or the law of any State in which such trade or business is conducted”. 26 USC 280E.

As a result of IRC 280E, medical marijuana business face substantially higher tax burdens than other businesses. In 2015, the state of California alone sold over $2.4 billion in medical marijuana, meaning the federal government collected a substantial amount of taxes from the operations.

Since IRC 280E’s passage, over half the states changed their laws to permit medical marijuana. Congress took action to permit the states to regulate marijuana according to their own laws without federal government interference.  Starting with the 2015 budget, Congress prohibited all enforcement by the Department of Justice (DOJ) for states with medical marijuana programs.

Specifically, none of the federal funds in the 2015 and 2016 budgets are available for DOJ “to prevent any of them [medical marijuana states and territories] from implementing their own laws that authorize the use, distribution, possession, or cultivation of medical marijuana.”  (Section 542). Consolidated Appropriations Act, 2016, Pub. L. No. 114-113, § 542, 129 Stat. 2242, 2332-33 (2015).  The application of IRC 280E to medical marijuana businesses since enactment of Section 542 is the billion dollar question in the medical marijuana market.

As a result of Section 542 of the federal budget, certain trafficking of a schedule I controlled substance, specifically marijuana, is not prohibited by law.  If anything, the federal government is prohibited from stopping states from implementing medical marijuana programs.  In U.S. v. McIntosh, the Ninth Circuit Court of Appeals applied Section 542 in remanding numerous DOJ actions against very large medical marijuana businesses.  Medical marijuana businesses have a defense against the CSA.

While the CSA provides that it is unlawful to have marijuana, Section 542 of the budget prohibits enforcement of the law.  Substantively, for the 2015 and 2016 tax years, the “objective economic realities of a transaction” for the sale of medical marijuana is one free from risk of DOJ interference.  Since tax courts “are concerned with substance and realities,” then IRC 280E should not apply because the sale of medical marijuana is not prohibited by federal law.  A medical marijuana business has a defense against the federal law, and that same defense should apply to IRC 280E.

Section 542 creates an economic reality for medical marijuana businesses, namely a reality free from DOJ enforcement of the CSA.  Therefore, substantively speaking, trafficking in medical marijuana is permitted and not prohibited. On the other hand, IRC 280E still applies to recreational marijuana businesses as those are not covered by Section 542 of the budget. If IRC 280E does not apply to medical marijuana businesses because of Section 542, that class of taxpayers paid substantially more than what was required of them in 2015, and 2016.