Up in Smoke – Section 280E’s Buzz not Harsh by Excessive Fines Clause: Northern California Small Business Assistants, Inc. v Commissioner

A tax provision that blocks marijuana companies from claiming federal business tax deductions is constitutional ruled the U.S. Tax Court on October 23rd. Northerner California Small Business Assistants, Inc. v Commissioner, 153 TC No. 4 (No. 26889-16, October 23, 2019).

Northern California Small Business Assistants, Inc., a California medical marijuana business, claimed $1.5 million in ordinary and necessary business expenses for its 2012 tax year. The IRS disallowed the company’s tax deductions under Section 280E of the Internal Revenue Code. That provision blocks companies that are involved in drug trafficking from claiming business deductions and credit that are available to businesses not engaged in trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act).

Cannabis companies that are organized and operated legally under state law, face what amounts to a federal income tax on their gross receipts – with effective tax rates as high as 70% because for federal purposes, those companies are considered to be trafficking in the illegal drug trade. Some types of marijuana businesses are able to reduce the amount of their income subject to tax based on their inventory costs.

The Company claimed that Section 280E violated the prohibition on excessive fines contained in the Eighth Amendment. The Excessive Fines Clause guards against abuses of the government’s ability to punish civil or criminal infractions. Specifically the company argued that:

  • The Eighth Amendment applied to corporations,
  • That Section 280E operates as a penalty through the tax laws on the company’s gross receipts, and
  • That this “penalty” is excessive.

The Tax Court held, however, that Section 280E does not violate the Constitution because it is not a penalty provision. “Despite efforts by several States to legalize marijuana use to varying degrees, it remains a Schedule 1 controlled substance within the meaning of the Controlled Substance Act,” wrote Judge Joseph Goeke. “Unlike in other context where the Supreme Court has found a financial burden to be a penalty, disallowing a deduction from gross income is not a punishment,” said the Court. The court noted its holding was consistent with the only Circuit Court of Appeals decision on this point.

The company also argued that, assuming Section 280E is constitutional, that it should be applied more narrowly than as interpreted by the IRS.  According to the taxpayer, while Section 280E may be appropriately applied to limit ordinary and necessary business expenses, other provisions, such as depreciation deductions, and the deductions for state and local taxes should be excluded from Section 280E’s reach. The Tax Court declined this invitation, stating, “Congress could not have been clearer in drafting this section [280E] of the Code.”

Perhaps most interesting, is that there were two dissenting opinions. Judge Gustason, dissenting in part, wrote that he believed Section 280E unconstitutionally exceeded Congress’ power to impose an income tax under the Sixteenth Amendment. “I would hold that this wholesale disallowance of all deductions transforms the ostensible income tax into something that is not an income tax at all, but rather a tax on an amount greater than the taxpayer’s ‘income’.”

Judge Copeland, agreeing with Judge Gustafson’s dissent, also wrote a partial dissent of her own, insisting that Section 280E is a penalty and urging further analysis of whether it violates the Eighth Amendment.

Read full opinion here.

Fraser Trebilcock attorney Paul V. McCord has more than 20 years of tax litigation experience, including serving as a clerk on the U.S. Tax Court and as a judge of the Michigan Tax Tribunal. Paul has represented clients before the IRS, Michigan Department of Treasury, other state revenue departments and local units of government. He can be contacted at 517.377.0861 or pmccord@fraserlawfirm.com.

Department of Labor Releases Proposed Regulations Expanding Employer’s Ability to Provide ERISA Disclosures Electronically

Pursuant to a 2018 Executive Order, the Department of Labor released proposed regulations this week which would expand an employer’s ability to provide ERISA disclosures electronically. These rules do not replace existing guidance, but instead add an additional safe harbor option for employers to comply.

The proposed regulations essentially adopt a “notice and access” regime under which employers may post required disclosures on a website and provide participants with notification of their availability and instructions for access. Critically—after providing a one-time initial notice on paper—this notification may be delivered electronically as a default, as long as the participant either:

  1. Provides a personal email address to the employer, plan sponsor, or plan administrator, as a condition of his or her employment, OR
  2. Is assigned an email address by the employer.

For former employees, the employer must take reasonable steps to ensure that it continues to have an accurate email address for the terminated participant. Participants who desire to receive the disclosures on paper are permitted to opt out of electronic delivery.

The content of the notice of internet availability is fairly standard, as far as ERISA disclosures go, and the proposed regulations place a strong emphasis on the use of ordinary language, indicating that the notice should use “short sentences without double negatives, everyday words rather than technical and legal terminology, active voice, and language that results in a Flesch Reading Ease test score of at least 60.” Generally, a separate notice is required for each document, but there are opportunities for combining these notices and providing them on an annual basis.

While these proposed rules are generally a positive development, we expect that employers will be disappointed to learn that—at least at this point—these rules are limited to retirement plans (although the proposed regulations do reserve consideration for the possibility of expansion to health and welfare plans). It is also important to note that these rules are merely proposed and that plan sponsors should continue following the existing ERISA disclosure rules unless and until the regulations are adopted as final.

If you have any questions about the rules that apply to participant disclosures for your retirement plans, please contact Brian Gallagher at (517) 377-0886 or bgallagher@fraserlawfirm.com.

Brian T. Gallagher is an attorney at Fraser Trebilcock specializing in ERISA, Employee Benefits, and Deferred and Executive Compensation. He can be reached at (517) 377-0886 or bgallagher@fraserlawfirm.com.