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Case Study: Northern California Small Business Assistants, Inc.

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January 15, 2020

Last week, we covered a recent court case Alternative Health Care Advocates et al. v. Commissioner of Internal Revenue. (Watch the Video)

In that case, we saw that the courts do not exempt management companies from the 280E regulation. The case has big implications for how you structure your cannabis operation. 

This week, we’re covering another tax case: Northern California Small Business Assistants Inc. (NCSBA) v. Commissioner of Internal Revenue (CIR). The court made its ruling in October 2019.

Here’s how the case might impact your cannabis operation. 

What happened in the case? 

NCBSA is a California corporation that operates a legal medical cannabis dispensary. NCBSA claimed $1.5 million in ordinary and necessary business expenses on its 2012 tax return. The IRS disallowed the company’s tax deductions under Section 280E

In court, NCBSA argued their case in three points: 

  1. The 280E regulation violates the Eighth Amendment, which states that “Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.”  

  2. If the 280E regulation is constitutional, then it only prohibits “ordinary and necessary business deductions” under section 162, and does not apply to other sections of the Internal Revenue Code.

  3. NCBSA was operating legally under state law, and therefore is not subject to the 280E. 

Unfortunately, the court disagreed with NCBSA’s arguments.

The court concluded that the 280E does not violate the constitution or Eighth Amendment. It also held that the 280E doesn’t apply to just general business expenses from Section 162; but applies to bar all deductions in this case.

Lastly, if you’re a state-licensed cannabis operator, you are still “trafficking” cannabis in the eyes of the federal law – a Schedule 1 controlled substance. 

“We are constrained by the law, and Congress has not carved out an exception in section 280E for businesses that operate lawfully under State law. Until then, [the taxpayer] is not entitled to deduct expenses incurred in the operation of its drug-related business,” the tax court concluded in its ruling. 

Main takeaways from the case

This verdict follows the precedent set in Harborside vs. IRS. Arguments against the 280E using the Eighth Amendment always fail. Taxes are not considered “penalties or excessive fines.” Taxes might seem excessively punishing to the cannabis industry; but law experts argue that the main goal of taxation “has always been to raise revenue to fund the government.”

This law professor continues to explain... 

"Using taxes as an instrument of social policy does not transform the taxes into punishment for the disfavored activity. Think of tax-exempt organizations. Congress wants to encourage or support certain social useful organized activities and so entirely exempts from taxation organizations that foster that purpose. That does not mean that taxing other entities is punishing them!"

Not only are the courts not interested in hearing any arguments against the constitutionality of the 280E, but if you lose the case, the IRS will bring the full power of the 280E against your cannabis operation. In the written opinion from NCBSA v. CIR, the court writes, “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.” There is little room for negotiation in this statement.

It’s true that one judge in the case argued that “‘Income’ must take account of the basis and cost of goods sold.” However, when all was said and done, in this case, all the deductions were disallowed. NCSBA was taxed to the full extent. The court even went so far as to rule that NCSBA could not apply tax payments as credits.

With razor-thin margins in cannabis, can you afford to pay a 20 or 30% tax on your topline and still stay in business?

Lessons learned from NCBSA v. CIR

There is some good news unrelated to the verdict in NCBSA v. CIR. In November 2019, California signed Assembly Bill 37 into law. This eliminates the Section 280E restriction for licensed Personal Income Tax (PIT) cannabis businesses. It means that PIT cannabis businesses may now deduct ordinary and necessary business expenses on their California income tax return. 

It doesn’t, however, impact your federal taxes. As NCBSA v. CIR demonstrated, it doesn’t matter if you run a state-licensed, legal cannabis business. Cannabis is still a Schedule 1 controlled substance. This court case that reaffirms this stance.

Lastly, in its conclusion, the Court stated that it is limited in its powers based on the law. The proper avenue to redress petitioner’s grievances is through Congress because changing tax laws is a legislative process that must originate with Congress. The fight to allow tax deductions for dispensaries operating legally under state law is a legislative fight not a judicial one.

Bottom line: get professional tax advice that is backed by experience and tax court rulings.  Do not try to bypass or bend the laws in your favor by trying some new, creative tax strategy. A CPA that has experience in cannabis can guide you through the many nuances in cannabis law that a local CPA may not have experience in navigating. 

Reach out to our team today to get help with you cannabis business taxes.

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Post Tags: Case Studies, Taxes, Accounting

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