Recent Cases Outline Prospects for Change in Taxation and Banking for Medical Marijuana
The treatment of cannabis under Federal law presents a formidable challenge to the survival of medical marijuana companies. “Marihuana” and “tetrahydrocannabinols” are Schedule I controlled substances under the Controlled Substances Act (CSA), meaning that the federal government defines them as drugs with no currently accepted medical use and a high potential for abuse. The listing of cannabis under the CSA imposes significant financial burdens on cannabis companies that are legal under state law, as it prevents them from deducting their costs of doing business under §280E of the Internal Revenue Code and limits their access to federally regulated banking services.
Legal and legislative efforts to address the financial issues have faced significant roadblocks despite growing support for the cannabis industry. Despite these challenges, legislators who support the cannabis industry should focus on removing “marihuana” and “tetrahydrocannabinols” from the CSA rather than on repealing §280E or passing cannabis banking legislation. Although doing so would be a challenge, legislators should expend their political capital on the most direct route to removing both financial impediments to the cannabis industry.
State Legalization of Medical Marijuana and Federal Law
The tax and banking issues that marijuana companies face stem from a conflict between state and federal marijuana laws that has arisen since states began legalizing medical and recreational marijuana. The legalization trend started in 1996, when California voters approved Proposition 215, known as the Medical Marijuana Initiative, and California became the first state to legalize medical marijuana. After California voters approved the ballot initiative, the state legislature enacted the Compassionate Use Act, which provided an affirmative defense to charges of possessing or cultivating marijuana for people who did so for personal, physician-approved use; it also provided the defense to primary caregivers. Marijuana remained a controlled substance under California law. In 2003, California enacted Senate Bill 420, the Medical Marijuana Program Act, which extended the affirmative defense to charges of transporting marijuana for patients and primary caregivers who “associate within the State of California in order collectively or cooperatively to cultivate marijuana for medical purposes.”
One of the stated purposes of the Compassionate Use Act was “[t]o encourage the federal and state governments to implement a plan to provide for the safe and affordable distribution of marijuana to all patients in medical need of marijuana.” Since 1996, 36 states and four territories have followed the same path, but state and federal law regarding medical marijuana continued to diverge. In 2001, the U.S. Supreme Court held in United States v. Oakland Cannabis Buyers' Cooperative that there is no medical necessity exception to the prohibition on manufacturing and distributing marijuana under the Controlled Substances Act. In 2005, in Gonzalez v. Raich, the Court held that the Commerce Clause of the Constitution gave Congress the authority to prohibit the local cultivation and use of marijuana despite state laws that permit its medical use.
These cases removed any doubt as to the federal government’s authority under the Constitution’s Supremacy Clause to regulate and criminalize marijuana sales and use in states that permit medical marijuana. The cases also provided clarity in the emerging issues of how the federal government would treat medical marijuana under the Internal Revenue Code and under federal banking laws.
§280E of the Internal Revenue Code
The Internal Revenue Code under §280E prohibits business deductions and credits for any trade or business “trafficking” in controlled substances covered by I and II of the Controlled Substances Act. This includes marijuana and cannabidiol (CBD) derived from marijuana plants. The §280E limitation came in response to the Tax Court case of Edmondson v. Commissioner, which addressed the issue of whether the denial of a deduction for illegal expenses under IRC §162(c)(2) prevented the deduction of the legal expenses of an illegal business. In that case, a trafficker in the illegal business of selling amphetamines, cocaine, and marijuana was allowed under §162 to deduct the legal expenses of his drug business, including rent from his home office, a scale, packaging, telephone expenses, and automobile expenses, and the cost of goods sold of the illegal drugs. The Tax Court held that the expenses were made “in connection with petitioner's trade or business and were both ordinary and necessary.”
Congress registered its disapproval of the decision by passing the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which added §280E to the Internal Revenue Code. The section states:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
A Joint Committee on Taxation report on TEFRA cited as support for the law a “sharply defined public policy against drug dealing” and reasoned that business expense deductions “must be disallowed on public policy grounds.” This disallowance of an expense that violates a “sharply defined public policy” derived from the judicially created “public policy doctrine,” developed through a series of cases over several decades and codified in amendments to IRC §162(c). The doctrine presumed a broad reading of §162 in that all ordinary and necessary business expenses were deductible regardless of whether the underlying business was legal or illegal. A deduction would frustrate a “sharply defined” public policy, however, when the actual payments were illegal or were the payment of a government fine. Overall, the doctrine focused on whether the payment of the expense itself violates a prohibition found in a statute or regulation, not whether the underlying conduct was in violation of public policy. IRC §280E, however, turned this reasoning on its head. Instead of denying illegal payments, the section denied deductions according to the type of business.
Additionally, §280E arguably goes against the principles of taxation of illegal businesses, which are usually taxed in the same manner as legal businesses under the justification that those who earn income illegally should pay their share of taxes. IRC §61 defines gross income as “all income from whatever source derived,” but makes no distinction between income derived from legal or illegal sources. Gross income derived from business is calculated as “the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources.” The cost of goods sold is an offset to gross receipts that includes the cost of items purchased for resale and the cost of producing items for resale adjusted for opening and closing inventories.
Like other taxpayers, those who earn income illegally are taxed on their net income, which includes deductions for expenses. IRC §62 defines adjusted gross income as gross income less deductions, including deductions “attributable to a trade or business,” and IRC §162(a) allows businesses to deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Taxpayers are not entitled to deductions, but rather “[w]hether and to what extent deductions shall be allowed depends upon legislative grace.” Taxpayers that are disallowed deductions pay an additional amount of income tax that equals the amount of the denied deduction and the marginal tax rate at which the denied deduction is taxed. The disallowance could make the transaction a net loss if the illegal payment produces a relatively small amount of revenue.
Legal challenges
The IRS has applied §280E to deny a number of deductions under the Code apart from “ordinary and necessary” business expenses under §162. Notably, as stated in the Senate Finance Report, §280E allows income to be reduced by the cost of goods sold out of concern for possible constitutional challenges. Reflecting its passage before the growth of the medical marijuana industry, the bill did not make a distinction for businesses that were legal under state law.
The application of §280E to medical marijuana companies has been subject to several unsuccessful legal challenges that affirmed that supplying medical marijuana is “trafficking” within the meaning of the law but that a taxpayer is not subject to §280E with respect to its other lines of business. Constitutional challenges that the section imposes an “excessive fine” in violation of the Eighth Amendment have also been unsuccessful.
Most recently, in April 2021, the Ninth Circuit of U.S. Court of Appeals upheld the Tax Court’s disallowance of deductions for marijuana dispensaries in Patients Mutual Assistance Collective Corp. v. Commissioner. The court also refused to consider the company’s challenge that § 280E exceeds the government’s taxing authority under the Sixteenth Amendment of the Constitution, as the issue was not first raised in the Tax Court.
In November 2020, a Colorado marijuana dispensary petitioned the U.S. Supreme Court to review a Tenth Circuit decision that includes two constitutional challenges. The petition in Standing Akimbo, LLC v. United States includes the argument that Colorado’s law permitting the sale of cannabis does not violate the Controlled Substances Act under the Supremacy Clause of the Constitution and that §280E violates the Sixteenth Amendment by taxing more than constitutional income. Although there is no guarantee that the Court will hear the case, the case would address circuit court splits concerning constitutional income under the Sixteenth Amendment and would be determinative in the future application of §280E to medical marijuana companies.
Congressional initiatives to reform cannabis taxation
In addition to legal challenges, Congress has made some efforts to address the federal tax treatment of cannabis companies. In 2010, members of the U.S. House of Representatives from Arizona, California, Colorado, and Massachusetts requested IRS guidance that would allow a deduction for expenses for taxpayers who sell marijuana for medical purposes. The request stemmed from a 1997 IRS revenue ruling that held that payments for medical marijuana were not deductible expenses for medical care under IRC §213 even if the state law requires a prescription of a physician. The IRS responded to the legislators that “[b]ecause neither section 280E nor the Controlled Substances Act makes exception for medically necessary marijuana, we lack the authority to publish the guidance that you request.” The Chief Counsel said such an allowance “would require the Congress to amend either the Internal Revenue Code or the Controlled Substances Act.”
Additionally, a number of “tax equity” bills that would exempt from §280E marijuana businesses that are legal under state law have been introduced since 2011 without passage. Tax professionals have requested clarification as to how §280E applies to businesses that are legal under state law, but the IRS has reportedly prioritized other guidance.
Federal Banking Laws
The second main financial impediment to the cannabis industry is the federal limitation on access to banking, which reduced access to credit for cannabis companies and often forces them to operate on a “cash only” basis. The Bank Secrecy Act (BSA), which makes it a crime to engage in certain financial and monetary transactions with the proceeds of a “specified unlawful activity,” is the primary federal law that affects the provision of banking services to marijuana businesses. The Treasury’s Financial Crimes Enforcement Network (FinCEN) is the primary regulator that enforces the BSA, but the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, and the Office of the Comptroller of Currency (OCC) also enforce BSA compliance.
The BSA requires financial institutions to file various reports on banking activity, including currency transaction reports (CTRs) for all cash deposits in excess of $10,000 in one business day; suspicious activity reports (SAR) for any suspicious activities that might signify money laundering, tax evasion, or other criminal activity; and Foreign Bank Account Reports (FBAR). Under federal law, proceeds generated by marijuana businesses are unlawful, even if the businesses are legal under state law, and financial transactions with such proceeds may constitute illegal money laundering. The banking of funds related to the production, cultivation, distribution, or sale of marijuana require the filing of an SAR.
FinCEN guidance
In 2014, FinCEN issued guidance on BSA expectations for financial institutions seeking to provide services to marijuana-related businesses. FinCEN issued the guidance following a series of Department of Justice memos, beginning with the Ogden Memorandum, that outlined the Obama administration’s policy that the department would not prioritize prosecutions of “individuals whose actions are in clear and unambiguous compliance with existing state laws providing for the medical use of marijuana.” A series of subsequent memos, known as the Cole memos, outlined eight enforcement priorities focused on preventing unwanted distribution of marijuana and enabling criminal activity and reiterated the eight principles with a focus on financial crimes. The most recent memo noted that the “provisions of the money laundering statutes, the unlicensed money remitter statute, and the Bank Secrecy Act (BSA) remain in effect with respect to marijuana-related conduct.”
The FinCEN guidance reiterated the Cole memo, emphasized the importance of customer due diligence, and outlined what customer due diligence should include. The guidance clarified that a financial institution is required to file a SAR on activity involving a marijuana-related business, including those licensed under state law, because financial transactions involving a marijuana-related business would generally involve funds derived from illegal activity. The guidance discussed the “red flags” that indicate when a marijuana-related business may be engaged in activity that implicates one of the Cole memo priorities or violates state law. It also outlined three different types of reports that depository institutions that service marijuana-related businesses must file. The first type of report is a “Marijuana Limited” SAR, which the financial institution must file if it has no reason to believe that a particular client has implicated the Cole Memo priorities. The second type of reports is a “Marijuana Priority” SAR, which the financial institution must file if it believes that a customer in a marijuana-related business has engaged in an activity that implicates one or more of the Cole memorandum priorities or violates state law. The third type of report is a “Marijuana Termination” SAR, which the financial institution must file if it deems it necessary to terminate a relationship with a marijuana-related business in order to maintain an effective anti-money laundering compliance program.
Although Attorney General Jeff Sessions rescinded these memos in January 2018, the FinCEN guidance is still effective and the Department of Justice memos provide guidance on how the Biden administration could approach its enforcement priorities.
Congressional initiatives to reform cannabis banking laws
There have also been legislative efforts to reform banking laws to accommodate cannabis companies that are legal at the state level. In 2014, Congress included in its 2015 Fiscal Year spending bill the Farr-Rohrabacher Amendment, which prohibited the Department of Justice from preventing the implementation of state laws “regarding the use of medical marijuana.” In 2016, the Ninth Circuit held that federal prosecutions of individuals who complied with state medical-marijuana laws interfered with the implementation of these appropriations riders. Similar appropriations riders were included through 2017.
In 2017, Senator Jeff Markley introduced a version of the Secure and Fair Enforcement Banking (SAFE) Act in the Senate, which would prohibit federal banking regulators from penalizing banks and other depository institutions for providing banking services to cannabis businesses. The Democratic-controlled House of Representatives then passed a version of the SAFE Act in 2019, included it in the HEROES Act COVID relief legislation in 2020, and passed it again in April 2021. The Senate, however, has prevented the passage of the bill.
California initiatives to reform cannabis tax and banking laws
Continuing its role as a leader in cannabis policy, California has attempted to ameliorate the effects of federal tax and banking restrictions through state relief. In 2019, Governor Gavin Newsom signed into law AB 37, which rescinds California’s conformity with §280E for licensed cannabis sole proprietorships and pass-through entities. AB 37 allows state deductions for ordinary and necessary business expenses for cannabis companies that file their taxes as sole proprietors or partnerships for tax years beginning on or after January 1, 2020 and before January 1, 2025. Medical marijuana businesses organized as corporations were already able to deduct ordinary and necessary businesses expenses and the cost of goods sold. Newsom’s signing of the law was a notable change in policy, as Governor Jerry Brown vetoed a similar bill, AB 1863, the previous year.
In banking, in September 2020, Newsom signed into law AB 1525, which provides a safe harbor from prosecution for financial institutions and accountants that serve the cannabis industry. This includes financial institutions that receives deposits, extends credit, conducts fund transfers, transports cash or financial instruments, or provides other financial services. Earlier efforts to license cannabis limited charter banks and credit unions to provide depository services to cannabis businesses came in 2018 with SB 930 and in 2019 with SB 51.
Conclusion: Delisting cannabis from the Controlled Substances Act
Medical marijuana companies face two interlinking challenges in taxes and banking that have very different prospects for change. A repeal of §280E is unlikely given that the law serves a popular purpose in preventing deductions for dealers of illicit drugs. A constitutional challenges against §280E as it is applied to medical marijuana businesses is a difficult and uncertain strategy, and the Supreme Court seems unlikely to want to examine the statute on behalf of one industry. In banking, FinCEN guidance has proven inadequate, as financial institutions have been hesitant to provide services to marijuana businesses and often charge them high fees. Legislation to change marijuana banking restrictions is a possibility, but still faces political opposition.
The most direct path to address both issues is for Congress to remove “marihuana” and “tetrahydrocannabinols” from the Controlled Substances Act. Recent legislation in this regard, the Marijuana Opportunity Reinvestment and Expungement (MORE) Act of 2019, passed the Democratic-controlled House of Representatives in December 2020 along party lines. Given the current political gridlock in Washington, passing the bill will be difficult. However, the growing tension between federal law and state laws concerning marijuana, and the growing support for medical marijuana throughout the country, could force Congress to act. Additionally, the growing industry could be a significant source of tax revenue and job growth as the country recovers from the COVID-19 pandemic.