Sec. 280E is not an excessive fine under Eighth Amendment

The Tax Court held that the denial of federal deductions for a company legally operating a medical marijuana dispensary is allowable. A partially dissenting opinion, however, concluded that Sec. 280E is unconstitutional.

Facts: Northern California Small Business Assistants Inc. (NCSBA) is a California corporation that operates a medical marijuana dispensary legally under California law. In 2016, the IRS issued a notice of deficiency to NCSBA for its 2012 income tax of $1,264,212 and an accuracy-related penalty under Sec. 6662(a) of $252,842. The notice of deficiency stated that NCSBA was subject to the limitations of Sec. 280E since its business consists of trafficking in marijuana, a controlled substance within the meaning of Schedule I of the Controlled Substances Act, P.L. 91-513. NCSBA timely filed a petition with the Tax Court and moved for partial summary judgment on the grounds that Sec. 280E violates the U.S. Constitution’s Eighth Amendment prohibition of excessive fines.

Issues: Sec. 280E provides: “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.”

The Eighth Amendment to the U.S. Constitution provides: “Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.“

NCSBA argued that Sec. 280E imposes a gross receipts tax as a penalty in violation of the Eighth Amendment. In addition, NCSBA argued that even if Sec. 280E is constitutional, it only bars ordinary and necessary business deductions under Sec. 162 and does not apply to other sections of the Code. Lastly, NCSBA argued that it was not subject to Sec. 280E because its business, legally operated under California law, does not consist of “trafficking” in a controlled substance.

Holding: The Tax Court held that Sec. 280E is not a penalty provision and therefore does not violate the prohibition on excessive fines in the Eighth Amendment. In addition, the court held that Sec. 280E is not limited to deductions claimed under Sec. 162 but applies to bar all deductions claimed by NCSBA. The Tax Court further held that NCSBA provided no compelling argument to overrule the court’s precedent holding that Sec. 280E applies to businesses operating legally under state law.

The court determined that to conclude that Sec. 280E violates the Eighth Amendment’s excessive-fines clause, the court must find that Sec. 280E operates as a penalty and that the penalty is excessive. The court, noting that no previous case had held that the disallowance of a deduction was a penalty, found that Sec. 280E is not a penalty provision. The court also disagreed with NCSBA’s contention that the reach of Sec. 280E should be limited to ordinary and necessary business expenses under Sec. 162, stating that Congress “could not have been clearer” in drafting Sec. 280E than to state that “no deduction or credit shall be allowed.”

Judge David Gustafson dissented in part, stating Sec. 280E, by bypassing any inquiry into the amount of a taxpayer’s gain, taxes more than income subject to taxation under the 16th Amendment. This results in the imposition of a fine for purposes of the Eighth Amendment’s excessive-fines clause, he wrote. Gustafson further stated that the additional income tax liability due to the disallowance of deductions under Sec. 280E was a fine because it is intended, in part at least, to punish and deter the unlawful activity of trafficking in marijuana. The judge concluded that further proceedings would be needed to determine whether such a fine is in fact excessive and whether the Eighth Amendment’s protections extend to corporate taxpayers.

• Northern California Small Business Assistants, Inc., 153 T.C. No. 4 (2019)

— By Maria M. Pirrone, CPA, LL.M., associate professor of taxation, St. John’s University, Queens, N.Y.