Cannabis businesses that cultivate, distribute, or sell marijuana have long been subject to I.R.C. § 280E. Section 280E states that no deduction or credit is allowed for a business that “consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act).” Marijuana has been classified as a Schedule I drug since 1970 when the Controlled Substances Act was passed.
The IRS and courts have consistently stated that cannabis businesses cannot deduct business expenses because of I.R.C. § 280E. See Alternative Health Care Advocates v. Commissioner, 151 T.C. 225 (2018); Patients Mutual Assistance Collective Corp. v. Commissioner, 151 T.C. 176 (2018) (“Harborside I”). Instead, cannabis businesses can only claim cost of goods sold (COGS) to reduce the taxable income on their IRS tax returns. See Patients Mutual Asst. Collective Corp. v. Commissioner, 995 F.3d 671 (9th Cir. 2021) (“Harborside II”); Treas. Reg. § 1.471-3(b). These restrictions can create a “cannabis trap” for businesses and cause increased scrutiny by the IRS.
Help May Be on the Way…
On May 16, 2024, the U.S. Department of Justice (DOJ) issued a notice of proposed rulemaking to reschedule marijuana from Schedule I to Schedule III. Once this rule is final, it would remove the applicability of I.R.C. § 280E from cannabis businesses. This change would allow cannabis businesses to fully deduct business expenses on their IRS income tax returns (in addition to claiming COGS). The DOJ notice of proposed rulemaking on marijuana is not final yet. Under the Administrative Procedures Act, the government must seek comments from the public before issuing a final ruling. There is no specific timeframe for a final ruling.
Effective Date of Rescheduling Unclear
The DOJ notice of proposed rulemaking does not say when the change will be effective. Most likely, the IRS will issue guidance on the effective date once the DOJ’s rescheduling is finalized. While not certain, the IRS could allow retroactive application—meaning that a taxpayer can go backwards in time and claim tax refunds for prior tax years.
Protective Claim to Open Possibility for More Refunds
The IRS generally lets taxpayers go back 3 years from the date a tax return is filed to claim a refund (the “refund statute of limitations”). See I.R.C. § 6511(a). Thus, if a 2020 tax return was filed on September 15, 2021, the taxpayer could file a refund claim for that year any time before September 15, 2024. There are other rules that apply for refund claims, but the 3-year rule is the general rule. The 3-year clock is not paused while the marijuana rescheduling rule is finalized. Thus, a taxpayer could miss out on a refund (for 2020 tax year for example) while waiting on DOJ and IRS.
The solution may be filing a protective claim for refund. This specialized type of informal refund claim puts a taxpayer’s “foot in the door” for purposes of the 3-year rule and allows a taxpayer to later amend their refund claim after DOJ and IRS finalize the rules. That being said, there are specific requirements for a protective claim to ensure that it meets the rules for a refund claim. In addition, businesses should ensure that they have a strong position to claim a refund to avoid substantial penalties for “excessive” refunds. See I.R.C. § 6676(a).
Former IRS Attorneys at Holtz, Slavett & Drabkin Can Help File Protective Claims for Cannabis Businesses
David J. Warner is a former IRS senior trial attorney (all the attorneys at Holtz, Slavett & Drabkin are former IRS attorneys) who now represents clients in sensitive domestic and international tax examinations, tax litigation, employment tax cases, criminal tax matters, and difficult tax collection matters. David has advised clients in IRS cannabis audits, cannabis businesses looking to fully comply with IRS rules and regulations, and taxpayers filing protective refund claims. Please contact David at (949) 999-6606 to schedule a consultation.