Last week’s article in the New York Times Legal Marijuana Ends at Airport Security, Even if It’s Rarely Stopped discusses the increasingly odd situation of passengers who are legally entitled to possess and use marijuana finding themselves at risk when they transport marijuana across state lines, even if the air travel originates and ends in states where the possession and use is legal. The federal income tax treatment of the marijuana industry likewise reflects an odd reality: those in the business are expected to pay tax on their sizeable profits, yet Section 280E prohibits those in the business from claiming deductions that they would be entitled to if they were trafficking in other products that did not constitute a controlled substance under federal law.
In the NYT article, a spokesperson for TSA stated that it does not actively look for marijuana when it screens passengers; yet if an agent comes across it in her screening (as an agent did with my banana and apple I forgot about placing in my wife’s carry on bag on our flight last month from Frankfurt), she will alert local law enforcement.
In contrast with TSA, IRS appears to be pretty active in enforcing its mandate under Section 280E. High Desert Relief v US, out of a district court in New Mexico, highlights a couple of procedural issues, including the IRS’s ability to use its considerable summons powers to gather information about the businesses and their compliance with the federal civil tax laws.
High Desert Relief (HDR) operates a legal medical marijuana business in New Mexico (its motto is “relief through high quality medicine”). IRS began examining its 2014 and 2015 tax years, and as part of the examinations it issued third party summonses to a bank and the New Mexico Department of Health and another state agency.
HDR sought to quash the summonses, essentially on the ground that the IRS could not satisfy the Powell requirements that its actions were conducted pursuant to a legitimate purpose because IRS was using its civil summons powers to conduct a criminal investigation. The government responded and included an affidavit from the Revenue Agent, claiming that she issued the summonses to “assess the correctness of [HDR’s] returns and determine if HDR has unreported taxable income” and to “substantiate the gross receipts reported in HDR’s tax returns.”
As part of its argument, HDR claimed that Section 280E requires a “finding of criminal behavior” that is beyond what was needed in the summary summons process. Unfortunately for HDR, a number of cases have already rejected this and similar arguments. Section 280E, though referencing a criminal statute, does not require any outside determination that a crime has been committed. Quoting from a 2016 federal district court case out of Colorado, Alpenglow Botanicals v US, the opinion explained that
[t]rafficking as used in § 280E means to buy or sell regularly. Californians Helping to Alleviate Med. Problems v. C.I.R., 128 T.C. 173, 182 (T.C. 2007). As such, the real issue here is whether the IRS has authority to determine if, in the course of plaintiffs’ business, they regularly bought or sold marijuana. The Court cannot understand why not. Such a determination does not require any great skill or knowledge, certainly not skill or knowledge of a criminal investigatory bent….
While Section 280E references a criminal statute, as the HDR court explained, IRS civil examinations can investigate “whether a party violates the [Federal Controlled Substances Act] without conducting a criminal investigation.”
There were a couple of other arguments worth highlighting. HDR argued that the information was available for the IRS; under US v Powell, in establishing that the summons was issued in good faith, IRS must show that the information was not already in the Service’s possession. HDR had claimed it made all the requested information available to the IRS. Yet, in making the information available, HDR conditioned its release on it getting “assurance from the IRS, that the IRS will use the information furnished for this civil audit, and not to support the IRS’s determination that the Taxpayer’s business consists of illegal activities.”
The court found that this conditioned availability was not enough. In addition to HDR not showing that there was a complete overlap between the requested documents and what HDR offered to make available, the court pointed to Section 6103(i). That, in certain situations, requires IRS release of tax return information for other federal laws not relating to tax administration. Restricting the IRS’s use of the information was not the same as providing the requested information.
Another issue in the case received relatively little attention and perhaps is the meatiest of the procedural issues. HDR argued that it was not given sufficient notice of the IRS’s use of a third party summons. Section 7602(c) (1) states that during an IRS inquiry and IRS employee may not contact a third party “with respect to the determination or collection of the tax liability of such taxpayer without providing reasonable notice in advance to the taxpayer that contacts with persons other than the taxpayer may be made.”
The IRS argued that its sending to HDR a Publication 1 was sufficient notice. That publication, which IRS sends to every taxpayer subject to audit, states the following:
Potential Third Party Contacts
Generally, the IRS will deal directly with you or your duly authorized representative. However, we sometimes talk with other persons if we need information that you have been unable to provide, or to verify information we have received…. Our need to contact other persons may continue as long as there is activity in your case.
Without analysis, the district court in New Mexico found that the generic publication was adequate for purposes of Section 7602(c)(1). As I recently described in the revision to the Saltzman Book IRS Practice and Procedure treatise in the chapter on examinations at 8.7 Third Party Contacts and in Chapter 13 addressing the IRS summons power, last year in Baxter v US a federal district court in California concluded that in fact the generic notice is insufficient to meet IRS’s notice requirements for these purposes. The district court held that the government had to tell the taxpayer which third party it was going to contact. This issue deserved a little more attention in the opinion, and as I have noted in the Saltzman write up, the courts are applying Section 7602(c)(1) and reaching differing outcomes. IRS in years past given more specific notice but lately has defaulted to its Pub 1 for these purposes. The current IRS approach seems to be inconsistent with regulations and Congressional purpose in enacting the notice provisions, and I suspect that other courts will give this issue greater attention.
A final issue in HDR is worth mentioning. The taxpayer argued that the “federal criminal drug laws with respect to state-legal marijuana sales [are] dead letter.” As such, it looked to old cases under Section 162 that allowed beer and liquor distributors deductions for activities that technically violated state laws, such as gifting beer or providing rebates to distributors. States turned a blind eye to those practices and did not enforce the laws prohibiting them. The main difference is that while Section 162 disallows deductions for activities in violation of state law, the Code itself provides that the limitation on deduction under Section 162 only applies if the state law is “generally enforced.” No such limitation appears in Section 280E.
The bottom line for HDR is that Section 280E does not in any way limit the government’s broad reach to access documents and information in a civil examination. The tax system thus contributes to the schizophrenic legal approach to the marijuana business. While the federal government is willingly collecting tax revenues and enforcing the internal revenue laws, the marijuana industry operates on a different substantive plane.