The Internal Revenue Service (IRS) recently filed its first written response to arguments used widely by cannabis taxpayers as justification for not paying Section 280E taxes. The closely-watched U.S. Tax Court case, New Mexico Top Organics v. Commissioner, has been heralded as the critical vehicle for challenging the applicability of Section 280E to legally sold cannabis. The significance of the case for the cannabis industry is underlined by the fact two amicus briefs have been filed in support of the taxpayer’s position.
Taxpayer Position
The taxpayer’s principal argument relies on the parenthetical language in Section 280E referring to controlled substances “within the meaning of schedule I and schedule II of the Controlled Substances Act.” The taxpayer asserts the federal government’s current position is that cannabis belongs on Schedule III and thus cannabis is no longer a controlled substance within the meaning of Schedule I.
The evidence that cannabis belongs on Schedule III is a Department of Health and Human Services (HHS) study that recommended cannabis be rescheduled from Schedule I to Schedule III, and a National Institute on Drug Abuse study to similar effect. Although the taxpayer position acknowledges there has been no formal rescheduling, it asserts the government’s position is that cannabis no longer fits within the meaning of Schedule I, and thus falls out of section 280E.
A secondary taxpayer argument is: 1) the Department of Justice is not allowed to prosecute persons engaged in state legal cannabis commerce under various Congressional appropriations riders to the Department of Justice budget, and 2) thus medical cannabis is not subject to 280E since it is not “prohibited by Federal law” as required under section 280E. The appropriations riders also form the basis of a tertiary argument that medical cannabis falls out of Congressional commerce clause authority and thus cannot be a Schedule I controlled substance.
IRS Position
The March 6 IRS response to these arguments is forceful. It points out the Tax Court lacks authority to undertake a de novo analysis of cannabis scheduling and that cannabis remains in Schedule I pursuant to Congressional legislation. The Controlled Substances Act has a complex procedure for rescheduling which can’t be set aside by the Tax Court (under which the U.S. Drug Enforcement Agency (DEA), not HHS, is responsible for rescheduling). The taxpayer contemplates cannabis being in Schedule I for CSA purposes, but not in Schedule I for tax purposes, a nonsensical outcome.
With respect to the appropriations riders, the IRS states their only impact is “to limit funds being used for limited purposes during limited periods of time” and do not constitute a covert federal legalization of cannabis. Furthermore, the riders do not stand for an implicit overruling of Congressional authority under the Commerce Clause, as decided by the Supreme Court in Gonzales v. Raich.
Significance of the IRS Response in New Mexico Top Organics
If rescheduling is imminent, what is the significance of New Mexico Top Organics? Any change in the application of the tax law from rescheduling would be prospective only, so the open tax years (generally speaking, 2022 through the present) for which cannabis taxpayers have taken non-280E positions are still subject to audit.
Further, the IRS is making clear from its position in this case that the reasons advanced by many taxpayers (and their opinions from counsel) do not meet a reasonable basis standard and will be subject to appropriate penalties.
