Making Sense of Internal Revenue Code Section 280E – Part II

Today, we’re picking up right where we left off last week, shedding more light on Section 280E by examining some of the noteworthy cases (and one memo) that have come to define it.

IRS Chief Counsel Advice Memorandum

In 2015, the IRS Office of Chief Counsel issued guidance on the application of Section 280E in the form of a memorandum. It’s a very technical document, but also very useful in understanding the statute, walking through the distinction between gross receipts and gross income (primarily, COGS) and discussing what constitutes COGS for purposes of Section 280E. The key takeaway from the Chief Counsel Advice Memorandum is that COGS should be determined under the Section 471 inventory rules, and that the Section 263A UNICAP rules have limited bearing, as they require capitalization of otherwise deductible expenses. Effectively, a cannabis business can’t use Section 263A to convert business expenses disallowed under Section 280E into COGS.


Finally, on to some new case law. Alterman doesn’t offer any new issues to contend with. It is, in many ways, similar to Olive, but with somewhat more compelling facts. Alterman sold cannabis products, and in order to meet Colorado licensing requirements, also had a grow site. The cultivation aspect of the business generated substantial COGS. However, because Alterman failed to account for COGS properly and its books and records were inadequate, it was denied significant portions of the COGS, resulting in a steep tax bill. Similar to the taxpayer in Olive, Alterman also sold pipes, papers, and other paraphernalia, and made a weak attempt at characterizing this activity as a separate non-trafficking trade or business. The court rejected Alterman’s separate trade or business argument, finding that the marijuana sales dwarfed the non-marijuana sales, and that non-marijuana products were merely a complement to its sole business of selling marijuana.


In Loughman, the taxpayer-cannabusiness owners were assessed additional tax on a flow-through basis, resulting from the disallowance of expense deductions at their S corporation under Section 280E. The taxpayers contested the adjustments as they pertained to their wages because S corporations are required to pay their shareholders reasonable wages, and by disallowing the deduction for those wages, Section 280E was creating double taxation that is discriminatory with respect to S corporations. The court disagreed and walked through an example showing that the end result of applying Section 280E is economically no different in the S corporation context than it is for other flow-through organizations. For good measure, the court also pointed out that the taxpayers were free to choose the form of their business operations, and they chose to operate as an S corporation.

Alpenglow Botanicals

Alpenglow was on appeal to the Tenth Circuit and, as such, its opinion contains no factual development, but rather a review of specific questions of law. Namely, does the IRS have authority to apply Section 280E if there is no federal conviction for drug trafficking, and is Section 280E in conflict with the 16th Amendment and, therefore, unconstitutional? The 16th Amendment question is fairly easily disposed of because 280E doesn’t affect COGS. Congress considered this in 1982 when drafting Section 280E, and there is also ample prior case law on point. Whether a conviction is required is the more interesting question. In my opinion, the court avoids really getting into it. Instead, the court finds that no conviction is required on the basis that:

  • Well . . . Section 280E doesn’t say a drug trafficking conviction is required. Though, I would point out it doesn’t say it isn’t required either.
  • The IRS has been given express authority to determine tax liability, and like we’re always telling you: deductions are a matter of legislative grace. This doesn’t really seem to answer the question. Congress already determined to grace us with ordinary and necessary business expense deductions. We just aren’t sure whether Section 280E limits them only when there is a federal conviction for drug trafficking or otherwise.
  • Lots of other Section 280E cases have been decided, and those courts didn’t even mention this issue. I might ask whether the taxpayer raised the argument in those other cases because the court probably wouldn’t voluntarily consider this issue.

I think the conviction question raised in Alpenglow can be pushed further and is likely to pop up again. For now, the answer is no—no drug trafficking conviction necessary.

In a nutshell: A taxpayer-cannabis business does not need to be convicted of the crime of drug trafficking under federal statute in order for the IRS to apply Section 280E. Section 280E disallows ordinary and necessary business expenses attributable to producing, transporting, and/or selling cannabis and cannabis-derived products. However, if an enterprise has two or more bona fide business segments, at least one of which involves an aforementioned cannabis trade or business, that enterprise should keep separate books for each segment, or at least document its use of reasonable methods for allocating expenses among its cannabis and non-cannabis business segments. Section 280E does not affect COGS because COGS are not business expenses, but rather a component of calculating gross income. Though, a lack of proper books and records may result in a cannabusiness’ COGS being disallowed under other provisions of the Code (as is the case with any business in any industry).

Well, there it is, but try not to get too salty about Section 280E, as there may be some planning opportunities to help mitigate its impact. Check back for a follow-up installment on the subject in the near future.