A judge on the U.S. Court of Appeals for the Tenth Circuit on Tuesday expressed exasperation with federal tax audits of state-legal marijuana dispensaries, urging the U.S. Department of Justice to “fish or cut bait” on pursuing licensed operations.

U.S. Circuit Judge Carlos Lucero said the threat of federal prosecution “is like a hammer over” marijuana businesses' heads “whenever it comes time to pay their taxes.”

“The Department of Justice at some point ought to make a decision, to either fish or cut bait on the issue,” Lucero said during oral arguments in Feinberg v. Commissioner of Internal Revenue. “And if they're going to prosecute, then prosecute and bring the whole thing to a head. Or grant immunity and allow the tax operations to operate somewhat more smoothly.”

At issue is whether owners of a Colorado dispensary should be allowed to deduct the same business costs from their taxes as other, non-marijuana companies. The Feinbergs and a third shareholder are appealing a U.S. Tax Court ruling that upheld the U.S. Internal Revenue Service's decision to deny certain deductions.

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The case is the latest front in Greenwood, Colorado, firm Thorburn Walker's attack on Section 280E of the Internal Revenue Code, which bars tax deductions from income derived from drug trafficking. The firm's lawyers have challenged the law and dispensary tax audits on the grounds that the IRS has become a de facto criminal law enforcement agency.

Judges have generally not been sympathetic to their arguments. And on Tuesday, that seemed to be the case with Lucero's fellow panelists, Circuit Judges Carolyn Baldwin McHugh and Nancy Moritz.

“This is a huge conflict between how the federal government treats marijuana and how some of the states treat marijuana,” McHugh said to the plaintiff's lawyer, James Thorburn. “And so long as we have a supremacy clause, your clients are going to lose because it's still illegal under federal law.”

Lucero, however, accused the IRS of “punish[ing] this business to the point of destruction” amid “this huge mix of tax-raising and criminal law.”

“So the IRS says in this case, even though the business is legal in Colorado, because the federal government says it is not legal to sell marijuana or “traffic” in marijuana you're going to have to pay taxes on the whole bloody thing,” Lucero said at one point. “'Colorado, up yours. We're going to ignore everything that you as a state, under the United States Constitution, have the power to do and has done.'”

Francesca Ugolini, assistant chief at the Department of Justice's tax division, said the plaintiffs were allowed to take a “substantial” deduction for costs of goods sold—an amount the IRS actually increased after the audit. Both the Ninth and Tenth circuits have upheld the constitutionality of Section 280E and barring deductions of certain business expenses to marijuana operations, she said.

“We enforce the laws that exist and this law has been on the books, I believe, since the '80s,” Ugolini said. “So the businesses in Colorado and California and some of the other states that have decided to go into this business are, or at least should be, fully aware of the tax implications of deciding to enter this type of business.”

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