Updated on Aug. 28 at 9:12 a.m.

With some form of marijuana now legal in 31 states and the District of Columbia, the nation may be marching toward the end of cannabis prohibition. The Internal Revenue Service, however, is moving to a very different legal beat.

Last month, the U.S. Circuit Court of Appeals for the Tenth Circuit upheld the federal tax agency's power to block state-legal marijuana operators from deducting certain business expenses from their taxes. The IRS derives its authority from Section 280E of the Internal Revenue Code, which bars companies from taking those deductions if they “traffic” in Schedule 1 drugs.

While California and other states may regulate licensed marijuana businesses, the IRS says the activity remains illegal for tax purposes. Without those deductions, state-legal operators can be hit with an effective total tax rate of 70 percent or more.

“I hear a lot of 'If we had only known,'” said Jennifer Benda, a tax attorney at Fox Rothschild in Denver. “Most of my [cannabis] clients are already teetering on the edge because of this.”

So how does an attorney counsel clients facing that kind of tax bill? Generally, there are three tacks, according to interviews with lawyers focusing on tax issues in the cannabis arena.

|

Challenge 280E in the courts.

Greenwood, Colorado-based Thorburn & Walker has made a niche practice of challenging 280E and the IRS interpretation of its provisions. In the case Alpenglow Botanicals v. United States of America, James Thorburn and Richard Walker sued the federal government on behalf of two Colorado dispensary owners smacked with a combined $53,000 bill from the IRS for allegedly taking improper tax deductions.

A Tenth Circuit panel sided with the IRS. Thorburn and Walker have asked the full court to reconsider that ruling. The attorneys have declined to comment on the case, but they have alleged in the past that the federal government is using tax laws—instead of criminal prosecutions—to crack down on state-legal marijuana operations. In Alpenglow, they argue, the court gave the IRS too much prosecutorial power.

➤➤ Get the latest cannabis lawyering, compliance and commentary straight to your inbox with Higher Law, a new Law.com briefing. Learn more and sign up here.

“The court's decision has now opened the door to criminal convictions of drug law crimes via administrative order,” Thorburn and Walker wrote in petitioning the Tenth Circuit for review. “For the sake of our Constitution, this is not a door that should be opened.”

Other lawyers are resigned to the likelihood that courts are unlikely to curb IRS power. “A court is not going to say that 280E does not apply to these businesses,” said Benda.

James Hunt, an attorney at Harris Bricken in Seattle, said he's “never advised clients to not apply 280E” to their tax returns. “A lot of this comes down to the statute says what it says, and there's no doubt that is a very harsh statute.” Hunt said. “It's unfair.”

|

Fight to change another section of tax law.

Another potential area of tax law ripe for challenge, Benda said, is Section 263A of the Internal Revenue Code. The statute could allow marijuana businesses to calculate their inventory costs in a way that would help lower their tax bills—if they could use the provision. The IRS office of chief counsel said in a 2015 memo that 263A was not meant to make non-deductible expenses deductible.

“What I tell these [tax] agents is, if I wasn't a marijuana business you would let me put this into costs of goods sold,” Benda said.

Benda said that singling out cannabis companies from inclusion in this provision is a weak legal argument, and while it hasn't been challenged yet, “it will be soon.”

|

Just deal with it and wait for Congress to act.

Marijuana businesses can factor in the heavy tax load that comes with federal laws and still survive, but “it's very, very hard,” said Hunt of Harris Bricken.

Marijuana tax law “is clearly punishment. It's meant as a punishment” to the industry, he said.

Some things can be done to lower tax bills, Benda said.Packaging done where marijuana is cultivated is generally accepted as includible in a cost of goods sold but packaging done at a retailer's site can present issues, she said.

“You have to minimize your retail costs,” Benda said. “That's how you minimize your 280E costs.”

Congressional allies of the regulated marijuana industry have introduced legislation that would allow cannabis operators to take the same tax deductions enjoyed by other companies. Those bills and others favorable to state-legal businesses have stalled amid opposition from key congressional leaders.

Read more: