Tax burdens are based on a company’s or individual’s income during the taxable year. Two of the most important figures viewed by the Internal Revenue Service (IRS) are: 1) gross income and 2) taxable income. A taxpayers’ gross income is determined by looking at the amount of money made minus the cost of the products sold. For example, let’s say a person sells computers. If they buy a computer for $1,000, and sell the computer for $1,800, their gross income is $800 per computer. You can extrapolate this figure to determine the taxpayer’s gross income in a given tax year.
Taxable income is a different beast entirely. Taxable income takes a taxpayer’s gross income and then accounts for various deductions including business expenses. This is the gray area where every criminal tax defendant, aggressive CPA, and tax lawyer spends their time. Unlike determinations of gross income, the calculation of taxable income is at the sole discretion of Congress. Congress can choose which expenses are properly deductible and which shall be barred from consideration.
Every deduction dispute in tax court will follow a similar modus operandi. The tax filer will file their returns with the IRS. The IRS will then mail out a deficiency notice claiming an inaccuracy in the deductions. This deficiency notice will provide the tax payer with the new amount owed. The taxpayer can then challenge this assertion in a formal proceeding before a tax court.
During litigation, the tax payer will own the burden of proving the accuracy of the deduction. Put differently, they must produce evidence to show the IRS is wrong in their assertion of the new tax calculation. This concept is straightforward in most cases. However, it becomes murky when dealing with IRS challenges under 26 U.S.C. §280E. This section of the Internal Revenue Code (IRC) states:
“deductions are prohibited for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
26 U.S.C. §280E.
A taxpayer involved in an illegal business will be placed in a predicament when challenging any deduction under this section. Most criminal lawyers will advise a client to not turn over any evidence to the government, or a court’s clerk, which implicates them in criminal activity. But in challenging a §280E deduction, the rules are asking the taxpayer to do exactly that – turn over information about the business so a court can determine the validity of the deductions.
This may sound like an absurd area of the law. After all, how many criminals file tax returns for their criminal enterprise. The short answer is most do not. Most of the others file under a seemingly legitimate business through money laundering schemes. However, there is one notable industry considered legitimate by the states and illegal by the federal government – marijuana grow and sale operations.
In February of 2019, the Tenth Circuit delivered an opinion regarding this apparent clash between the United States Constitutional right against self-incrimination and the burden of proof under §280E.
Feinberg v. Internal Revenue Service
In 2010, three Colorado residents (taxpayers) formed a company named Total Health Concepts, LLC (THC). THC was organized as a S-Corporation and engaged in selling medical marijuana within the state of Colorado. Based on THC’s S-Corporation status, the taxpayers were responsible for declaring business income and deductions on their personal returns. The IRS conducted an audit of their 2010-2011 returns. After audit, the IRS disallowed certain deductions under 26 U.S.C. §280E. The loss of these deductions resulted in an increased tax liability to each individual taxpayer.
Title 26 U.S.C. §280E deals with the validity of business deductions for illegal businesses. Notably, §280E makes it improper to allow business deductions for any business which trades in illegal substances, including marijuana. THC was welcome to pay their taxes for income on a marijuana business approved by Colorado law, but they would not be able to receive any business deductions.
THC, and its owners, now had two options: 1) prove the deductions did not fall under the confines of §280E or 2) agree to the increased tax burden. The taxpayers chose to fight the finding in United States Tax Court. In doing so, they took on the burden of proof as discussed earlier. During the litigation, the IRS requested various documents in discovery involving the nature of THC’s business. The taxpayers failed to turn over any evidence to counter the IRS’ notice that §280E barred their deductions asserting their Fifth Amendment right against self-incrimination. To the taxpayers, the United States Constitution contradicted the burden of proof mandates in the tax litigation.
The United States Tax Court ruled against the taxpayers stating the taxpayers failed to provide evidence showing that §280E did not apply. The taxpayers appealed that decision to the Federal Court of Appeals for the Tenth Circuit. The taxpayers’ argument on appeal was the government must hold the burden in a §280E analysis because a burden shift would require all taxpayers to incriminate themselves contrary to the Fifth Amendment.
It was undisputed that prior case law established the burden falls on the taxpayer in a §280E determination. However, no case had reviewed whether such a ruling violated the Fifth Amendment rights of the taxpayer. The taxpayers provided case law to the Tenth Circuit in support of their position. However, the case law dealt with the criminal prosecution of a person for failing to self-incriminate. For instance, if a statute forbids a person’s failure to register a firearm, but registering would provide incriminating information, the government is barred from prosecuting that person for failing to register. Put differently, a person cannot be given a choice between self-incrimination or prosecution.
The taxpayers at THC faced no such issue. Their choice was simple. Either produce evidence showing that §280E does not apply or pay the increased tax burden. Their failure to provide the information would not lead to criminal prosecution. At worst, they would be stuck with the IRS’ tax determination. The Tenth Circuit summed up its argument as follows:
“Such a concept would convert the [Fifth Amendment] privilege from the shield against compulsory self-incrimination which it was intended to be into a sword whereby a claimant asserting the privilege would be freed from adducing proof in support of a burden which would otherwise have been his.”
The taxpayers lost in the Tenth Circuit and their taxable income for the year did not account for various business deductions which would have been acceptable for legal businesses. In recent years, the federal government has not aggressively enforced federal marijuana laws. They have allowed the states who legalized marijuana for medicinal and recreational use to pursue the experiment within their states’ borders. However, the IRS continues to utilize §280E as a tool to maximize taxes on marijuana companies. There is no doubt the IRS is correctly using §280E to enforce higher taxes. The question now becomes whether the federal government will take further steps in legitimizing the marijuana industry beyond their states’ borders.
The push and pull between federal and state law has always been a staple of this country’s jurisprudence. The growing marijuana industry is a great example of another cog in that fight. For decades, it has been established the federal government can criminalize and enforce marijuana laws within state borders. The states, and the companies within their borders, function at the compassion of the federal government. The federal government can decide to shut down the entire experiment, or they can continue to loosen their strangle hold over marijuana and its cultivation. My guess is the federal government will continue to loosen their restrictions on marijuana laws and their companies. The main question is how quickly they will move. They could decide to legalize marijuana and nullify §280E’s applicability tomorrow. Or they could slowly start carving out exceptions in different federal laws to ease the concerns of the industry. It will be interesting to see how this modern-day states’ rights issue continues to evolve over the next decade.