Public opinion on marijuana use and legalization has undergone a seismic shift over the past few decades. According to the Pew Research Center, about two out of three Americans now support the legalization of marijuana. In contrast, as recently as 1989, 81 percent of the population favored laws prohibiting the use or sale of the drug. By looking at generational differences in opinion, it is clear that the winds of change are gusting in the direction of legalization. Most Baby Boomers, Generation Xers, and Millennials believe the drug should be legal, while the Silent Generation stands alone in opposition.

As of 2020, eleven states have passed laws legalizing marijuana for recreational use. Yet, the status of dispensaries in those states is complicated because federal law still considers the drug to be illegal. One area in which these conflicting laws becomes problematic for businesses is taxation. Under the Federal Tax Code, marijuana dispensaries owe taxes like any other business. Tax laws were clearly written to ensure that illegal revenue is still subject to taxation. However, thanks to IRS Code Section 280E, these businesses cannot benefit from tax breaks that are afforded to others outside of the marijuana industry. In dollar signs, that distinction adds up to a lot of green. Not surprisingly, leaders in the rapidly-growing multi-billion dollar industry are ready to challenge Section 280E.

The History of Section 280E and the Harborside Lawsuit

IRS Code 280E went into effect as part of the Reagan Administration’s anti-drug efforts. During the 1980s, the “War on Drugs,” which was started by the Nixon administration, remained a government priority. By enacting 280E, the government ensured that businesses dealing in controlled substances were not eligible for deductions and credits. For the purpose of the tax code, “controlled substances" are those defined as schedule I and II substances in the Controlled Substances Act. That law categorizes marijuana as a Schedule I drug, placing it in the same legal category as heroin.

When California legalized marijuana, Harborside Health Center became an early giant within the industry. The company was one of the first to receive approval for medical marijuana and later began operating in the recreational market as well.

In 2012, the IRS initiated litigation against Harborside, alleging that the company had claimed tax benefits not entitled to a business that primarily sells marijuana. In a U.S. Tax Court ruling, the court sided with the IRS, stating that Harborside must repay many of the deductions that it had claimed between 2007 and 2012. In total, that sum amounted to more than eleven million dollars in taxes owed.

The Treasury and the Justice Department are Separate

In finding in favor of the IRS, the court had to rationalize the difference between tax law and criminal law. Congress has enacted laws prohibiting the US Justice Department from using its funds to prevent the distribution, possession, cultivation, or use of marijuana in states that have legalized the drug. These laws allow some freedom for marijuana businesses with legal sanction from the state to operate without fear of harassment from the Justice Department.

However, the court pointed out that the IRS is not in the Justice Department, but rather is controlled by the Department of Treasury. As such, the laws prohibiting the Justice Department from shutting down a legal dispensary in California do not prevent the IRS from taxing such a business as one that deals in controlled substances.

Harborside Appeals

Harborside criticized the court’s findings and lamented the government-imposed setback to what is becoming a burgeoning and lucrative industry in many parts of the country. The company next filed an appeal with the United States Court of Appeals for the Ninth Circuit.

In an appellate brief filed this May, Harborside’s attorneys made their case for declaring Section 280E unconstitutional. The industry is backing Harborside, and trade organizations were quick to weigh in on the decision in two amicus briefs. The argument suggests that 280E is not taxing “income,” which the government has the right to do pursuant to the 16^th Amendment of the U.S. constitution. Instead, the section taxes "phantom income," which is not taxable because the taxpayer has not actually received the funds.

The brief also argues that Harborside is facing discriminatory taxing because it is not able to claim standard business deductions, such as the cost of rent or labor.

The government has yet to file a brief, but there is speculation regarding the argument that the state will use to challenge the appeal. In short, it is supposed the government will claim that dispensaries are subject to an extremely narrow interpretation of the tax law and can deduct only the cost of storing and transporting its products.

The Decision Will Impact the Growth of the Marijuana Industry

The decision of the Ninth Circuit Appeals case will signal the future treatment of the marijuana industry. While the court’s decision will have authority only within the Ninth Circuit, a win for Harborside could empower businesses from other parts of the country to challenge the law. If the government prevails, it could mean hard times for the many dispensaries throughout the country, especially when so many businesses are struggling to cope with the economic difficulties imposed by the COVID-19 pandemic.

Is the IRS Treating Marijuana Dispensaries Fairly?

The tax treatment of the marijuana industry is somewhat strange because even the Federal Government appears to be moving in the direction of legalization. Given that the shift to legal marijuana appears to be an issue that has the increasingly rare luxury of bipartisan support, aggressive taxation of the industry seems like a government cash grab. Taxing marijuana as an illegal substance is out of touch with the political and cultural climate of 2020. The IRS might be seizing millions through the use of an anachronistic law, even while it appears that the law’s days are numbered.

The War on Drugs has not aged well. Laws that were designed to crack down on drug users and dealers are believed to be racist and ineffective. In fact, the country is still struggling with a massive opioid epidemic that kills an average of more than 130 Americans every day.

While the courts may decide the government’s taxation is legal, it is not fair, nor is it beneficial to the public. Higher taxes on legal marijuana dispensaries only make it more challenging for these businesses to compete with their illegal counterparts. With the high cost of taxes, legal marijuana can only be sold at prices far higher than the drugs that are sold on the black market. Taxing Harborside and other reputable players in the industry is tantamount to putting money in the pockets of criminal organizations.