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Taxes in Your Practice: Medical cannabis dispensary deductions denied by the tax court

Vol. 77, No. 2 / Mar. - Apr. 2021

Scott VincentScott E. Vincent

Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City. 


The U.S. Tax Court recently upheld the denial of deductions and imposition of penalties by the Internal Revenue Service relating to a medical cannabis dispensary.

In San Jose Wellness v. Commissioner,2 the court upheld the IRS disallowance of depreciation and charitable deductions and the imposition of penalties. The court found that the taxpayer’s business consisted of trafficking in controlled substances and the deductions were for expenditures paid or incurred in carrying on this business, and therefore disallowed under Code § 280E.3


San Jose Wellness is a corporation operating a medical cannabis dispensary under California law and licensed by the City of San Jose. The taxpayer sold cannabis to individuals with valid doctor recommendations, sold a variety of non-cannabis items, and provided “holistic” services without a separate fee.

The taxpayer deducted a variety of expenses related to its operations for the tax years in question, including depreciation and charitable contributions. The IRS disallowed all of the taxpayer’s deductions pursuant to Code § 280E for the years in question, as well as determined penalties for some of the years. The taxpayer challenged the IRS, arguing its depreciation was not paid or incurred during the taxable year and that its charitable contributions were not made in carrying on a trade or business. Despite prior case law, the taxpayer also argued that none of its expenses should be disallowed under § 280E because its business did not consist of trafficking in controlled substances. The taxpayer also asserted a reasonable cause and good faith exception to the penalties determined by the IRS.

The code generally imposes tax on taxable income, defined under Code § 63 as gross income reduced by allowable deductions.4 Section 280E provides that no deduction or credit is allowed for amounts paid or incurred during a tax year in carrying on a trade or business that consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) that are prohibited by federal law or the law of any state where the trade or business is conducted.5

The court referenced several prior Tax Court cases denying all deductions relating to medical marijuana dispensaries but proceeded with a full analysis of the key requirements under § 280E due to some unique textual arguments by the taxpayer.

“Consist Of” Argument

The taxpayer argued its trade or business includes more than just the sale of cannabis items, so therefore does not solely “consist of” trafficking in controlled substances. The court noted the taxpayer offered this argument simply to preserve appeal rights, since it was clearly rejected in Patients Mutual v. Commissioner.6 The court did not further consider this argument.

“Paid or Incurred During the Taxable Year” Argument

The taxpayer argued its depreciation falls outside the scope of § 280E because it was not “paid or incurred during the taxable year.” The taxpayer’s argument is that the actual expenditures were in different tax years, so only allowable depreciation deductions were taken in the years in question.

The court cited § 7701(a)(25)7 for the provision that “paid or incurred” is to be construed according to the taxpayer’s method of accounting, which San Jose Wellness used the accrual method during the years in question. Per the court, the accrual method is authorized to enable taxpayers to use accounting principles that charge against income the expenses properly attributable to earning that income during a given period. With respect to depreciation, the court cited Commissioner v. Idaho Power Co.8 for the proposition that depreciation is an accounting device that recognizes that physical consumption of a capital asset is a true cost as the asset is depleted, and the purpose of depreciation accounting is to allocate an asset expense to the various periods benefited by that asset. The court also noted that the U.S. Supreme Court referred to depreciation as a “cost … certainly presently incurred.”

Based on this precedent, the court concluded that depreciation is “paid or incurred” during the taxable year. Since the parties agreed the depreciation was incurred in carrying on the taxpayer’s trade or business, and the court had already found that the taxpayer’s trade or business consists of trafficking in controlled substances, the court disallowed the taxpayer’s claimed depreciation deductions for the years in question.

“In Carrying On” Argument

The taxpayer next argued its charitable contributions should be deductible even if its depreciation is not allowable because the charitable deductions were not paid “in carrying on” a trade or business. The taxpayer also argued its charitable contributions were not “business expenditures” and that they should be allowed on policy grounds.

The court again noted § 280E disallows a deduction for “any amount paid or incurred … in carrying on a trade or business” that consists of trafficking in controlled substances.9 The court found the taxpayer was engaged in a trade or business when it made the contributions and found no reason to conclude that making the contributions was separate from or outside the scope of its business activities. In contrast, the court noted that many courts have acknowledged the permissible benefits for corporations in making charitable gifts, such as promoting the goodwill of the business by making substantial contributions in the form of gift. Based on this analysis, the court concluded the taxpayer’s charitable contributions were made in carrying on its trade or business. The court also rejected the taxpayer’s “business expenditure” and policy arguments and held that § 280E disallowed the taxpayer’s charitable contributions for the years at issue.

Accuracy-Related Penalty

The IRS imposed a § 6662 understatement penalty, and the taxpayer sought to avoid this penalty by showing it acted with reasonable cause and in good faith with respect to the underpayment. The court notes that reasonable cause requires consideration of the facts and circumstances, including taxpayer efforts and experience, advice of professionals, and an honest misunderstanding of facts or law. The court found little evidence supporting the taxpayer’s position in this case, including no meaningful allocation issues and no claim of reliance on a tax professional. 

The taxpayer argued that this area of law was unsettled at the time it filed the returns in question, but the court was not persuaded. The court noted the broad language of § 280E precluding deductions for any amounts in carrying on any trade or business that consists of trafficking in controlled substances. The court also referenced prior cases denying deductions for ancillary non-trafficking activities related to trafficking activities, including a U.S. Supreme Court case decided prior to the time the taxpayer’s returns in question were filed. Based on these findings, the court held the taxpayer failed to establish reasonable cause and good faith for the substantial underpayment in question.


San Jose Wellness is a good outline of prior cases and the current Tax Court analysis, which supports the IRS denying deductions related to cannabis dispensary businesses and their ancillary and related activities. The decision does show the complexity in interpreting § 280E in the context of various deductions and activities. As the court notes, some of these issues are apparently being postured for further appeal, so we should continue to follow these issues as the law further develops and more courts review these cases.  


1 Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.

2 San Jose Wellness v. Commissioner, 156 T.C. No. 4 (2021).

3 26 U.S. Code § 280E.

4 26 U.S. Code § 63.

5 26 U.S. Code § 280E.

6 Patients Mutual v. Commissioner, 151 T.C. 176, 196-197 (2019).

7 26 U.S. Code § 7701(a)(25).

8 Commissioner v. Idaho Power Co., 418 U.S. 1, 16-19 (1974).

9 26 U.S. Code § 280E.