Mission Organic Center, Inc. v. Commissioner

Cannabis Dispensary’s $65k Offer Meets $57M Rejection

A state-legal cannabis dispensary's attempt to settle a multi-million dollar tax liability for a mere $65,000 has been rejected by the IRS, and the Tax Court has sided with the agency. The core dispute centered on the dispensary's "Offer in Compromise" (OIC), a formal agreement to resolve tax debt for less than the full amount owed. The IRS dismissed the OIC, determining the company's "Reasonable Collection Potential" (RCP) to be nearly $58 million. The massive difference stemmed from the IRS's refusal to factor in standard business expenses, citing the limitations of IRC § 280E. In a reviewed decision, the Tax Court upheld the IRS's rejection, finding no abuse of discretion. The decision hinged on the IRS's ability to incorporate the restrictions of § 280E into settlement negotiations, a move that drew significant dissents within the court.

The Business of Trafficking: Facts of the Case

As previously mentioned, the IRS rejected Mission Organic Center's offer-in-compromise (OIC), determining the company's "Reasonable Collection Potential" (RCP) to be nearly $58 million. The massive difference stemmed from the IRS's refusal to factor in standard business expenses, citing the limitations of IRC § 280E. In a reviewed decision, the Tax Court upheld the IRS's rejection, finding no abuse of discretion. The decision hinged on the IRS's ability to incorporate the restrictions of § 280E into settlement negotiations, a move that drew significant dissents within the court.

The facts of the case are as follows: Mission Organic Center, Inc., operated as a legal cannabis dispensary in San Francisco, California. Established over a decade ago, the business generated substantial gross receipts, ranging from approximately $2 million to over $16 million between 2016 and 2021. However, because of Section 280E of the Internal Revenue Code, these gross receipts translated into significant unpaid tax liabilities. Section 280E precludes taxpayers from deducting any expense related to a business that consists of trafficking in controlled substances, such as cannabis, which remains a Schedule I controlled substance under federal law. Consequently, Mission Organic could not deduct ordinary business expenses like rent, wages, and utilities for federal income tax purposes.

Faced with these liabilities, Mission Organic submitted an offer-in-compromise (OIC) to the IRS, seeking to resolve its unpaid tax debts. The offer included Form 656, Offer in Compromise, and Form 433-B, Collection Information Statement for Businesses. On its Form 656, Mission marked "Doubt as to Collectibility" as the reason for the offer. The company included its tax returns, bank statements, and a 2021 profit and loss statement, among other financial documents. On Form 433-B, Mission listed total business expenses of $1,490,236, including inventory, wages, rent, supplies, and other overhead costs. The company initially calculated its minimum offer to be $78,582. However, Mission ultimately offered $65,000 in periodic payments, intending to reserve cash for operating expenses.

The IRS's Centralized Offer in Compromise Unit assigned the offer to a revenue officer. The Revenue Officer (RO) evaluated the offer by computing Mission’s Reasonable Collection Potential (RCP). The Internal Revenue Manual (IRM) defines RCP as “the amount that can be collected from all available means.” The RO used Mission’s 2022 profit and loss statement and bank statements to determine its current assets and future income. To determine future income, the RO took the projected gross monthly income and subtracted "allowable expenses," multiplying the difference by the number of months applicable to the terms of offer. The revenue officer determined the future income amount was $57,821,293. This amount included the gross monthly income of $1,323,951, minus monthly expenses of $812,258, multiplied by 113 months.

However, when calculating Mission’s future income, the revenue officer included the income, cost of goods sold, and vehicle expenses as reported on Mission’s 2022 profit and loss statement, but did not allow other business expenses, citing Section 280E and the nature of Mission's cannabis business. Thus, the RO effectively calculated future income by subtracting zero expenses. The revenue officer then added Mission’s total future income to its assets of $30,785 to reach a RCP of $57,852,078.

The Majority View: Discretion and Public Policy

The court's review of the IRS's rejection of Mission's offer-in-compromise (OIC) was limited to determining whether the IRS settlement officer abused their discretion. The Tax Court noted that de novo review is applied where the underlying tax liability is at issue. Sego v. Commissioner, 114 T.C. 604, 610 (2000). But, because the underlying liability was not at issue, the abuse of discretion standard applied. An abuse of discretion occurs if the IRS adopts "an erroneous view of the law or a clearly erroneous assessment of the facts."

Mission argued that the IRS was required to consider Mission's actual ability to pay when evaluating the OIC. However, the court disagreed, finding that the IRS did not abuse its discretion. The court emphasized that Section 7122(a) authorizes the Secretary of the Treasury to compromise any civil or criminal case arising under the internal revenue laws. Furthermore, Section 7122(d)(1) gives the Commissioner wide discretion to accept offers-in-compromise and to prescribe guidelines “to determine whether an offer-in-compromise is adequate and should be accepted.” The court noted that it does not decide for itself what would be an acceptable collection alternative.

The court found that the Internal Revenue Manual (IRM) provided specific guidance for calculating the reasonable collection potential (RCP) of businesses engaged in trafficking controlled substances. IRM section 5.8.5.25.2 instructs that when calculating the future income of a marijuana business, allowable expenses should be limited consistent with Section 280E, which disallows deductions for businesses trafficking in controlled substances. Specifically, Section 280E states that "No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business...of trafficking in controlled substances..." The court reasoned that the settlement officer’s rejection of Mission’s OIC was consistent with these procedures outlined in the IRM.

The court addressed the argument that the IRS's rejection letter did not explicitly cite "public policy" as a reason for the rejection. Citing SEC v. Chenery Corp., the court noted that its review is confined to the rationale the agency used in its Notice of Determination, and it will not uphold a notice of determination on grounds other than those actually relied upon by the Appeals officer. However, the court stated that even if the reference to Section 280E in the Notice of Determination was based on an erroneous understanding that Section 280E mandated the rejection of the OIC, it would not remand the case. The court reasoned that remanding the case to make the policy reference explicit "would be an idle and useless formality" because the Commissioner had the authority to create guidelines to accept offers-in-compromise pursuant to section 7122(d) and did so.

Concurrences: Preventing a '280E Loophole'

The court, having found no abuse of discretion in the IRS's rejection of the offer-in-compromise, also included concurring opinions to emphasize specific points. Judge Copeland, joined by Judges Jones, Guider, and Fung, argued that accepting the taxpayer's offer-in-compromise would circumvent the purpose of Section 280E. Section 280E disallows deductions or credits for amounts paid or incurred in carrying on any trade or business that consists of trafficking in controlled substances, as defined in Schedules I and II of the Controlled Substances Act. Judge Copeland explained that the taxpayer, Mission Organic Center, a marijuana dispensary, complied with Section 280E by filing its returns without taking deductions for rent, salaries, and other business expenses. However, in pricing its products and failing to pay income tax, Mission behaved as if Section 280E did not exist. Copeland reasoned that if Mission priced its products ignoring the limitations of 280E, it shouldn't be bailed out by an offer-in-compromise that would effectively allow those deductions.

Judge Toro, joined by Chief Judge Urda and Judges Pugh, Ashford, Copeland, Jones, Greaves, Guider, and Fung, concurred, relying on INS v. Yueh-Shaio Yang to support the agency's right to define its own discretionary policies strictly. In INS v. Yueh-Shaio Yang, the Supreme Court held that while an agency's discretion may be unfettered initially, if it announces a general policy, it must follow that policy. Judge Toro reasoned that Section 7122(a), which states that "The Secretary may compromise any civil or criminal case arising under the internal revenue laws," gives the Secretary of the Treasury broad discretion in compromising tax cases. Toro argued that the concept of "ability to pay," as well as "reasonable collection potential", are concepts not explicitly found in the statute, but rather are introduced by regulations and the Internal Revenue Manual. Judge Toro asserted that it was within the Commissioner's discretion to define these concepts, and that the IRS Appeals office faithfully followed the Internal Revenue Manual in this case.

The Dissents: Administrative Law and the Manual vs. Regs

Several judges strongly dissented, raising concerns about administrative overreach and the Tax Court's deference to the IRS. These judges argued that the majority opinion stretched legal principles to uphold the IRS's rejection of the settlement offer.

Judge Landy, joined by Judges Jenkins and Holmes, argued that the Court's decision "departs from settled tenets of administrative law and steps into the role of settlement officer." Landy invoked the Chenery doctrine, established in SEC v. Chenery Corp. This doctrine states that a reviewing court can only uphold an agency's decision based on the reasons the agency itself gave when making the decision. In other words, the court cannot invent new justifications for the IRS's actions after the fact. Landy pointed out that the IRS's rejection letter cited Section 280E, which disallows deductions for businesses trafficking in controlled substances, not a discretionary public policy concern. Therefore, the Tax Court could not uphold the rejection by arguing that the IRS was exercising its broad discretion to reject offers that violate public policy, because the IRS never made that argument itself.

Judge Jenkins focused on the conflict between Treasury Regulations and the Internal Revenue Manual (IRM). The IRS uses the concept of "Doubt as to Collectibility" when evaluating Offers in Compromise (OICs). An Offer in Compromise (OIC) is a formal agreement between a taxpayer and the IRS that settles a tax liability for less than the full amount owed. Treasury Regulations define "Doubt as to Collectibility" based on the taxpayer's "ability to pay," considering their assets and income. However, the IRM, which provides internal guidance to IRS employees, appeared to redefine "income" to mean "gross income," disregarding the taxpayer's actual business expenses. Jenkins argued that the IRM cannot override a valid Treasury Regulation. The IRS was, in effect, ignoring the actual economic reality of the taxpayer's financial situation by using gross income instead of net income.

Judge Holmes took a textualist approach, emphasizing the plain language of the relevant regulations. He quipped that "we're all textualists now," referencing a growing trend in legal interpretation that prioritizes the literal meaning of statutes and regulations. Holmes pointed out the inconsistency that the IRS does allow these disallowed expenses for Installment Agreements (another form of settling tax debt over time), yet it disallows them for OICs. If the regulation states "ability to pay," Holmes reasoned, then the focus should be on the taxpayer's actual ability to pay, not some artificially inflated number based on gross income. If the money isn't there, it isn't there, he said, regardless of whether Section 280E disallows those expenses as deductions.

Impact: The Hard Line for Cannabis Settlements

As Judge Holmes pointed out, the IRS does allow these disallowed expenses for Installment Agreements (another form of settling tax debt over time), yet it disallows them for Offers in Compromise (OICs). If the regulation states "ability to pay," Holmes reasoned, then the focus should be on the taxpayer's actual ability to pay, not some artificially inflated number based on gross income. If the money isn't there, it isn't there, he said, regardless of whether Section 280E disallows those expenses as deductions.

The Tax Court, in Mission Organic, has solidified the IRS's hardline stance against cannabis businesses attempting to use the Offer in Compromise program to negotiate their tax debts. The court deferred to the IRS's discretion under Treasury Regulation § 301.7122-1(a)(1), which states that "the Secretary may, at the Secretary’s discretion, compromise” a liability. The court reasoned that calculating a business's ability to pay is not addressed in the regulation, so the IRS could set forth its calculation method in the Internal Revenue Manual (IRM).

The "ability to pay," when determining Reasonable Collection Potential (RCP) for these businesses, will be calculated based on gross receipts, not net income. This makes OICs effectively impossible for cannabis businesses, as the disallowed deductions under Section 280E create an artificially high RCP. Section 280E of the tax code disallows businesses trafficking in controlled substances from taking standard business deductions.

The court found that the IRS's specific marijuana policy, as detailed in the IRM 5.8.5.25.2, survived judicial scrutiny. The IRS's policy of disallowing deductions for RCP calculations was deemed "consistent with Internal Revenue Code 280E." This means that the IRS is permitted to adhere to the public policy underlying the enactment of Section 280E when evaluating a business's ability to compromise its tax debt.