Mission Organic Center, Inc. v. Commissioner

Cannabis Industry's Settlement Hopes Up in Smoke

Cannabis businesses, already struggling under the weight of Internal Revenue Code (IRC) § 280E, which prohibits deductions, sought a lifeline through the Offer-in-Compromise (OIC) program. In a reviewed opinion that has significant implications for the cannabis industry, the Tax Court ruled that the IRS can disregard 'real' business expenses when calculating a marijuana business's ability to pay, effectively closing the door on OICs as a workaround for 280E. The case highlights the extreme tax burden faced by cannabis companies: the taxpayer offered $65,000 to settle a $5.2 million debt, but the IRS calculated they could pay $57 million.

The $57 Million Calculation

Mission Organic Center, a San Francisco-based marijuana dispensary operating legally under California state law, found itself facing a crippling federal tax burden due to Section 280E. Section 280E of the Internal Revenue Code disallows deductions for businesses trafficking in controlled substances, which, under federal law, includes cannabis. Established over a decade ago, Mission's gross receipts ranged from approximately $2 million to over $16 million between 2016 and 2021. However, because of 280E, the company could not deduct ordinary business expenses, leading to substantial unpaid income tax liabilities. To resolve these liabilities, Mission submitted an offer-in-compromise (OIC) to the IRS. An offer-in-compromise, authorized under Section 7122, allows the IRS to settle a tax liability for less than the full amount owed under certain circumstances.

Mission based its OIC on "doubt as to collectibility," arguing that its assets and income were insufficient to pay the full liability. Accompanying the OIC was Form 433-B (OIC), which detailed Mission's financial information, including $1,490,236 in total business expenses encompassing inventory, wages, rent, and other operational costs. While Mission calculated its minimum offer to be $78,582, it proposed a settlement offer of $65,000 in periodic payments.

The IRS, however, viewed the situation differently. The Centralized Offer in Compromise Unit assigned a revenue officer to evaluate Mission's "reasonable collection potential" (RCP). According to the Internal Revenue Manual (IRM), the RCP is "the amount that can be collected from all available means." Using Mission's 2022 profit and loss statement and bank statements, the revenue officer calculated Mission's current assets and future income. The IRM stipulates that future income is calculated by subtracting allowable expenses from projected gross monthly income and multiplying the difference by the number of months applicable to the terms of the offer.

The revenue officer determined Mission's future income to be $57,821,293. This figure was based on a gross monthly income of $1,323,951, minus monthly expenses of $812,258, multiplied by 113 months (representing the remaining months in the collection period). Crucially, the revenue officer disallowed the business expenses, citing Section 280E because Mission was a cannabis business. 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 any other business expenses. Adding this future income to Mission's assets of $30,785 resulted in an RCP of $57,852,078, an amount significantly exceeding Mission's outstanding liability of $5,246,293 and its $65,000 offer. Consequently, the revenue officer made a preliminary decision to reject Mission's OIC.

The Court's Ruling: Policy Mirrors Statute

Following the calculation that resulted in a RCP of approximately $57 million, the Court addressed the core legal dispute: whether the IRS can use Section 280E—a statute concerning taxable income—to determine "ability to pay," a factor in evaluating offers in compromise under Section 7122. Section 7122(a) authorizes the Secretary of the Treasury to compromise any civil or criminal tax case, while Section 7122(d) authorizes the Secretary to prescribe guidelines for IRS employees to determine whether an offer is adequate. The Court held that it could.

While acknowledging that Section 280E does not explicitly mandate the disallowance of business expenses for calculating reasonable collection potential (RCP) in the context of offers-in-compromise (OICs), the Court reasoned that the IRS has discretion under Section 7122 to adopt guidelines for evaluating OICs. Section 280E, titled "Expenditures in connection with the illegal sale of drugs," 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 if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances."

The Court reasoned that the IRS's policy of disallowing deductions for marijuana businesses when calculating RCP mirrored the Congressional intent behind Section 280E—namely, to penalize drug trafficking. The Court emphasized that the IRS's policy, as articulated in Internal Revenue Manual (IRM) 5.8.5.25.2, doesn't claim to be required by Section 280E, but merely "consistent with" it, thereby fitting within the broad discretion granted to the IRS to set OIC guidelines.

The Court also addressed concerns raised about the Chenery doctrine, which generally requires a court to judge the propriety of agency action solely on the grounds invoked by the agency at the time of the action. Referencing Morgan Stanley Capital Group Inc. v. Public Utility District No. 1 of Snohomish County, the Court stated that remand would be unnecessary because the Commissioner’s reliance on public policy, as stated in the IRM, was consistent with the Section 280E reference in the Notice of Determination. The Court stated that even if the Section 280E reference was an erroneous understanding, remand would be unnecessary because the result would be a fait accompli.

The Dissents: Administrative Overreach?

The majority's decision did not sit well with all members of the court. Three dissenting judges – Landy, Jenkins, and Holmes – voiced sharp disagreement, arguing that the majority opinion overstepped judicial bounds and improperly bolstered the IRS's position. Their dissent centered on three key points: a violation of the Chenery doctrine, an overreach of the Internal Revenue Manual (IRM) over Treasury Regulations, and the creation of a "fiction" of solvency.

The dissenting judges first contended that the majority opinion ran afoul of the Chenery doctrine, established in SEC v. Chenery Corp. This doctrine dictates that a reviewing court can only judge the propriety of an agency’s action based on the grounds the agency invoked at the time of the action. Here, the dissent argued that the Notices of Determination from the IRS did not explicitly state "public policy" as the reason for denying the Offer in Compromise (OIC). According to the dissent, the court was improperly supplying a rationale that the agency itself did not use, thus violating Chenery.

Second, the dissent took issue with the court's reliance on the IRM. The dissent highlighted that the IRM, which provides internal guidance to IRS employees, cannot override Treasury Regulations. The dissent underscored that Treasury Regulations interpret "ability to pay" under Section 7122, which governs Offers in Compromise, based on assets and income. The dissent asserted that this usually implies available income, not the "phantom taxable income" created by disallowing deductions under Section 280E, which prohibits businesses from taking deductions or credits for expenses incurred in the trafficking of Schedule I or II controlled substances.

Finally, the dissent criticized the majority for upholding a "fiction" of solvency. Even when a company technically cannot pay its tax debt, the dissent argued, the IRS is treating it as if it can by disallowing legitimate business expenses under Section 280E when calculating the Reasonable Collection Potential (RCP), which is the measurement the IRS uses to determine a taxpayer’s ability to pay. This, according to the dissent, leads to an unrealistic assessment of the taxpayer's ability to compromise their tax debt.

Impact: No Exit for Cannabis Taxpayers

Following the criticism from the dissent, this ruling confirms that the reach of Section 280E extends beyond the tax return itself and into the collection process. Cannabis businesses are effectively barred from negotiating their tax debts down by arguing that their 'real' expenses render them insolvent, if those expenses are disallowed under Section 280E. This is because of the way the IRS calculates the Reasonable Collection Potential (RCP), which is the measurement the IRS uses to determine a taxpayer’s ability to pay. The court's decision validates the IRS's aggressive internal manual provisions for the industry. For cannabis businesses, this means there is effectively no exit strategy from crushing tax debt.