In this case, the IRS disallowed tens of millions of dollars in exclusions for cost of goods sold and business expense deductions claimed by one of the largest medical marijuana dispensaries in the country. Taxpayers cannot claim a deduction for ordinary and necessary expenses if the taxpayer is engaged in an unlawful business such as selling a controlled substance like marijuana. I.R.C. § 280E, 21 U.S.C. § 812(c). While acknowledging it was subject to section 280E, the dispensary, which operated a legal business under California law, petitioned the United States Tax Court for a redetermination of the IRS decision. The Tax Court affirmed the multi-million-dollar deficiency judgment resulting from the dispensary’s corporate income tax liabilities from tax years 2007 to 2012.


On appeal to the United States Court of Appeals for the Ninth Circuit, the dispensary argued that section 280E was unconstitutional or, alternatively, that the denied deductions should qualify as cost of goods sold and therefore be excluded from its gross income. Historically, challenges to the constitutionality of section 280E have been unsuccessful. N. Cal. Small Bus. Assistants Inc. v. Comm'r, 153 T.C. 65, 72 (2019); Alpenglow Botanicals, LLC v. United States, 894 F.3d 1187, 1201 (10th Cir. 2018). Here, the court declined to consider the dispensary’s 16th Amendment argument because it was not raised before the Tax Court.

Excludible Inventory Costs

The dispensary alternatively claimed that the approximately $7 million it incurred by purchasing and processing marijuana qualified as excludible inventory costs. The costs, for example, included employee compensation relating to the negotiation of bud purchases and the cost of laboratory testing of marijuana.

The Tax Court found that the dispensary “purchased” rather than “produced” the products it sold and that taxpayers reselling products that they “purchased” are entitled to include as cost only “the invoice price,” less certain discounts not relevant here, as well as “transportation or other necessary charges incurred.”  See Treas. Reg § 1.471-3(b). The dispensary did not appeal the Tax Court’s purchaser determination, but rather claimed that because its inventory method satisfied I.R.C. § 471 by meeting the general requirements for best accounting practice and clear reflection of income, the IRS could not force the dispensary into a particular cost method under Treas. Reg. § 1.471-3. The Ninth Circuit disagreed, stating that § 471 requires taxpayers to take inventory as set forth by the IRS. I.R.C. § 471(a). Therefore, taxpayers must follow the detailed regulations on how to compute their inventories. See Treas. Reg. §§ 1.471-1 to -11.

The dispensary next claimed that because the IRS did not challenge whether the dispensary’s inventory method failed to clearly reflect its income, the IRS could not require a particular accounting method. In rejecting this argument, the court explained that the IRS did not attempt to compel a particular accounting method, but rather disallowed an accounting method that was not in conformance with the applicable regulations.

Lastly, the dispensary argued that under Treas. Reg. § 1.471-3(d), it could include both its production and purchasing costs in the inventory costs. The court stated that § 1.471-3(d) only applies to industries “in which the usual rules for computation of cost of production are inapplicable.” Such industries include famers, some miners and manufacturers, and retail merchants that use the retail method of accounting. The court noted that while the normal inventory accounting rules may be unfavorable to the dispensary, it was still subject to those rules and regulations.

Patients Mutal Assistance Collect Corp. v. Comm'r, 2021 WL 1570288 (9th Cir. April 22, 2021).