Federal Cannabis Taxation Dispute: Shareholder Deductions Challenged Under §280E
In Feinberg v. Commissioner of Internal Revenue, 916 F.3d 1330 (10th Cir. 2019), the Tenth Circuit addressed whether shareholders of a state-licensed medical marijuana business could claim federal tax deductions for ordinary business expenses. Neil and Andrea Feinberg, along with Kellie McDonald, were shareholders in Total Health Concepts, LLC (THC), a Colorado dispensary classified as an S (Subchapter) corporation. Following an IRS audit, the agency disallowed their deductions under Internal Revenue Code §280E, which bars deductions for businesses trafficking in federally controlled substances even if the conduct is legal under state law. The taxpayers challenged the deficiency and invoked their Fifth Amendment right against self-incrimination during discovery.
The U.S. Tax Court initially denied the deductions based on substantiation, an issue not raised in the IRS’s original deficiency notice, a procedural error later acknowledged by the Tenth Circuit. On appeal, the Tenth Circuit upheld the ruling on alternative grounds: the taxpayers failed to prove that §280E did not apply. The court ruled that the burden of proof rested with the taxpayers and that asserting the Fifth Amendment did not relieve them of that obligation. The decision underscores the legal risks cannabis businesses face under federal law and highlights how insufficient accounting records can weaken tax defense strategies.
Chronology of Feinberg v. Commissioner: Cannabis Tax Dispute from Audit to Appellate Ruling
2009–2011: Tax Reporting and IRS Audit Initiated
Neil and Andrea Feinberg and Kellie McDonald, shareholders in Total Health Concepts, LLC (THC), reported the company’s income and losses on their individual tax returns. THC, a Colorado-based S corporation, operated state-licensed medical marijuana dispensaries. The IRS audited their returns for 2009–2011 and issued a notice of deficiency. It disallowed business deductions under IRC §280E, asserting THC was engaged in federally prohibited drug trafficking.
2013–2015: Legal Disputes Over Discovery and Fifth Amendment Rights
The taxpayers filed a petition in U.S. Tax Court challenging the IRS’s determination. During discovery, they invoked the Fifth Amendment to avoid producing business records. The Tax Court granted the IRS’s motion to compel, leading the taxpayers to seek a writ of mandamus from the Tenth Circuit. The court denied the petition, holding that constitutional claims could be reviewed after trial.
2016–2017: Pretrial Motions and IRS Abandons Discovery Demand
Following the appellate ruling, the IRS abandoned its discovery request and sought summary judgment. The Tax Court denied the motion, citing unresolved factual issues. The parties agreed to narrow the trial to whether higher COGS could be substantiated and whether §280E applied. These became the two central issues at trial.
2018: Tax Court Decision Based on Substantiation
The Tax Court denied the taxpayers’ deductions based on a lack of substantiation, a rationale not cited in the IRS’s original notice of deficiency. Although the Tenth Circuit acknowledged this procedural error, it affirmed the outcome on alternative grounds concluding that the taxpayers failed to disprove the applicability of §280E. Both parties agreed that relying on substantiation was improper, but the appellate court upheld the disallowance because the taxpayers did not meet their evidentiary burden. The Tax Court subsequently denied the taxpayers’ motion for reconsideration.
2019: Tenth Circuit Affirms Deduction Denial on §280E Grounds
On appeal, the Tenth Circuit found the Tax Court erred by introducing substantiation as a new issue. However, it upheld the deduction denial on the alternative ground that the taxpayers failed to disprove §280E’s applicability. The court also rejected the claim that this burden violated their Fifth Amendment rights. It concluded that withholding evidence did not excuse the taxpayers from proving their eligibility for deductions.
Expert Witness Contributions in Feinberg v. Commissioner of Internal Revenue
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Certified Public Accountant (CPA) Expert Witness
- The taxpayers retained a Certified Public Accountant (CPA) to support their claimed business deductions and cost of goods sold (COGS). The CPA provided testimony to support THC’s financial records; however, the Tax Court found the evidence lacking in detail and insufficient to substantiate the claimed deductions. As a result, the court rejected the testimony and denied all deductions.
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Forensic Accounting Expert Witness
- Although not directly cited in the Feinberg case, forensic accountants are commonly involved in cannabis-related tax audits. They analyze expense classifications, financial records, and potential §280E implications. Their insights often support IRS assessments or taxpayer defenses in disputes involving controlled substances.
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Accounting Expert Witness
- Accounting experts often assist legal teams in preparing financial records and evaluating compliance with §§162 and 280E. They help substantiate business expenses and support audit responses. In cannabis tax matters, their role is essential to reconciling state-legal operations with federal tax restrictions.
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Cannabis Expert Witness
- Given THC’s operation under Colorado marijuana laws, cannabis industry experts were likely consulted to explain regulatory compliance. Their insight would have helped argue that the business operated legally at the state level despite federal restrictions. These experts typically support strategy behind the scenes unless regulatory interpretation becomes a core legal issue.
Navigating §280E and Beyond: Legal Lessons from the Feinberg Cannabis Tax Case
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§280E Enforcement Applies Regardless of State Legality
Even if a cannabis business is fully compliant with state regulations, §280E of the Internal Revenue Code disallows federal tax deductions for any business engaged in trafficking-controlled substances. Legal teams must anticipate strict IRS enforcement and prepare clients accordingly.
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Burden of Proof Remains on the Taxpayer
The Tenth Circuit emphasized that taxpayers bear the burden of proving the IRS’s application of §280E was erroneous, regardless of constitutional claims. Attorneys should collaborate with tax professionals early to build strong evidentiary records, especially regarding COGS, business structure, and lawful activity claims.
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Fifth Amendment Claims Don’t Shield Against Evidentiary Burden
Invoking the Fifth Amendment to avoid disclosing information does not eliminate the obligation to prove entitlement to deductions. Legal counsel must carefully weigh constitutional defenses against the risk of insufficient evidence in tax court.
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Expert Testimony Must Be Thoroughly Documented
Accounting expert testimony must be backed by detailed records, accurate classifications, and clear analysis. Lawyers should ensure all financial opinions, especially those related to business expenses and deductions are audit-ready and grounded in accepted accounting practices.
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Prepare Clients for Dual Compliance Risks
Cannabis clients face a unique compliance challenge: reconciling state legality with federal restrictions. Legal strategies should address not only licensing and operational law but also how tax reporting may expose clients to penalties or deduction limitations under federal law.
Conclusion
The Feinberg v. Commissioner of Internal Revenue case underscores the ongoing conflict between state-legal cannabis businesses and federal tax law, particularly the rigid enforcement of Internal Revenue Code §280E. Despite operating within Colorado’s regulatory framework, the taxpayers were denied federal business deductions because their activity involved trafficking in a Schedule I controlled substance under federal law. The Tenth Circuit’s ruling reaffirmed that the burden of proof remains on taxpayers to disprove IRS determinations, even when constitutional protections like the Fifth Amendment are invoked.
This decision highlights the importance of strategic documentation, expert testimony, and proactive financial planning in cannabis-related tax disputes. Attorneys representing such businesses must partner closely with accounting professionals to substantiate expenses, defend COGS calculations, and anticipate IRS scrutiny. As long as cannabis remains federally prohibited, practitioners should expect continued litigation over tax compliance and prepare accordingly with strong evidentiary and regulatory strategies.
