protective refund claims Archives

IRC Section 280E Will No Longer Apply if Marijuana Is Rescheduled

On May 16, 2024, the US Department of Justice submitted a Notice of Proposed Rulemaking (NPRM) to reschedule marijuana from Schedule I to Schedule III within the Controlled Substances Act.

As the NPRM recognizes, this action would have a significant economic impact on a substantial number of businesses – specifically, medical and recreational marijuana dispensaries – because Internal Revenue Code (IRC) Section 280E “bars businesses from claiming tax deductions for otherwise allowable expenses where the business ‘consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act.’” Thus, “[i]f marijuana is ultimately transferred to schedule III, [IRC] section 280E would no longer serve as a statutory bar to claiming deductions for those expenses.” Because IRC Section 280E’s impact has meant marijuana businesses were not able to deduct their ordinary and necessary business expenses when computing their taxable income, the reversal of IRC Section 280E could be a gamer changer for the industry.

Businesses currently impacted by IRC Section 280E are now asking whether they will be able to claim refunds for deductions and other tax benefits that Section 280E previously denied them. In other words, will the rescheduling be treated as retroactive for tax purposes?

Nothing in the NPRM speaks to this question, and the answer may likely be determined at the discretion of the US Department of the Treasury and the Internal Revenue Service (IRS) in anticipated future guidance. If the rescheduling is implemented during a tax year (without a stated effective date), taxpayers may be able to apply the treatment to the entire tax year in which the change was made.

Practice Point: Taxpayers in the marijuana industry should consider whether to file protective refund claims for past tax years before definitive guidance is issued. As we have previously reported here and here, a taxpayer can file a “protective” refund claim that is expressly contingent on a specified future event, like guidance from the Treasury to the effect that the rescheduling of marijuana is retroactive to open tax years prior to the change. The Supreme Court of the United States has endorsed protective refund claims to toll the statute of limitations and thereby protect a taxpayer’s right to claim the refund if a favorable event should occur. But taxpayers should keep in mind that, in the IRS’s view, meritless protective refund claims made without “reasonable cause” can be subject to substantial penalties under IRC Section 6676. Therefore, when determining whether to file a protective refund claim, taxpayers should first consider consulting with a tax advisor on the pros and cons of filing.

Can the IRS Assert IRC Section 6676’s Erroneous Refund Penalty on Protective Refund Claims?

We once again want to bring to your attention the Internal Revenue Service’s (IRS) new favorite penalty provision: Internal Revenue Code (IRC) Section 6676. We have reported on this provision several times before (See here, here and here), but this time we’re analyzing it in the context of protective refund claims.

As background, IRC Section 6676 was enacted in 2007 in response to the high number of presumed meritless refund claims being filed at the time. It imposes a 20% penalty to the extent that a claim for refund or credit with respect to income tax is made for an “excessive amount.” An “excessive amount” is defined as the difference between the amount of the claim for credit or refund sought and the amount that is actually allowable. For example, if a taxpayer claims a $2 million refund and the IRS allows only $1 million, the taxpayer can still be penalized $200,000 (e.g., 20% of the amount of the refund that was disallowed). Significantly, IRC Section 6676 does not require the IRS to show any fault or culpability on the part of the taxpayer (e.g., negligence or a disregard of rules or regulations). Neither the IRC nor the regulations provide for any defense to the Section 6676 penalty other than “reasonable cause.” Moreover, the penalty is immediately assessable, and generally taxpayers cannot fight the IRS on the penalty in a prepayment forum like it can the US Tax Court. Instead, the taxpayer must first pay the penalty and seek redress in a refund forum in either the relevant US federal district court or the US Court of Federal Claims.

Now that the IRS is asserting the IRC Section 6676 penalty more frequently, taxpayers are asking whether the penalty can apply to a protective refund claim. A protective refund claim is a judicial creation under which a taxpayer files a “protective” refund claim that is expressly contingent on a specified future event, like a taxpayer-friendly holding in a relevant court case. The Supreme Court of the United States has endorsed protective refund claims to toll the statute of limitations on the refund claim and thereby protect the taxpayer’s right to claim the refund if the favorable event should occur. (See, e.g., United States v. Kales, 314 US. 186 (1941), and CCA 201136021 (describing protective claims in detail).)

So, does the IRC Section 6676 penalty apply to a protective refund claim? Based on IRS internal guidance from 2022, the IRS believes that the IRC Section 6676 penalty applies to any filing that constitutes a “claim for credit or refund” of income tax, including a protective refund claim. To apply the penalty, the IRS would have to process the protective refund claim, deny the claim and then assert the IRC Section 6676 penalty.

Processing and denying a protective refund claim go against most tax practitioners’ experience and understanding of how the IRS treats protective refund claims. Typically, the refund claim is [...]

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