IRS’s rejection of marijuana dispensary’s offer in compromise upheld

The Tax Court held that in rejecting the offer in compromise (OIC) of a marijuana dispensary, the IRS did not abuse its discretion by following Internal Revenue Manual (IRM) provisions that excluded business expenses that are nondeductible under Sec. 280E from the calculation of the dispensary’s reasonable collection potential.

Background

Mission Organic Center Inc. is a marijuana dispensary in San Francisco. Established over 10 years ago, Mission had gross receipts ranging from around $2 million to over $16 million from 2016 through 2021. As a marijuana business, it was subject to Sec. 280E, under which:

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 (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Because it could not deduct its business expenses related to its trafficking of marijuana for federal income tax purposes, Mission incurred significant tax liabilities. For the years at issue, it did not pay all of those tax liabilities.

The IRS issued two notices of intent to levy to Mission, one for 2016 through 2019 and another for 2019 through 2020. In response, Mission timely submitted two Forms 12153, Request for a Collection Due Process or Equivalent Hearing. Mission did not challenge the amounts of its liabilities on either form.

Mission subsequently submitted an OIC to the IRS on a Form 656, Offer in Compromise. It included with its Form 656 a Form 433–B (OIC), Collection Information Statement for Businesses, which was accompanied by tax returns, bank statements, its 2021 profit–and–loss (P&L) statement, and other financial information.

On its Form 433–B (OIC), Mission listed total business expenses of $1,490,236. Those expenses included inventory purchased, gross wages and salaries, rent, supplies, utilities/telephones, vehicle costs, insurance, current taxes, and other expenses. In fall 2022, Mission also submitted its P&L statement for January through July 2022. The OIC was reviewed by a revenue officer (RO) from the IRS’s Centralized Offer in Compromise Unit.

To evaluate the OIC, the RO calculated Mission’s reasonable collection potential. The IRM in effect at that time defined reasonable collection potential as “the amount that can be collected from all available means,” and stated that “the decision to accept or reject usually rests on whether the amount offered reflects the [reasonable collection potential]” (IRM §5.8.4.3(2) (Sept. 24, 2020)).

The RO used the 2022 P&L statement and bank statements provided by Mission to determine its current assets and future income, combining the amounts of those two items to determine its reasonable collection potential. Following the instructions in IRM Section 5.8.5.25(3), he calculated Mission’s future income by “taking the projected gross monthly income, less allowable expenses, and multiplying the difference by the number of months applicable to the terms of offer.” However, in calculating the dispensary’s future income, he did not allow a deduction for its business expenses that were disallowed for income tax purposes because of the limitation in Sec. 280E.

The RO determined Mission’s future income amount was $57,821,293. Adding that to its assets of $30,785, he arrived at a reasonable collection potential of $57,852,078. Because Mission’s reasonable collection potential substantially exceeded its outstanding liability of $5,246,293, he and his supervisor made a preliminary decision to reject Mission’s April 2022 OIC.

The preliminary decision was forwarded to the IRS Office of Appeals, which conducted a Collection Due Process hearing in which the RO’s decision to reject Mission’s OIC was reviewed by an Appeals settlement officer (SO). The SO sustained the RO’s rejection.

The IRS then issued two notices of determination to Mission sustaining its notices of intent to levy. Both notices explained that Mission’s OIC was being rejected because it was involved in a cannabis business, an illegal business activity for federal purposes, and that therefore its business expenses that were not deductible under Sec. 280E were not allowed in the calculation of its reasonable collection potential.

IRM Section 5.8.5.25.2

IRM Section 5.8.5.25.2 (Sept. 24, 2021) requires expenses that would be disallowed by Sec. 280E to be disregarded when calculating a taxpayer’s reasonable collection potential. That section states:

Calculation of Future Income — Cultivation and Sale of Marijuana in Accordance with State Laws

(1) The value of future income used in the determination of an acceptable offer amount is calculated in a different manner when a taxpayer is involved in the cultivation and sale of marijuana, in accordance with applicable state laws. The method of calculating future income will be based on the following guidance:

a. Determine the taxpayer’s gross income over a specific time period (normally annually);

b. Limit allowable expenses consistent with Internal Revenue Code 280E, where a taxpayer may not deduct any amount for a trade or business where the trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances.

Arguments in Tax Court

Mission filed petitions in Tax Court challenging the IRS’s denial of its OIC. Mission argued that the IRS abused its discretion by disallowing business expenses that were not deductible under Sec. 280E when calculating Mission’s reasonable collection potential, because IRM Section 5.8.5.25.2 conflicted with the Code, Treasury regulations, and other IRM provisions.

The IRS argued that its SO did not abuse her discretion in rejecting the proposed OIC and sustaining the proposed collection action, taking the position that its policy of excluding expenses disallowed under Sec. 280E in calculating a taxpayer’s reasonable collection potential was consistent with congressional intent and with the discretion Congress granted the IRS to set guidelines for OICs.

The Tax Court’s decision

The Tax Court held that the IRS did not abuse its discretion in rejecting Mission’s OIC. The court found that it was not improper for the SO to rely on IRM provisions regarding how to calculate a taxpayer’s reasonable collection potential or for the IRS to adopt a policy of disregarding expenses that are nondeductible under Sec. 280E for purposes of calculating a taxpayer’s reasonable collection potential.

Sec. 7122: Offer in compromise

The IRS is authorized under Sec. 7122(a) to compromise a taxpayer’s tax liability and under Sec. 7122(d) to establish guidelines to determine whether an OIC is adequate. Under Regs. Sec. 301.7122–1(b)(2), the IRS can compromise a tax liability based on doubt as to collectibility, which exists in any case where the taxpayer’s assets and income are less than the full amount of the liability. However, the IRS may reject an OIC when a taxpayer’s reasonable collection potential exceeds the offer.

Sec. 7122(d)(1) gives the IRS wide discretion to accept OICs and to establish guidelines “to determine whether an offer–in–compromise is adequate and should be accepted.” The Tax Court has held that, in its review of an SO’s decision regarding an OIC, it is limited to determining whether the SO abused their discretion (Thompson, 140 T.C. 173, 179 (2013)). In making this determination, the court considers, among other things, whether the SO complied with applicable procedures, many of which are set out in the IRM (Eichler, 143 T.C. 30 (2014); Kosmides, T.C. Memo. 2023–138). In some cases, the court has found that the IRS abused its discretion by not following the IRM (see e.g., Fairlamb, T.C. Memo. 2010–22, and Gurule, T.C. Memo. 2015–61).

Review of the IRS’s determination in Mission’s case

The Tax Court first observed that although the dispensing of medical marijuana is legal under California law, it remained illegal under federal law during the years Mission’s tax liabilities arose, when the company made its OIC, and when the RO and SO evaluated the OIC. The court, citing Olive, 139 T.C. 19, 39 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015), stated that even if a trafficking business is legal under state law, its being illegal under federal law results in the application of Sec. 280E.

The Tax Court determined that the question presented in the case was the extent to which Sec. 280E may be taken into account in calculating a taxpayer’s reasonable collection potential. The court found that there were two plausible readings of the IRS’s reliance on Sec. 280E in rejecting Mission’s OIC.

The first plausible reading was that the RO and the reviewing SO thought Sec. 280E required them to disallow the business expenses of a marijuana business when calculating the business’s reasonable collection potential. However, according to the court, “Simply stated, section 280E disallows deductions or credits for any amount paid or incurred in carrying on the trade or business of trafficking in controlled substances; it does not address what expenses may or may not be considered for the purpose of calculating a taxpayer’s reasonable collection potential.” Thus, if the RO and SO rejected the OIC solely on the basis that Sec. 280E required business expenses disallowed under it to be disregarded for purposes of calculating a taxpayer’s reasonable collection potential, the court concluded they would have been in error.

The second plausible reading identified by the Tax Court (which it adopted) was that the RO and SO had disallowed such expenses as a policy matter, relying on Sec. 280E as the foundation for establishing the policy and the IRM as its articulation. The court noted that it had held in Kosmides that an SO ordinarily does not commit an abuse of discretion by adhering to collection guidelines published in the IRM but has also held that it can consider whether the IRS’s policy itself is an abuse of discretion (see, e.g., Cunningham, T.C. Memo. 2014–200).

As the Tax Court observed, the IRS, for public policy reasons, has determined to disallow the business expenses of marijuana businesses in the reasonable collection potential calculation. The IRM instructs in Section 5.8.5.25.2 that when the Service calculates the reasonable collection potential for businesses trafficking in controlled substances, expenses are to be disallowed consistent with Sec. 280E. Accordingly, the court held that the SO’s rejection of Mission’s OIC was consistent with the procedures adopted by the IRS and set forth in the IRM and that she did not abuse her discretion in relying on those procedures.

With respect to whether the IRS’s adoption of the procedures in the IRM regarding the treatment of a marijuana business’s expenses in calculating its reasonable collection potential was an abuse of discretion, the Tax Court held that it was not, because of Congress’s enactment of Sec. 280E. The court, citing its opinion in Californians Helping to Alleviate Medical Problems, Inc., 128 T.C. 173 (2007), stated that the legislative history of Sec. 280E showed it was Congress’s intent to disallow the deduction of business expenses attributable to a trade or business of trafficking in controlled substances. Thus, the court found that by disallowing these same expense items for purposes of calculating a taxpayer’s reasonable collection potential, the IRS was adhering to the public policy underlying the enactment of Sec. 280E. Consequently, in light of Congress’s enacting Sec. 280E, the court held that it was not an abuse of discretion for the IRS to disallow such expenses for reasonable–collection–potential purposes.

Reflections

An executive order issued by President Donald Trump dated Dec. 18, 2025, Increasing Medical Marijuana and Cannabidiol Research, could render this issue moot. The executive order directs the attorney general to “take all necessary steps to complete the rulemaking process related to rescheduling marijuana to Schedule III of the [Controlled Substances Act] in the most expeditious manner in accordance with Federal law.” Sec. 280E applies only to businesses trafficking in substances that fall under Schedules I and II of the Controlled Substances Act. Therefore, if marijuana is rescheduled to Schedule III, absent a change in the law, the ordinary business expenses of a marijuana business will be deductible in calculating taxable income and, by extension, in calculating the business’s reasonable collection potential.

Mission Organic Center, Inc., 165 T.C. No. 13 (2025)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.