Sec. 280E bars claim for refundable portion of ERC

The Court of Federal Claims held that the Sec. 280E prohibition on deductions and credits for businesses trafficking in controlled substances applies to the refundable portion of the employee retention credit (ERC).

Background

Gravenstein 116 LLC operated three marijuana dispensaries when the COVID–19 pandemic hit in 2020. Through these dispensaries, Gravenstein trafficked in marijuana, which is a Schedule I controlled substance under the Controlled Substances Act of 1970, P.L. 91–513. Therefore, Gravenstein was subject to Sec. 280E, which provides 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 (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.

According to Gravenstein, during the COVID–19 pandemic, orders issued by state and local health departments “significantly limited” its business, and pandemic safety practices increased its costs and reduced its output.

In 2020, to reduce COVID–19’s economic impact, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116–136, which included the Sec. 3134 ERC, a refundable tax credit. The ERC subsidized employers that were forced to close or suspend operations due to COVID–19–related public health orders.

Under the ERC, eligible employers could reduce the amount paid in employment taxes by 70% of the amount paid to employees during the pandemic–related shutdowns. If the credit exceeded the amount of employment taxes employers paid, they could claim the difference as a cash refund. However, Sec. 3134 does not include a suspension of any rules related to a taxpayer’s general eligibility to claim credits or deductions.

Gravenstein contended that it was eligible to claim the ERC for the first and second quarters of 2021 because it paid qualifying wages and was harmed by COVID–19–related shutdowns. It also contended that it met all requirements to claim the refundable ERC during that time. On its original Form 941, Employer’s Quarterly Federal Tax Return, employment tax returns for the first and second quarters of 2021, Gravenstein reported that it had no outstanding employment tax liability for the quarter. On a Form 941–X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund, it filed for the first quarter of 2021, it claimed it was entitled to a refundable ERC of $150,786, and on a Form 941–X for the second quarter of 2021, it claimed that it was entitled to a refundable ERC of $171,230.

The IRS did not respond within six months to Gravenstein’s refund claims. Gravenstein therefore filed suit in the Court of Federal Claims seeking a tax refund of $322,016, based on its alleged entitlement to the ERC. The IRS moved to dismiss Gravenstein’s complaint for failure to state a claim under Fed. R. Civ. P. 12(b)(6), on the basis that Gravenstein, as a business subject to Sec. 280E, was ineligible to claim the refundable portion of the ERC.

The Court of Federal Claims’ decision

The Court of Federal Claims granted the IRS’s motion to dismiss Gravenstein’s complaint. The court held that Sec. 280E’s anti–trafficking bar on deductions and credits applies to the ERC, including the refundable portion of the credit. Consequently, Gravenstein, as a trafficker in marijuana, a federally controlled substance, was not eligible for the ERC or its refundable portion.

Gravenstein argued that at least the ERC’s refundable portion is not a deduction or credit for taxes. However, the Court of Federal Claims concluded that the ERC, including its refundable portion, is a tax credit, which Sec. 280E unequivocally bars Gravenstein from claiming.

To determine whether the ERC is a tax credit, the Court of Federal Claims began by considering the statute’s text. As the court explained, if the statutory language is plain, a court must enforce it according to its terms (King v. Burwell, 576 U.S. 473, 474 (2015)). In interpreting a statute, the normal rule of statutory construction assumes that identical words used in different parts of the same act are intended to have the same meaning (Sorenson v. Secretary of Treasury, 475 U.S. 851, 860 (1986)).

The Court of Federal Claims found that it was unambiguous that the ERC is a tax credit because Sec. 3134(a) unequivocally labels it as “a credit,” and Sec. 3134(b)(2) describes its refundable portion as one part of this credit.

With regard to the use of the word “credit” in Sec. 280E, Gravenstein did not provide any evidence, and the Court of Federal Claims could find none, that the term “credit” has a different meaning when describing the ERC and the Sec. 280E bar. Furthermore, Sec. 3134 did not provide a separate definition of “credit” that would indicate that its definition for purposes of the ERC was different than its definition elsewhere in the Code. Accordingly, because the term “credit” has the same meaning in the ERC as in the rest of the Code, the court concluded that Sec. 280E’s bar on eligibility for tax credits must be read to encompass the ERC.

Gravenstein also argued that even if the ERC is a tax credit, its refundable portion is not a tax credit, due to its structure as a refundable credit. Specifically, Gravenstein contended that while the form of the ERC is that of a tax credit, the substance of the amounts in excess of an employer’s tax liabilities is that of a nontax refund of wages paid. In Gravenstein’s view, the ERC’s refundable portion is a subsidy for employment rather than a tax credit.

The Court of Federal Claims rejected this argument, stating that “it is well–established that refundable tax credits are still tax credits subject to restrictions in the Internal Revenue Code.” In support of this position, the court pointed to Sorenson, which involved the applicability of overpayments arising due to the refundable earned income credit (EIC) to a law that permitted the IRS to intercept tax refunds of individuals who had failed to make child support payments. The Supreme Court held that the refundable credit was subject to the interception law because the Code defined the refundable EIC as an “overpayment” of taxes, and the interception law applied to any “overpayment.”

The Supreme Court specifically rejected the taxpayer’s argument that the refundable nature of the EIC changed the definition of “overpayment”; instead, it held that the structure of a refundable credit did not change the meaning of words in the Code. The Court of Federal Claims found that Gravenstein made almost the same argument as the Sorenson taxpayers, claiming that the word “credit” means something different in the ERC because the ERC is structured as a refundable credit.

The Court of Federal Claims noted that in Sorenson, the Supreme Court rejected an argument that public policy considerations prevented the application of Code provisions to refundable credits. In that case, the taxpayers argued that the law requiring the interception of tax refunds of people who miss child support payments “should be read narrowly to avoid frustrating the goals of the earned–income credit program” (Sorenson,475 U.S. at 864). The Supreme Court concluded that this was beyond the courts’ role to consider, stating that “[t]he ordering of competing social policies is a quintessentially legislative function.”

Similarly, in an appeal to the ERC’s policy aims, Gravenstein argued that the ERC’s social–support purposes (subsidizing employment during the COVID–19 pandemic) should override Sec. 280E’s bar on providing tax credits to businesses engaged in drug trafficking. Consistent with the Supreme Court in Sorenson, the Court of Federal Claims refused to consider policy arguments that sought to undermine the unambiguous text of Sec. 280E.

Reflections

In a somewhat amusing aspect of its public–policy–based arguments, Gravenstein attempted to distinguish its own business from that of an “illegal cocaine dealer” whose business is illegal under state law and further argued that its state–legal (California) marijuana business is more deserving of federal support than that of an illegal cocaine dealer, in that it “actually contributed to the American economy, at a significant expense no less.” The Court of Federal Claims determined that the distinction between a state–legal marijuana business and an illegal cocaine dealer has no basis in law and that Sec. 280E does not distinguish between different types of drug traffickers.

Gravenstein 116, LLC, No. 25–997 (Fed. Cl. 1/30/26) (order of dismissal)

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.