Lesson From The Tax Court: § 280E Does Not Violate The Eighth Amendment

My wife and I are considering putting in a solar tube.  It will cost about $1,000.  But if we add a $50 solar night-light, then we are told the entire installation qualifies for the §25D residential energy credit.  I dunno... 

If true, however, most of us probably see this as a tax benefit, reducing the taxes they would otherwise pay.  Congress is subsidizing those who choose to “go solar.”  But some might see it as punishment.  Congress is punishing those who choose not to go solar by denying them a tax credit and thus “increasing” their liability from what it would be with the tax credit.  Whether you view this as a benefit or punishment depends on your baseline.

This baseline issue is what I see going on in last week’s decision of Northern California Small Business Assistants Inc. v. Commissioner, 153 T.C. No. 4 (Oct. 23, 2019).  There, the IRS had audited the taxpayer’s marijuana business and said §280E disallowed deductions otherwise allowable by §162, et. seq.  The taxpayer argued the denial of deductions was a punishment.  Not only that, it was a punishment that violated the Eighth Amendment’s prohibition against “excessive fines.”   Most of the Tax Court rejected the argument and found that §280E does not impose a fine (or penalty) just because it disallows deductions to some taxpayers that Congress gives others.  But some of the Tax Court agreed with the taxpayer that §280E does impose a penalty within the meaning of the Eighth Amendment. 

This is a fun case.  It teaches a lesson on the difference between a tax and a penalty in the context of some cool constitutional law.  Details below the fold.

The Law:  The Eighth Amendment Can Apply to Taxes

The Eighth Amendment is short.  It provides that “Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.”

The text of the Eighth Amendment---bail and fines and punishments---appears to apply only to criminal sanctions.  Indeed, in Browning-Ferris Industries v. Kelco Disposal, 492 U.S. 257 (1989), the Supreme Court rejected the idea that the Eighth Amendment could apply to allegedly excessive punitive damage awards made by a jury in a civil case, saying: “our concerns in applying the Eighth Amendment have been with criminal process and with direct actions initiated by government to inflict punishment.”  Id. at 260.

The purpose of the Eighth Amendment, however, extends to all “direct actions initiated by government” whether labeled civil or criminal.  For example, in Austin v. United States, 509 U.S. 602 (1993), the Supreme Court applied it to civil forfeiture.  Said the Court: “the purpose of the Eighth Amendment, putting the Bail Clause to one side, was to limit the government's power to punish.”  Id. at 609.  In particular “the Excessive Fines Clause limits the government's power to extract payments, whether in cash or in kind, as punishment for some offense.” Id. (internal quotes omitted). 

The Eighth Amendment question is thus whether a direct action initiated by the government seeks to punish someone.  Here’s how the Court framed the test in Austin: “In considering this question, we are mindful of the fact that sanctions frequently serve more than one purpose. We need not exclude the possibility that a forfeiture serves remedial purposes to conclude that it is subject to the limitations of the Excessive Fines Clause.”  That is because “a civil sanction that cannot fairly be said solely to serve a remedial purpose, but rather can only be explained as also serving either retributive or deterrent purposes, is punishment, as we have come to understand the term." United States v. Halper, 490 U.S. 435, 448 (1989).

Bottom line: the Eighth Amendment applies any time the government requires payment of money as a punishment, period.  It does not matter whether the payment is punishment for criminal or non-criminal behavior.  And it does not matter whether the payment is labeled a “fine” or a “penalty.”  United States v. Halper, 490 U.S. 435 (1989).  Both are subject to the central purpose of the Eighth Amendment: preventing the government from imposing unfair punishments.  What matters is evaluating the purpose of the payment.  This idea of punishing, says the Supreme Court, “cuts across the division between the civil and the criminal law."  Austin, 490 U.S. at 610.

To me, at least, that means the Eighth Amendment can, at least in theory, indeed apply to tax statutes.  Taxes are, after all, the quintessential forced payment of money.  But it will only apply when the taxes are really disguised penalties, when they amount to a civil sanction.  Let’s look at that area of law for a moment. 

The Law: When Taxes Are Penalties Depends on Function, Not Label

Despite the howls of hobbyists, taxes are not generally not penalties.  The main purpose of taxation has always been to raise revenue to fund the government.  At the same time, Congress has always used taxation to further other policies.  Heck, until 1862 the federal government was almost entirely funded from tariffs.  See Historical Statistics of the United States, 1789-1945, Table Series P 89-98 (“Federal Government Finances”).  Decisions about tariffs are inextricably tied to decisions about protectionism.  It was true then, as ably described by none other than President William McKinley, who apparently cut his political teeth on the issue of tariff protectionism.  See William McKinley, The Tariff In The Days Of Henry Clay and Since: An Exhaustive Review Of Our Tariff Legislation From 1812 To 1896 (no public link, sorry).  It is true now, as the current administration employs tariffs as weapons in its trade wars.

Similarly, Congress uses taxes to encourage some behaviors and discourage others.  Using taxes as an instrument of social policy does not transform the taxes into punishment for the disfavored activity.   Think of tax-exempt organizations.  Congress wants to encourage or support certain social useful organized activities and so entirely exempts from taxation organizations that foster that purpose.  That does not mean that taxing other entities is punishing them!  Congress then favors certain types of tax-exempt organizations (we generally call charities) by allowing other taxpayers a deduction for donations made to them. 

So taxes have never been just about raising revenue.  They have always served other purposes.  And one of those purposes can sometimes be...to punish.  Sometimes, tax statutes that are labeled “taxes” might actually function as penalties.  Look at §4971, for example.  It is titled “Taxes on failure to meet minimum funding standards.”  Section 4971(a) imposes an “initial tax” on employers who fail to make the proper yearly deposits into their defined benefit pension plans.  The initial tax is 10% of their underfunding.  But then, if they don’t fix the problem, §4971(b) imposes an “additional tax” of 100% of the underfunded amount. 

In United States v. Reorganized CF&I Fabricators, 518 U.S. 213 (1996), the Supreme Court held that these taxes were actually penalties.  The Court refused to rely on the label.  Rather, the Supremes engaged in “a functional examination of §4971(a),” 518 U.S. at 224, explaining that its functional approach rested on this test:  “a tax is an enforced contribution to provide for the support of government; a penalty, as the word is here used, is an exaction imposed by statute as punishment for an unlawful act.”  Id.  The Court concluded that both the 10% and 100% excise taxes in §4971 sought not just to raise revenue, but primarily served the purpose of punishing employers who did not properly keep current on their deposits into pension plans.  Important to the Court’s functional analysis was that: (1) the fact that the tax rose to 100% of the underfunded amount; (2) paying the tax did not relieve the employer from the funding obligation; (3) the Senate Finance Committee Report explained that their purpose in creating this provision was to provide “new and more effective penalties where employers fail to meet the funding standards.” 

However, tax statutes labeled “penalties” might actually be...taxes.  In United States v. Sotelo, 436 U.S. 268 (1978) the Supreme Court held that the assessment of the Trust Fund Recovery Penalty imposed by §6672 was, actually, a “tax” and not a “penalty” for bankruptcy discharge purposes, despite the label in the Tax Code.  Said the Court: “that the funds due are referred to as a “penalty” when the Government later seeks to recover them does not alter their essential character as taxes for purposes of the Bankruptcy Act.” 436 U.S. at .  Here, as in CF&I, the Court employed a functional test.  Important to the Court’s conclusion was that the IRS would only collect a trust fund liability once, even if it assessed the penalty against multiple responsible persons.  Section 6672 simply did not function as a penalty so much as it functioned to provide the government alternative sources of collection.  No doubt, however, individuals subject to the TFRP feel punished.  But that is not the test.

Similarly, in National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012), the Court said that just because Congress labeled as “penalty” the payment required of individuals who refused to purchase health insurance, it was nonetheless a “tax” for Constitutional purposes.  Wrote Justice Roberts: “While the individual mandate clearly aims to induce the purchase of health insurance, it need not be read to declare that failing to do so is unlawful.  Neither the Act nor any other law attaches negative legal consequences to not buying health insurance, beyond requiring a payment to the IRS.”  567 U.S. at 567-8.  This again reinforces the idea: while being forced to pay the IRS may feel like punishment, that does not make the required payment a penalty. 

The Facts and The Opinions In The Case

The taxpayer here was a California company that operates a medical marijuana dispensary, legal under California law.  It tried to take deductions authorized by §162, §163, and §164.  Section 280E denies all of those deductions (and all other otherwise allowable deductions) to a trade or business that “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.”  So it is not surprising that the IRS disallowed the deductions and that the taxpayer petitioned Tax Court.

The taxpayer set up the issue for decision by moving for partial summary judgment.

All 15 of the Tax Court Judges who participated agreed that the right result was to deny the motion.  And all 15 also agreed that the label given in a tax statutes does not control the answer to the question of whether the statue is a fine or penalty for Eighth Amendment purposes.  But there the agreement ends and the split makes for an interesting lesson. 

In the opinion of 10 Judges, §280E does not impose a fine within the meaning of the Eighth Amendment.  End of story.  Motion denied, never to return.  Judge Goeke wrote the opinion for the Court and Judge Lauber wrote a concurring opinion elaborating on a couple of points. 

Judge Goeke starts with the baseline that Congress can tax all “gross income” within the meaning of §61.  These wide powers to tax gross income mean that any deductions Congress sees fit to provide are matters of “legislative grace.”  That is, the deductions are the exceptions to the norm of taxation. Section 280E is certainly meant to further a social policy disfavoring businesses trafficking in controlled substances.  But Congress does that all throughout the Tax Code, so that purpose does not transform the disallowance into a penalty.  Judge Goeke notes that “[p]etitioner does not cite, and we are not aware of, any case where the disallowance of a deduction was construed a penalty.”  Moreover, the only circuit court case on point concluded (albeit with minimal analysis) that §280E was not a penalty for Eighth Amendment purposes.  Alpenglow Botanicals v. United States, 894 F.3d 1187 (10th Cir. 2018). 

Judge Lauber’s concurrence emphasizes that “[h]undreds of Code provisions are designed to deter activity that Congress believes to be undesirable.  But this does not make these provisions 'in the nature of a penalty' for Eighth Amendment purposes.”  He points out that sometimes the activity disfavored by Congress is otherwise illegal and sometimes it is not. 

In the opinion of 3 judges (Gustafson, Copeland, and Gale) §280E does impose a fine.  Therefore, they wanted to see further proceedings to address whether it was excessive within the meaning of the Eighth Amendment, and whether the Eighth Amendment even protects corporations in the first place.  So while they would deny the motion at this time, they wanted to consider the matter again after further proceedings.  I consider that more of a deferral.

Judge Gustafson starts with a detour.  He says Congress is required by the Constitution to allow taxpayers to use concepts of basis and costs of goods sold (COGS) in calculating gross income.  For example, if taxpayers could not account for COGS, Congress would be taxing only something Judge Gustafson calls “sales” and would not be taxing “income.”  For Judge Gustafson, the wide sweep of §280E is tantamount to denying taxpayers basis and COGS adjustments and “would impose a tax based on artificial income.”  Accordingly, he is of the opinion that §280E exceeds the powers granted Congress by the 16th Amendment itself.  Only Judge Copeland joins him on that one.

As to the main issue, Judge Gustafson agrees with everyone else that whether §280E is a penalty for Eighth Amendment purposes requires a functional analysis.  He believes that because §280E’s effect is to increase tax liabilities and because it's purpose is, in part, to deter taxpayers from engaging in the activities covered by §280E, the resulting increased income tax is a fine. 

The last 2 judges (Judges Morrison and Foley) were unsure whether §280E imposes a fine or not.  They declined to opine.  Instead, they thought summary judgment should be denied because, even if §280E imposed a fine “petitioner has not shown it would be excessive as applied to petitioner.”  Apparently they thought that the taxpayer should receive no further opportunity to show excessiveness.  I say that because these two Judges concurred with the 10 judges who denied the motion rather than with the 3 judges who would effectively defer the motion.

Commentary: §280E Is Not a Fine When You Use The Proper Baseline

I see the main dispute between Judge Goeke (writing for 10 judges) and Judge Gustafson (writing for 3) as a dispute over the starting point, the baseline for deciding whether a tax statute is a penalty or not. 

Judge Goeke, on the one hand, seems to say that the proper baseline is zero deductions.  A Congressional decision to allow deductions is a benefit, a subsidy.  That means that those who do not get the deductions are not punished, they are just not subsidized.  They must pay the tax that Congress can otherwise rightfully extract from them. 

Judge Gustafson, on the other hand, uses as a baseline the deductions Congress generally allows.  That is why the disallowance of those normal deductions is punishment in the form of “the increased ta liability---uniquely imposed on drug traffickers—that results from that disallowance.”  It is important to Judge Gustafson that §280E does not simply disallow one deduction, but disallows all deductions.  Quite apart from whether Congress even has the power under the 16th Amendment to enact §280E, the broadness of the provision violates the sacred norm of allowing taxpayers to account for their costs of producing income in calculating their income subject to tax.  

I think Judge Goeke has the right baseline.  The measure of whether a tax is a penalty is the scope of the Congressional taxing power.  If Congress can tax in the first place, then its decisions on tax breaks are simply not going to be penalties or fines, no matter what their effect on the taxable income number.  Those decisions are certainly constrained by other provisions in the Constitution.  For example, denying deductions to certain classes of taxpayer may create equal protection problems.  See e.g. Moritz v. Commissioner, 469 F.2d 466, 470 (10th Cir. 1972) (finding dependent care deduction invalid for discriminating between unmarried male and unmarried female taxpayers).  It is true, as we saw above, an excise tax that Congress imposes on a particular behavior may be a penalty and not a tax.  But for income taxes, Congress could, if it chose, tax gross income and allow zero deductions.  It is against that background that it, and the courts, craft the various rules that define gross income, adjusted gross income, and taxable income.  The baseline is the authority to tax "income."

Judge Gustafson has the wrong baseline.  He seems to believe the 16th Amendment imposes constitutional constraints on what constitutes “gross income” and those constraints require Congress to allow certain adjustments to a taxpayer’s gross receipts, including the deductions disallowed by §280E.  I respectfully disagree.  The 16th Amendment gave Congress no powers to tax incomes.  Yes, you read that right.  Congress had the power to tax income from the get-go, back in 1789.  The 16th Amendment just gave Congress the power to tax income “without apportionment.”  Far from being a constraint, the 16th Amendment removed a constraint, the constraint of apportionment.  I give details in my article “The Play’s The Thing: A Theory of Taxing Virtual Worlds,”  59 Hastings Law J. 1 (2007).  I also recommend Calvin Johnson’s delightful tax-centric view of the formation of the Constitution: “Righteous Anger at the Wicked States: The Meaning of the Founders’ Constitution,” (Cambridge U. Press)(2005) (arguing that “[t]he Constitution was first a pro-tax document, written to give the federal government revenue to pay enough of the war debts to restore the public credit so that the federal government could borrow again in the next emergency”). 

Judge Gustafson’s reasoning reminds me strongly of the plaintiffs in Brushaber v. Union Pac. R.R., 240 U.S. 1 (1916) where the taxpayers were arguing that the taxing statutes violated the 5th Amendment’s Due Process clause.  Chief Justice White pointed out that all the arguments “effectively all rest upon the mistaken theory that, although there be differences between the subjects taxed, to differently tax them transcends the limit of taxation and amounts to a want of due process, and that, where a tax levied is believed by one who resists its enforcement to be wanting in wisdom and to operate injustice, from that fact in the nature of things there arises a want of due process of law....”  Substitute “punishment” for “want of due process” and you can see why I think Judge Gustafson’s theory is mistaken. 

I do not believe on can quibble with Judge Gustafson's central starting point: denial of the deductions definitely increases this taxpayer's taxes.  It has the same economic effect as a separate tax.  It is as if Congress had created a special income tax to be imposed on this class of taxpayers instead of a special disallowance of deductions other taxpayers get to take. 

From that starting point, however, it is does not follow that §280E is a penalty.  By that view, the §163(h) deduction for qualified residence interest is a disguised penalty because it lower marginal bracket taxpayers get a smaller benefit (and, hence, pay additional taxes) than higher bracket taxpayers.  That result, however, just flows from the progressive marginal rate structure.  It flows from a baseline of Congressional power to tax, not from a baseline of uniform deductions.  Denials of tax exclusions, tax deductions, and tax credits are surely all the economic equivalent of increased taxes.  That equivalence, however, does not transform them into fines or penalties because all exclusions, deductions and tax credits are given against a baseline of the power to tax income without any exclusions, deductions, or credits. 

Tax protestor hobbyists would love for courts to adopt Judge Gustafson’s baseline.  That would mean that tax statutes impose a penalty---a penalty that must be evaluated for Eighth Amendment compliance---every time they increase a taxpayer’s liability.  To borrow from Judge Lauber, taxpayers whose business expenses include illegal bribes would be very happy to explore whether the disallowance of those bribes is a punishment for their illegal activity.  Taxpayers whose hobbies produce losses disallowed by §183 would gladly argue that they are being punished by that disallowance.  Taxpayer who buy their homes in an East Coast housing market just before a housing crash would be eager to find out if the Congress’ refusal to allow them a loss deduction is punishing them within the scope of the Eighth Amendment. 

To be sure, we cannot let Congress abuse its taxing power.  But the Eighth Amendment is not the proper place to look for limits in this case.  The proper limitation is the constitutional command that Congress must give all citizens the equal protection of the law. 

The real complaint by the taxpayers here is equal protection.  This taxpayer is just bummed out that it cannot take the same deductions other businesses do.  Adding insult to injury is that the taxpayer's business is totally legal under state law. “If the Congress determines to grant deductions of a general type, a denial of them to a particular class may not be based on an invidious discrimination.”  Moritz,  469 F.2d at 469. 

So why don’t the taxpayers here actually raise an equal protection claim? 

Because it’s a loser.  Classifications do not per se violate equal protection principles.  Moritz.  If Congress has a rational justification for the classification and the classification promotes a legitimate governmental objective, then there is no constitutional problem, so long as the classification does not involve a protected class.  Moritz.  Marijuana dispensaries are not a protected class. 

One can be entirely sympathetic to the taxpayers here.  But sympathy should not lead to strange contortions of constitutional law canons.  This is a situation where Congress has to fix the problem by modifying §280E.  The courts cannot fix this problem.

Bryan T. Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law