Section 280E Expenses Disallowed in Calculating Reasonable Collection Potential

(Parker Tax Publishing January 2026)

The Tax Court held that, in rejecting a marijuana dispensary's offer-in-compromise, an IRS settlement officer did not abuse her discretion by relying on Internal Revenue Manual provisions for calculating the dispensary's reasonable collection potential (RCP). The court also concluded that the IRS did not abuse its discretion in adopting a policy of disregarding expenses rendered nondeductible by Code Sec. 280E for purposes of calculating a taxpayer's RCP. Mission Organic Center, Inc. v. Comm'r, 165 T.C. No. 13 (2025); Mission Organic Center, Inc. v. Comm'r, T.C. Memo. 2025-130.

Background

Mission Organic Center, Inc. (Mission), is a state legal marijuana dispensary based in California. Its gross receipts from 2016 through 2021 ranged from around $2 million to over $16 million. Those gross receipts resulted in significant tax liabilities because Code Sec. 280E precludes taxpayers from deducting any expense related to a business that consists of trafficking in controlled substances. Because of that provision, Mission could not deduct for federal income tax purposes its expenses related to its trafficking of marijuana and that resulted in large unpaid income tax liabilities for 2016 through 2020 (the years at issue). The IRS initiated collection actions, and Mission made an offer-in-compromise (OIC) seeking to resolve its unpaid tax liabilities.

The IRS evaluated the OIC by calculating Mission's reasonable collection potential (RCP) and comparing it to the amount of Mission's offer. In calculating Mission's RCP, an IRS settlement officer followed an established policy of disregarding for RCP purposes business expenses that are rendered nondeductible by Code Sec. 280E. According to the IRS, its authority to disregard such expenses derives from Code Sec. 7122(d), which authorizes the Treasury Secretary to prescribe guidelines for the officers and employees of the IRS to determine whether an OIC is adequate. Reg. Sec. 301.7122-1(b) sets forth three grounds for the compromise of a liability: (1) doubt as to liability, (2) doubt as to collectability, and (3) the promotion of effective tax administration. The IRS rejected Mission's OIC and issued Notices of Determination.

Mission challenged the IRS's rejection of its OIC, claiming it was an abuse of discretion to disallow the business expenses that were necessary for the production of Mission's income. Mission argued that the IRS committed an error of law, and thus abused its discretion, when it failed to consider Mission's operating expenses in computing its income and then its ability to pay the taxes owed. While admitting that the IRS's determination was dictated by Internal Revenue Manual (IRM) 5.8.5.25.2, Calculation of Future Income - Cultivation and Sale of Marijuana in Accordance with State Laws, Mission argued that the IRM contradicts the Code and regulations, which speak of "income", not "taxable income", for the purpose of considering an OIC.

In response, the IRS argued that marijuana is still illegal under federal law, and that as a matter of public policy, it is allowed to discern the intent of Code Sec. 280E and apply that intent - rather than the text - when computing income under the IRM.

Mission filed two petitions challenging the IRS's denial of its OIC. First, Mission argued that the IRS settlement officer abused her discretion by disallowing business expenses when calculating Mission's RCP. Second, Mission argued that IRM 5.8.5.25.2, was in conflict with the Code, regulations, and other IRM provisions.

The IRS countered that the settlement officer did not abuse her discretion in rejecting the OIC and sustaining the proposed collection action. According to the IRS, the policy to exclude expenses that are disallowed by Code Sec. 280E when computing the RCP is consistent with the congressional intent underlying Code Sec. 280E and is consistent with the discretion granted by Congress to set guidelines for an OIC.

Analysis

In a 16-3 decision, the Tax Court agreed with the IRS and held that the settlement officer did not abuse her discretion in rejecting Mission's OIC. The majority concluded that (1) disallowing business expenses in calculating Mission's RCP was consistent with the IRS's internal procedures as set forth in the IRM; and (2) the adoption of the policy to disallow such expenses was within the IRS's discretion to adopt guidelines for accepting OICs pursuant to Code Sec. 7122(d)(1).

The question presented, the court said, is the extent to which Code Sec. 280E may be used by the IRS in computing a taxpayer's RCP. The court found two plausible readings of the IRS's reliance on Code Sec. 280E: (1) Code Sec. 280E required the disallowance of business expenses in a marijuana business when calculating the RCP; or (2) the expenses were disallowed as a policy matter, relying on Code Sec. 280E as the foundation for establishing that policy and the IRM as the articulation of that policy. The court concluded that rejecting the OIC solely on the basis of an understanding that Code Sec. 280E required that result would have been an error.

With respect to the second option, the court noted that the IRM directly addresses the RCP of businesses engaged in the trafficking of controlled substances and, when calculating RCP, the IRM generally focuses on cashflow, not deductibility. When calculating the RCP for businesses trafficking in controlled substances, the court observed, the IRM instructs that expenses are to be disallowed consistent with Code Sec. 280E. Accordingly, the court concluded, the settlement officer's rejection of Mission's OIC was consistent with the procedures adopted by the IRS and set forth in the IRM.

Dissenting Opinions

Judges Landy, Jenkins, and Holmes dissented from the majority opinion. In a dissent written by Judge Landy, with whom Judges Jenkins and Holmes joined, the judges argued that the majority decision was at odds with the Chenery doctrine (SEC v. Chenery Corp., 318 U.S. 80 (1943) (Chenery I); SEC v. Chenery Corp., 332 U.S. 194 (1947) (Chenery II)), a doctrine by which it said the court was bound. According to the dissent, by holding for the IRS in a decision unsupported by the law or the administrative record, the court's opinion departed from settled tenets of administrative law and stepped into the role of settlement officer. The dissent argued that the opinion of the court implicitly and improperly adopted an exception to Chenery by offering two plausible readings for the IRS's determinations, neither of which were specifically stated in the IRS Notices or supported by the administrative record.

In a dissent written by Judge Jenkins, with whom Judges Landy and Holmes joined, the judges took issue with the majority holding that there was no abuse of discretion in either the rejection of Mission's OIC, given the rules laid out in the IRM for computing a taxpayer's RCP, or the adoption of those IRM rules. The judges expressed serious concerns about allowing the IRS to use the IRM to override duly issued regulations, thereby avoiding all of the requirements applicable to issuing regulations.

In determining doubt as to collectability, one of the grounds for compromise listed in Reg. Sec. 301.7122-1(b), the judges noted that there is a special rule in Reg. Sec. 301.7122-1(c)(2) which provides that doubt as to collectability exists in any case where the taxpayer's assets and income are less than the full amount of the liability. It was clear to the judges that "income," as used in this regulation, does not mean taxable income. Thus, the dissent argued, the IRM provisions for computing a taxpayer's RCP explicitly disregard rules applicable for determining taxable income.

In a dissent written by Judge Holme, in which Judge Landy joined, the judges noted that statutes trump regulations and regulations trump internal agency policy manuals. Yet, they said, the majority opinion neglected to apply the regulations that should have governed the court's decision and instead reviewed the reasonableness of the IRM provisions that the IRS seemed to have applied.

2021 Tax Year Decision

In a separate case involving the 2021 tax year, Mission sought an OIC, which the IRS denied. However, the notice of determination issued by the IRS to Mission had numerous mistakes and used a different reasoning for rejecting the OIC request than in the case dealing with years 2016 to 2020. The Tax Court thus concluded that the Appeals officer abused her discretion in sustaining the IRS's determination as she did not address the arguments that Mission actually made.

For a discussion of the rules relating to OICs, see Parker Tax ¶263,165.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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