Shareholders of a Washington marijuana beverage company are challenging roughly $4.6 million in federal taxes and penalties, arguing that the company’s finished THC-infused drinks do not qualify as controlled substances and therefore should not be subject to the federal tax provision known as Section 280E.
Three petitions filed recently in the U.S. Tax Court involve Dogtown Pioneers, a Washington-licensed marijuana producer and processor that makes Ray’s Lemonade and Lil’ Ray’s beverages. The challenges were brought by shareholders Raymond Kinney and Geyang Wu, Donna Auclaire and Rodney Boast and Daniel Kinney.
At the center of the dispute is Section 280E of the Internal Revenue Code, which generally prevents businesses trafficking in Schedule I or Schedule II controlled substances from claiming ordinary federal tax deductions or credits.
The Internal Revenue Service determined that Dogtown was engaged in trafficking a controlled substance and disallowed substantial business costs and expenses. Because Dogtown is structured as an S corporation, the resulting income adjustments flowed through to its shareholders, generating the disputed individual tax liabilities.
The shareholders argue that the IRS used the wrong product when determining whether Dogtown was dealing in a controlled substance. According to the petitions, the agency focused on the THC concentration of cannabis-derived material used to manufacture the drinks rather than the concentration of THC in the finished beverages ultimately sold by Dogtown.
Dogtown’s 12-ounce Ray’s Lemonade contained no more than 100 milligrams of delta-9 THC, while a 1.75-ounce Lil’ Ray’s beverage introduced in 2021 contained the same amount in a smaller container. The petitions calculate the THC concentration of the finished drinks at approximately 0.03% for the 12-ounce product and 0.2% for Lil’ Ray’s when measured against the total weight of the beverages.
The shareholders contend that the finished beverages therefore qualify as hemp rather than federally controlled marijuana. Federal law currently defines hemp as Cannabis sativa L. and its derivatives containing no more than 0.3% delta-9 THC on a dry-weight basis. The petitions acknowledge that distinction while arguing that neither the IRS notice of deficiency nor its examination report made a finding concerning the THC concentration of Dogtown’s products on a dry-weight basis.
Despite that federal argument, Dogtown operates within Washington’s regulated marijuana market. The company is licensed by the Washington State Liquor and Cannabis Board as a producer and processor, and the petitions state that its products were sold exclusively to licensed Washington retailers.
The cases also challenge the IRS’s treatment of Dogtown’s inventory and production expenses, including the disallowance of labor costs totaling about $347,000 in 2020, $638,000 in 2021 and $1.6 million in 2022. The shareholders argue that those wages were legitimate production costs because employees manufactured, bottled and packaged the beverages.
Across the three cases, the disputed deficiencies, penalties and other specified additions total approximately $4.61 million, not including certain interest and an additional penalty whose final amount has not yet been calculated.
The shareholders are asking the Tax Court to overturn the IRS adjustments and redetermine their liabilities.
