A taxpayer is entitled to challenge the IRS's interpretation of the law, including positions related to IRC § 280E. In fact, there are mechanisms built into the tax code and specified tax forms to facilitate this. This is probably the most misunderstood part of our work at Calyx. We are challenging the IRS, but we are following the prescribed procedures for doing so. We are accountants, after all... we follow the rules, even when "breaking" them.
There is a defined framework that must be followed, and here is what it relies on: Taxpayers cannot arbitrarily apply their own misguided understanding of how taxes "should be." Rather, § 1.6662-3(b)(3) requires that the position be supported by recognized authorities, examples of which include the Internal Revenue Code, regulations, court cases, and official IRS guidance, among others.
A "no 280E" position, if based on a well-reasoned interpretation of statutory language currently under litigation (see above: the Internal Revenue Code; court cases), may satisfy the reasonable basis standard. While the reasonable basis standard is considered an objective test, it is applied through evaluative judgment, so its application can be uncertain and contested.
Reasonable basis is not unilaterally determined by the IRS, and a position can indeed meet the standard even if the IRS claims it does not. The real issue is whether the position is supported by one or more relevant tax authorities in a way that is objectively reasonable. A position meeting the reasonable basis standard is stronger than a frivolous or merely colorable argument, but it does not require that the position be likely to prevail.
Frivolous > Reasonable Basis (~20%) > Substantial Authority (~40%) > More Likely Than Not (>50%)
When it comes to avoiding penalties, generally speaking, a disclosed position must only rise to the reasonable basis standard, whereas an undisclosed position must rise to the substantial authority standard.
Further, penalty assessment is nuanced and case-specific. The IRS is required to consider a range of factors when assessing accuracy-related penalties. The risk of assessment is significantly reduced when the taxpayer acts in good faith, maintains accurate accounting records, and provides transparent disclosure with the assistance of a qualified professional.
In fact, even if a position is determined not to meet the reasonable basis standard, demonstrating reasonable cause and good faith can still provide some penalty relief.
While there is always the risk of the IRS assessing penalties if it disagrees with the taxpayer's position, the buck does not stop with the IRS. The taxpayer retains the right to contest those penalties through administrative appeals or judicial review.
Of course, this is where each taxpayer's risk tolerance must be measured. Only the taxpayer can decide whether the risk is worth the reward and whether they want to fight the fight.
We're not saying this position is certain to succeed, but we do believe taxpayers are justified in taking it.
