Originally published on Forbes.com.
Harborside, Inc, a pioneer in the legal marijuana business founded by Steve DeAngelo and dress wedding has hired Greenspoon Marder to represent it in the appeal of a Tax Court decision to the Ninth Circuit. Greenspoon Marder, a national law firm with 240 attorneys in 26 offices has made a big commitment to the Cannabis industry I spoke with James Mann who will be handling the appeal. He tells me that he is passionate about the issue – or at least as passionate as a tax attorney can get about anything.
In Mann’s view, Harborside really did everything right in the way it complied with the complex rules under which California regulated medical marijuana. Although Harborside was not organized as such it had to operate on a not-for-profit basis. Profits from the sale of cannabis went into service programs.
Full state legalization, including recreational use, allows for-profit-operation. Harborside recently went public through a reverse takeover. Sara Brittany Somerset explained that in this piece. Due to the continuing federal problem with legality, the stock trades on the Canadian Securities Exchange with HBOR as its ticker.
IRS Overreach?
The fundamental tax problem of the state-legal cannabis industry is Code Section 280E which denies ordinary and necessary business deductions for taxpayers trafficking in controlled substances. That was added to the Code in 1982.
Because we have an income tax, not a gross receipts tax, deductions still had to be allowed for the cost of goods sold. The Tax Reform Act of 1986 expanded the costs that were included in the cost of goods sold(Code 263A). This was generally not a taxpayer-friendly provision since it had the effect of deferring deductions in inventory.
Having deductions running through the cost of sales was good for the “traffickers” though. It is better to get a deduction later rather than never. In 2015, the IRS Chief Counsel snatched even this half loaf off the table with CCA 201504011.
Read together, §280E and the flush language at the end of §263A(a)(2) prevent a taxpayer trafficking in a Schedule I or Schedule II controlled substance from obtaining a tax benefit by capitalizing disallowed deductions. Congress did not repeal or amend §280E when it enacted §263A. Furthermore, nothing in the legislative history of §263A suggests that Congress intended to permit a taxpayer to circumvent §280E by treating a disallowed deduction as an inventoriable cost or as any other type of capitalized cost. …………… Thus, we have concluded that a taxpayer trafficking in a Schedule I or Schedule II controlled substance is entitled to determine inventoriable costs using the applicable inventory-costing regulations under §471 as they existed when §280E was enacted.
To summarize in 1982 traffickers were denied deductions except cost of sales. In 1986 what went into cost of sales changed. In 2015, nearly twenty years later, IRS realizes that traffickers have to compute cost of sales like it is still 1982.
DOJ Veteran Disapproves
Mr. Mann had government experience as a political appointee during the Reagan Administration. He was Deputy Assistant Attorney General of the Tax Division’s Appellate Section. From that experience, he holds the view that IRS has an obligation to interpret the law in an even-handed manner not based on what maximizes revenue.
His inspiration from his time at DOJ is Ernest Brown. Professor Brown, as he was called even at DOJ, had a thirty-year career in government service after retiring from Harvard Law School at the age of 64. Brown died in 2001 at the age of 95 not long after his retirement.
In taking on this case Mr. Mann believes he is doing what Professor Brown would have approved of, focusing on what the law really says. The hard-line approach of the IRS is keeping much of the industry underground.
The Simple Fix
Given the large number of states that have now legalized, it is a wonder that Congress does not just cut through all this by dropping marijuana from the controlled substance list . I guess that would be too easy. Instead, the approach that is being proposed is blocking enforcement according to this piece by Tom Angell. That likely would not change anything at IRS.
Stock Analysts Take Note
A couple of items of interest that I was not able to get from Mr. Mann were what the stakes are and how it affects the public company. I thought I might be able to tease it out from public filings but have not managed to. According to the decision the deficiency notices covering the years 2007-2012
The notices denied most of Harborside’s claimed deductions and costs of goods sold, and asserted tens of millions in deficiencies and accuracy-related penalties.
The decision went pretty much against Harborside, although the penalty issue was subsequently decided in its favor. The Tax Court does not compute the tax, it gets pushed back on the parties to do what is called a Rule 155 Computation. As of early June, they were still not done.
The “tens of millions” exposure gives one pause since the public company has a market capitalization of less than $60 million, but I have not been able to find out one way or the other whether that overhanging tax liability is borne by the public company or if it somehow stayed off its balance sheet in the reorganization. I have stopped being surprised that the resolution of even quite large tax liabilities does not seem to affect stock prices, but it would seem that Harborside might be an exception. We’ll see.
And The Movie
Mr. Mann’s mention of Professor Brown got me going with him about On The Basis of Sex. Ernest Brown was one of the government lawyers portrayed in the film by Stephen Root in what I thought was a pretty cartoonish manner. Mann had not seen the film when he spoke to me, but he got back to me after watching it.
I think of On the Basis of Sex as a biopic in the tradition of Pride of the Yankees, Sergeant York or Spirit of St.Louis where Hollywood presents a pretty airbrushed view of a hero in a story based loosely on real events. So they take dramatic license for the sake of the movie – a great example of that is Sunrise at Campobello – when FDR’s children complained about the movie’s treatment of Sara Roosevelt, the screenwriter, Dore Schary, responded: “Every play needs a villain.”
And that’s what happened in On the Basis of Sex, where the two main villains (Dean Griswold and Professor Brown) are no longer alive to defend themselves.
Anyhow, I’m sure those who are inclined to believe the movie’s version of events haven’t the slightest interest in understanding the great service Professor Brown rendered to the Department of Justice for 30 years. Since, as I recall, he was a confirmed bachelor, he has no children to defend him.
Other Coverage
Cheryl Miller covered the appeal in a weekly column called Higher Law.
“We are not saying 280E is illegitimate or unconstitutional,” Mann said in a recent interview. “This is a more narrow argument. As such, it would not be a panacea for the industry.”
Mann is a former deputy assistant attorney general of the U.S. Department of Justice tax division. A win in the Ninth Circuit, he said, would not be “a magic bullet” but it could help ease the tax burden that’s “hurting members trying to do the right thing.”
Correction
I previously reported that the issue of penalties was undecided. The Tax Court did issue a separate ruling on penalties in favor of Harborside on December 20, 2018.
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