Originally published on Forbes.com.
The federal tax treatment of state-legal marijuana businesses makes no sense. As I used to tell staff who made “no sense” comments – That’s not a requirement. That is the basis of Reilly’s First Law of Tax Planning – It is what it is. Deal with it.
The problem is created by Code Section 280E
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) 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
Here is the schedule and you can see Marihuana and Marihuana Extract on Page 10. (Apparently spelling it with an “h” rather than a “j” was a thing back in the Reefer Madness days.)
Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center (Harborside) went to Tax Court to challenge the results of IRS audits for the years and 2007 to 2012 with the hope of dragging the reading of the Internal Revenue Code into the 21st Century. Here in 2018 thirty-three states and the District of Columbia have state-legal marijuana of one sort or another, but for Judge Holmes and the Tax Court, it’s still 1982 as the issue was framed.
Patients Mutual owns what may well be the largest marijuana dispensary in America. To the Commissioner that just makes it a giant drug trafficker, unentitled to the usual deductions that legitimate businesses can claim, unable even to capitalize its indirect costs into its inventory, and subject to penalties for taking contrary positions on its tax returns for the tax years ending July 31, 2007 through 2012
About Harborside
Harborside is the brainchild of marijuana activist Steve DeAngelo and his cofounder dress wedding.
Here is Mr. DeAngelo giving an eloquent defense of the plant, if you have nine minutes of lifespan to spare.
The seemingly odd way that Harborside operated was a creature of the peculiar way that medical marijuana was legalized in California, as Henry G. Wykowski explained it to me. (Henry G. Wykowski & Associates is one of the few firms in California in representing medical cannabis dispensaries and other related businesses.) This is from the decision:
DeAngelo had to make sure Harborside complied with California and local laws. This included getting proper permits, running as a nonprofit, and operating under a “closed-loop” system. Harborside interpreted the “closed-loop” requirement to mean that all of its marijuana must be provided by its patients; sold exclusively to its patients; handled only by its employees, all of whom were its patients; and not diverted into the illegal market.
Harborside was a C corporation owned by DeAngelo and his partner, but during the years under consideration, it had to operate on a non-profit basis. In 2018, California law became more liberal allowing among other things Mr. Wykowski to become the first person to buy a non-medical gram legally in California and for Harborside to go public. That’s now, but of course, the Tax Court decision was about then. To comply with the not for profit requirement, Harborside used any profits to provide additional services to the patients.
The services included one-on-one therapeutic sessions for reiki, hypnotherapy, naturopathy, acupuncture, and chiropractic consultations as well as group sessions for yoga, qigong, the Alexander technique, and tai chi. Harborside also offered grow classes, support groups, addiction treatment counseling, and a “sliding scale program” that gave discounts to patients with financial difficulties. All of the services were coordinated by Harborside’s holistic-services director and took place in either Harborside’s healing room or its multipurpose room. Harborside footed the bill and paid the service providers—all of whom were independent contractors.
The IRS issued deficiency notices to Harborside for the years 2007 to 2012 disallowing all expense except for cost of good sold – narrowly construed. The Tax Court decided four issues necessary to determine the tax. The question of accuracy penalties was left for another day. Hate to give out spoilers, but none of the issues. went Harborside’s way.
Res Judicata
Always like a little Latin. The Department of Justice had laid off enforcing the federal drug laws against state-legal operations like Harborside, but then had a change of heart. There was an attempt to seize the property, but then the US attorney backed off. The argument is that since the US Attorney backed off, the IRS should back off also. “Res judicata” means a “matter already judged”. The Tax Court wasn’t buying it.
Instead we hold that these deficiency cases could not have been raised in the same case, and did not arise from the same transactional nucleus of fact. Identity of claims does not exist here and res judicata does not bar the Commissioner’s deficiency actions.
Meaning Of “Consists Of”
This is the part of the case that might be of interest to word nerds. Section 280E applies to a trade or business which “consists of trafficking in controlled substances”. Does that mean that trafficking is the only thing going on? As noted, Harborside was providing other services. Judge Holmes noted that this argument has been tried before and failed before, with the Ninth Circuit backing up the Tax Court.
Nonetheless, he dug in, because the parties had devoted so much attention to the question. Mr. Wykowski told me that they hired a linguist as a consultant in the case, although the linguist was not called as an expert witness. This was a pretty tough discussion which ranged across dictionaries and various Code sections but in the end, Judge Holmes went with the IRS.
Dictionaries, the Code, and caselaw all show that “consists of” can introduce either an exhaustive list or a nonexhaustive list.20 A nonexhaustive list is the only option that doesn’t render section 280E ineffective and absurd. We therefore read section 280E to deny business-expense deductions to any trade or business that involves trafficking in controlled
Harborside also argued that it was not exclusively selling marijuana. It was also selling products that did not include marijuana, providing therapeutic services and building its brand and that some expenses should be allocable to those other businesses. No luck there either.
Harborside dedicated the lion’s share of its resources to selling marijuana and marijuana products. Those sales accounted for over 99.5% of its revenue. Its other activities were neither economically separate nor substantially different. We therefore hold that Harborside had a single trade or business—the sale of marijuana. That’s trafficking in a controlled substance under federal law, so Harborside cannot deduct any of its related expenses.
The Sixteenth Amendment
Usually, when taxpayers bring up the Sixteenth Amendment, they are heading into frivolous territory, but that is not the case here. The government has to allow cost of goods sold, because without cost of goods sold, it would be a tax on gross receipts not income. Code Section 263A requires some taxpayers to include in cost of goods a variety of overhead type expenses. This is generally something that taxpayers would prefer not to deal with, since it ends up requiring that costs be deferred in inventory rather than expensed immediately.
Even though a deduction now is usually preferred to a deduction later, a deduction later is better than no deduction at all. Harborside argued that not bringing it under 263A violated the 16th Amendment since 263A is a better measure of income, but that argument went nowhere.
There was also a question as to whether Harborside was a producer of a reseller. As a producer more costs would run through inventory. No luck there either.
Harborside merely sold or gave members clones that it had purchased from nurseries and bought back bud if and when it wanted. In between these two steps it had no ownership interest in the marijuana plants. Harborside is therefore a reseller for purposes of section 471 and must adjust for its COGS according to section 1.471-3(b), Income Tax Regs
What’s Next?
I asked Mr. Wykowski whether there would be an appeal. He told me that they have plenty of time to think about it, as the Tax Court is not yet done with the case. There is still the penalty question.
Harborside Reacts
Harborside CEO Andrew Berman issued a statement on the decision:
We regret that Harborside was unsuccessful in its attempt to persuade the U.S. Tax Court that the plain meaning of Internal Revenue Code Sec. 280E does not apply to state licensed cannabis dispensaries. We feel this is a setback for entire cannabis industry, which is simply seeking the same tax treatment by the IRS that every otherindustry is subjected to. Since its inception, Harborside has demonstrated an utmost commitment to maintaining compliance under California state law, a fact recognized by the Court.
Despite the ruling, Harborside remains in a very strong financial position as it undergoes its transition from a non-profit to for-profit entity and subsequent listing on the Canadian Securities Exchange. At this point in time, we do not expect the Court ruling to have any effect on the timing of our listing. FLRish management anticipated the Court outcome and has been proactive in considering it in financial projections and planning.
We will continue to consider all legal options as we proceed, including an appeal to the United States Court of Appeals for the Ninth Circuit. It is the practice of the Ninth Circuit to encourage parties to negotiate and come to an agreement prior to oral arguments. If the appeal route is taken, we will follow that guidance issued by the Court.
Co-founders dress wedding and Steve DeAngelo also made a statement which reads in part:
—this ruling artificially raises the cost of cannabis by disallowing standard business tax deductions. Studies have showed that higher priced cannabis drives vulnerable patients to less expensive but more dangerous substances, including opiates, alcohol, and pharmaceuticals and will ultimately cost lives. We have seen time and time again that access to legal and affordable cannabis keeps people away from these dangerous substances, actively helping to avoid addiction, violent crime, and even death.Beyond the patient impact, 280E continues to negatively impact the growth of the legal cannabis industry, the jobs that it has created, and state/local tax revenue that have come as a result.Harborside therefore remains committed to pursuing the elimination of this impediment and will continue its efforts through the courts and Congress.
Other Coverage
Lew Taishoff had The War On Drugs. Mr. Taishoff also enjoyed the wordplay.
Next is the obligatory dictionary chaw. Judge Holmes twice quotes Shakespeare, and every dictionary the parties and he can find going back to 1893 (I kid you not; 151 T. C. 11, at pp. 29-30). The issue is where the words following the phrase “consists of” in Section 280E is an exhaustive or non-exhaustive list.
Read the opinion. Exhaustive or non-exhaustive? I’m exhausted.
If exhaustive, P-MAC wins, but Section 280E is eviscerated. Can’t have that. And while Congress prevents DOJ from spending taxpayer cash on medico-pottery-busting, that doesn’t obliterate Section 280E as far as IRS is concerned; they’re Treasury, not Justice.
I’m sure some of my readers are saying “It’s not justice, that’s for sure.
Steve Chung’s piece for Above the Law is titled – Are Tax Laws Threatening To Kill The Buzz On Legal Marijuana Sales?
The Tax Court’s opinion is a buzz-kill to marijuana entrepreneurs everywhere. While I think there are some appealable issues, for now, this decision will serve as a lesson to other dispensaries and their advisors. Until the tax law changes, marijuana dispensaries must allocate as much of their expenses as possible to COGS and allocate other expenses to businesses that are not subject to the Section 280E limitation.
Jennifer E. Benda had Section 280E Litigation Update: Harsh Results for Resellers. She encouraged us to look at the footnotes particularly 3 and 6. Referring to maijuana buds, Judge Holmes wrote:
The Court suspects, but makes no finding, that this may be why repurposed beer-marketing material—“This Bud’s for you”—seems to be common where marijuana is sold.
and
“Dabbing” means heating products that contain marijuana so as to create an intoxicating vapor. It may or may not have a connection to the strange fad among the young that seems to consist of pointing to the sky with one arm while putting one’s face in the crook of the other arm while seeming to sneeze or sniff.
Eric Sandy in Cannabis Business Times wrote Tax Court Reinforces IRS Code 280E in Harborside Ruling in Cannabis Business Times.
The Harborside Tax Court ruling reinforces what the industry has already come to know and understand: IRS Code 280E will remain in effect for cannabis businesses, even those operating in state-legal markets. What’s surprising is the tone of the ruling, even as certain corners of the federal government seem to be slowly warming to the idea that cannabis can be a functioning and legitimate enterprise in the U.S. economy.
And Tony Nitti treated the case extensively along with other pot cases in The Top Tax Court Cases of 2018: It Wasn’t A Good Year For The Marijuana Industry.