In probably the biggest case in the marijuana industry since Californians Helping to Alleviate Medical Problems Inc. v. Commissioner, Harborside Healthcare Center is taking on the IRS in Tax Court. What is at stake is Section 280E of the Tax Code, which stemmed from a 1981 Tax Court decision.
According to that section of the Tax Code, “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.”
Twenty-five states and the District of Columbia have now legalized marijuana in some form or another. Although these states have legalized the sale, marijuana is still listed as a Schedule I controlled substance with the federal government. The gross income received from the sale of marijuana is taxable, but under Section 280E, only the cost of goods sold, or COGS, is deductible. This is forcing legal marijuana dispensaries to scramble to avoid paying a federal tax rate of 60 to 90 percent of their income in taxes.
Opinion Allowing COGS
In the 1981 case that led to Section 280E, Jeffrey Edmondson v. Commissioner, the petitioner was considered self-employed, having sold amphetamines, cocaine and marijuana. He received 1,100,000 amphetamine tablets, 100 pounds of marijuana and 13 ounces of cocaine on consignment in 1974.
Edmondson did not have a beginning inventory and had an ending inventory of 8 ounces of cocaine. He did not keep any books or records of sales and expenses. However, he reconstructed his income and expense for the purposes of filing his 1974 tax return in response to a jeopardy filing made by the IRS in 1975. He claimed $105,300 in COGS in 1974.
In addition to COGS, Edmonson had other expenses. In the opinion of the court, the judge allowed the COGS, telephone, auto and rental expenses. However, due to this case, Congress in 1982 enacted Section 280E, which only allowed COGS.
Opinion Allowing Separate Trade or Business
In 2007, another case, Californians Helping to Alleviate Medical Problems (CHAMP) Inc. v. Commissioner, showed that diversification in the marijuana industry was a good thing. The company began in 1996, operating a caregiving facility in San Francisco for people with debilitating illnesses. Only one component of the company’s caregiving program was to provide members with medical marijuana. The company also provided counseling, daily healthy lunches, hygiene supplies, yoga lessons and internet access. Members of CHAMP paid a monthly membership fee. In 2002, CHAMP went out of business and filed its final tax return with the IRS.
The IRS found a $355,000 deficiency in tax. It disallowed numerous business deductions such as salaries, maintenance and rent. The IRS contended these ordinary and necessary expenses were precluded by Section 280E.
CHAMP took its case to the U.S. Tax Court, arguing it had two separate trades or businesses, one that included caregiving and another that included medical marijuana. The court agreed with CHAMP and stated that it indeed had two separate businesses:
“We do not believe it to have been artificial or unreasonable for petitioner to have characterized as separate activities its provision of caregiving services and its provision of medical marijuana. Petitioner was regularly and extensively involved in the provision of caregiving services, and those services are substantially different from petitioner’s provision of medical marijuana. By conducting its recurring discussion groups, regularly distributing food and hygiene supplies, advertising and making available the services of personal counselors, coordinating social events and field trips, hosting educational classes, and providing other social services, petitioner’s caregiving business stood on its own, separate and apart from petitioner’s provision of medical marijuana.”
Based on the opinion the court allocated 18/25ths of employee expenses to caregiving services, in addition to all of the rent paid to a secondary facility not used to distribute marijuana, and expenses related to trucks, automobiles, laundry and cleaning. In addition, the court allocated 9/10ths of the remaining expenses to caregiving.
In another case, Olive v. Commissioner, the court held that the owner of a medical marijuana dispensary was not entitled to any business tax deductions. This included caregiving expenses provided alongside the sale of marijuana. The court found the business solely consisted of trafficking marijuana and fell under an exception in Section 280E. Olive took the case to the Ninth Circuit of Appeals, which ruled in 2015.
Olive had opened a medical dispensary, known as the Vapor Room Herbal Center. The dispensary transacted other business such as sales of vaporizers, games, books and art supplies. It also gave yoga classes, massages and showed free movies.
In Olive, the Ninth Circuit suggested that dispensaries, under some circumstances, might be allowed to reduce their tax liability by tying together caregiving services with marijuana sales. The court did so by distinguishing, rather than contradicting, the Tax Court’s decision in CHAMP. Since Tax Court decisions are not binding on circuit courts, the Ninth Circuit did not need to carefully distinguish CHAMP from Olive. However, in not calling into question the CHAMP decision, the court implied that it would find the expenses associated with the caregiving services of a dispensary similar to the one in CHAMP to be tax deductible. Thus, the Olive court’s passive acceptance of CHAMP suggests that for dispensaries in California, tax deductions may be allowed for caregiving services if these services embody a separate “trade or business” from that of selling medical marijuana.
Harborside’s Case
Harborside is taking it a step further and trying to get Section 280E repealed. Harborside is the country’s largest cannabis dispensary, grossing $30 million in sales. It has three locations and a network of 225,000 patients. In June of 2016, Harborside spent a week in Tax Court over a $2.4 million bill from the IRS. Its lead attorney is Henry Wykowski, who also represented CHAMP in its landmark case.
Don’t look for a decision until 2017, but I will update you when the case becomes final.
Craig W. Smalley, MST, EA, has been admitted to practice before the Internal Revenue Service and the United States Tax Court. He has a Masters in Taxation from UCLA, and is the founder and CEO of CWSEAPA, LLP, and Tax Crisis Center, LLC, with locations in Florida, Delaware, and Nevada. He has been in practice for 22 years.