Tax Court Addresses 280E for Cannabis Businesses
On November 29, 2018, the U.S. Tax Court published its opinion, Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner, 151 T.C. No. 11, which may prove to serve as the prevailing guidance for cannabis businesses. Harborside operates as a medical marijuana dispensary under California law. As a result of the Tax Court’s opinion, Harborside was ordered to pay back tax deficiencies on millions of dollars of business deductions improperly claimed between the years 2007 and 2012.
IRC Section 280E – Background
Generally, the Internal Revenue Code allows a business to deduct all of its “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business,” but there are exceptions. For the cannabis industry, the primary exception is IRC Sec. 280E.
IRC Sec. 280E states: 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) that are prohibited by federal law or the law of any state in which such trade or business is conducted.
Under the Federal Controlled Substances Act, cannabis is labeled as a Schedule I drug. Therefore, any sales activity is considered trafficking under federal law. IRC Sec. 280E prevents cannabis businesses from enjoying the benefit of otherwise ordinary business deductions, making it one of the most significant tax issues affecting the industry.
Key Rulings from Harborside
- The Tax Court found that Harborside had only a single trade or business (trafficking in a controlled substance) and thus could not deduct business expenses related to its non-marijuana activities.
Harborside’s non-marijuana activities included the sale of apparel and other non-marijuana products, therapeutic services and brand development. The court noted that almost all of Harborside’s resources were dedicated to its marijuana sales, which made up more than 99.5% of its revenue. Accordingly, the Tax Court held that Harborside did not have multiple lines of businesses.
The Tax Court further held that the uniform capitalization rules of IRC Sec. 263A do not apply to cannabis businesses. The rules under IRC Sec. 263A permit certain costs normally expensed to be capitalized as part of inventory for tax purposes, increasing cost of goods sold (“COGS”). The Tax Court ruled that only IRC Sec. 471 could be applied to calculate inventory costs for purposes of IRC Sec. 280E.
Many taxpayers try to avoid the IRC Sec. 263A capitalization rules since they would rather deduct costs in the year incurred rather than capitalizing them and having to defer the deductions. Harborside tried to assert the application of IRC Sec. 263A since, in the case of cannabis businesses, deductions as part of COGS are all that are allowed under IRC Sec. 280E. The Tax Court disagreed, relying on the language at the end of IRC Sec. 263A(a)(2) that: “Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.” Admittedly, this may be circular reasoning, but it is currently the law.
Finally, the Tax Court held that as a retailer, Harborside was denied expanded COGS deductions under IRC Sec. 471, limiting what can be included in COGS to inventory purchase price and freight costs.
Harborside Not Liable for Accuracy-Related Section 280E Penalties
In a separate opinion published December 20, 2018, T.C. Memo. 2018-208, the Tax Court ruled that Harborside was not liable for accuracy-related penalties related to its disallowed business deductions under IRC Sec. 280E. Harborside was deemed to have acted “with reasonable cause and in good faith when taking its tax positions for the years at issue.”
Although Harborside was granted relief from penalties, since there were no IRS regulations or rulings and no court decisions furnishing guidance on the proper application of IRC Sec. 280E, other taxpayers contesting disallowed deductions under IRC Sec. 280E may not be automatically granted such relief now that the Tax Court has spoken.
Relief for the Hemp Industry
The hemp industry received good news on December 20, 2018, when the Agriculture Improvement Act of 2018 (“Farm Bill”) was signed into law. The Farm Bill included removing hemp from the Controlled Substances Act, making it legal under federal law and no longer subject to IRC Sec. 280E limitations.
Takeaways from Harborside
- The Harborside Tax Court opinion is the only current authoritative guidance to cannabis businesses as they look to limit their tax liability and exposure. In addition to reinforcing IRC Sec. 280E, the Tax Court’s rulings in Harborside significantly limit the expenses cannabis businesses can include in COGS. If the Tax Court’s position that the uniform capitalization rules of IRC Sec. 263A do not apply to most cannabis businesses stands, cannabis businesses will be forced to look solely to IRC Sec. 471 for guidance on the appropriate inventory costing methods to use. Retailers will be impacted most, as they are only able to include in COGS the purchase price of inventory and freight costs. Producers, on the other hand, may still able to capitalize indirect production costs into inventory, albeit in a modified form compared to IRC Sec. 263A.
- Cannabis businesses should revisit previously filed tax returns to determine if certain positions taken are contradictory to the Tax Court’s opinion in Harborside. Contradictory positions may increase tax exposure, which could leave a business potentially liable for IRS penalties and also have an impact on M&A deals. Since the IRS apparently is auditing all returns of cannabis businesses, this is a necessary exercise.
- Cannabis operators should evaluate whether they can take steps to isolate different lines of businesses that operate under the same roof. The benefit of isolating different lines of business would be to allow the non-cannabis business to potentially avoid being limited by IRC Sec. 280E as to the business lines that don’t directly “touch the plant,” thereby creating the ability to deduct all ordinary and necessary business expenses for the eligible line or lines of business. The test of whether a separate line of business exists is facts-and-circumstances based. Examples include:
- The company has created a separate legal entity;
- The company has its own dedicated space in the facility;
- The company has its own separate books and records;\
- There are separate employees between the businesses; and
- The percentage of overall revenue derived from the non-cannabis business.
The Tax Court has previously stated there can be more than one line of business under the roof of a dispensary. The mere presence of one federally illegal business does not negate the expenses related to the legal business. (Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173.)