Marijuana

Are Tax Laws Threatening To Kill The Buzz On Legal Marijuana Sales?

When you are facing large tax bills totaling several million dollars due to Section 280E, you will do odd things to minimize the tax burden.

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One of the biggest legal controversies involving taxes involve marijuana sales. In the past it was criminalized in all states, because it was seen as a gateway drug to harder substances.

But over the years, the attitude towards marijuana has changed and the law has been somewhat receptive. Many states allow its use for medicinal purposes and have decriminalized marijuana possession. In recent years, a few states allowed it for recreational use under certain conditions.

Entrepreneurs are starting marijuana dispensaries in states with friendly marijuana laws. Generally, businesses pay tax on its net income – meaning gross receipts reduced by ordinary and necessary business expenses.

But the federal tax law is not friendly to marijuana businesses. Section 280E of the Internal Revenue Code disallows the deduction of ordinary and necessary business expenses connected with trafficking of controlled substances, which includes marijuana.

There are two exceptions to the Section 280E limitation. First, the limitation did not apply for expenses associated with cost of goods sold (COGS). COGS is the cost of acquiring inventory, through either purchase or production. Second, if the taxpayer can show that their business expenses are connected with a separate trade or business that is not connected to marijuana sales, then those expenses are deductible.

On November 29, 2018, the U.S. Tax Court decided Patients Mutual Assistance Collective Corporation v. Commissioner. Did this decision set new precedent on Section 280E? Or did it uphold the status quo?

In this case, the taxpayer formed a marijuana dispensary known as Harborside Health Center (Harborside). In addition to marijuana sales, Harborside sold products that contained marijuana and non-marijuana products. Also, Harborside provided other services to its patients at no additional cost, claiming that it was part of the purchase price. These services included hypnotherapy, yoga, acupuncture and Tai Chi.

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What’s interesting about this case is that Harborside purchased its marijuana flowers from its patients. What Harborside did was give marijuana clones from nurseries and gave or sold the clones or seeds to its patients with the understanding that the cultivated marijuana could be sold back to Harborside. Harborside had the discretion to not purchase the marijuana if it did not meet their needs at that time. The growers can then sell them to another collective if they choose to.

If this arrangement sounds odd to you, I’m sure there are all kinds of similar arrangements like this in the cannabis industry. When you are facing large tax bills totaling several million dollars due to Section 280E, you will do odd things to minimize the tax burden.

In 2012, the federal government filed a civil forfeiture action alleging that Harborside was illegally cultivating, distributing and possessing marijuana. The lawsuit was eventually dismissed.

The IRS audited Harborside and disallowed most of its claimed business deductions. It then asserted tens of millions of dollars in taxes, penalties and interest, citing Section 280E. Harborside petitioned the U.S. Tax Court to review the decision.

First, the Tax Court considered whether the dismissal of the forfeiture lawsuit allowed a res judicata claim on Section 280E, thus preventing the court from even considering whether that section applies in determining the business expenses are deductible. Harborside argued that the dismissal means that as a matter of law Harborside was not a drug trafficker and thus not subject to Section 280E. However, the Tax Court found that res judicata does not apply because there is no identity of claims in both actions. This is because the IRS cannot finalize a proposed tax liability in a civil forfeiture case.

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Since res judicata does not apply, the Court next decided whether Section 280E applies in the case. First, the Court noted that Section 280E applies even if a trade or business has multiple different activities that do not involve marijuana sales.

Second, the court looked at whether the multiple activities of Harborside constitutes one business or several. This is crucial because if Harborside is found to be operating multiple businesses, including some that are not related to marijuana sales, then a portion of the business expenses can be deductible by allocating them to the nonmarijuana related businesses. On the other hand, if the other businesses are merely incident to marijuana sales, then the multiple business activities considered as one. For example, just because McDonalds includes a toy in a Happy Meal does not turn McDonalds into a toy store.

In sum, the court found that the Harborside’s other activities were merely incident to marijuana sales. The sale of nonmarijuana products generated less than 1% of its revenue. Also, the taxpayer did not have separate books and records for the nonmarijuana sales. Regarding the free therapeutic services provided, such as yoga and acupuncture, this too was also considered incident to marijuana sales. The court noted that security only checked in 5% of the time to monitor the services provided while spending 60% of their time checking in people who were purchasing marijuana.

Finally, Harborside tried to argue that their expenses connected to the sale of marijuana should be attributed to COGS which is an allowable deduction despite the limitations of Section 280E. This required a determination as to whether Harborside was a reseller or producer of the marijuana. If Harborside is a producer, then it can deduct indirect inventory costs such as labor, raw materials, supplies, and production costs. If Harborside is considered a reseller, then it can only include its inventory price and transportation costs.

The Court held that Harborside was a reseller. The Court noted that Ninth Circuit case law holds that for the taxpayer to be considered a producer, he must be considered an owner of the property produced. However, the determination of ownership will depend on the facts and circumstances, not merely holding title. The Court found that Harborside did not have all of requisite bundle of sticks of ownership. It noted that Harborside did not create the clones, maintain tight control over them, order specific quantities, prevent sales to third parties, or take possession of everything produced. Harborside merely sold or gave its patients clones that it purchased from nurseries and bought back marijuana from them if and when they wanted.

In a footnote, the Court recognized that some states allow recreational and medical use of marijuana. So it appears that even in states with marijuana friendly laws, the Court will not release or mitigate the effects of Section 280E. The Court stated that the only way to get relief from Section 280E is to change the federal law.

Future audit victims may want to consider bringing their case before a U.S. District Court where their case may be heard and decided by a local jury who may be more sympathetic. The problem is that the District Court only has jurisdiction in tax cases when the taxpayer pays the tax first and then sues for a refund. Unfortunately, this means that only wealthy businesses will be able to access this alternative forum.

The Tax Cuts And Jobs Act lowered the corporate tax rate to a flat 21% starting in 2018. This can lower the tax burden for larger dispensaries and may eliminate the need for complex and risky tax strategies. However, the finances of C Corporations must be handled very carefully. If a shareholder withdraws excessively from the corporation, the withdrawals can be classified and taxed as wage income or as constructive dividends. However, if the shareholders leave the money in the corporation, the corporation may be subject to the accumulated earnings tax.

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.

Shannon Achimalbe was a former solo practitioner for five years before deciding to sell out and get back on the corporate ladder. Shannon can be reached by email at sachimalbe@excite.com and via Twitter: @ShanonAchimalbe.

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