Up In Smoke…Again

Where there’s smoke, there’s fire. Where there’s a marijuana business, there’s Section 280E and the desire to find a means around it. The Tax Court looked at two cases today involving semi-legal marijuana dispensaries (legal on the state level, but decidedly illegal on the federal level). Would inventiveness allow the deduction of general and administrative expenses? Would a dispensary get out of the Section 6662(a) accuracy-related penalties because what they did was reasonable?

In the first case, a marijuana dispensary knew about the problem of Section 280E. That section disallows all deductions except Cost of Goods Sold for a business trafficking in illegal drugs. So what are means around that? Well, you can have a second line of business, but it has to be real and the books have to clearly separate this out. But that wasn’t what this dispensary came up with.

Why not have a management company provide management services to the dispensary? And we’ll be able to deduct all the expenses of the management company (including general and administrative expenses)–that’s a different business. It was a Eureka! moment for the dispensary…until the IRS disallowed all of the expenses of the management company. (The IRS also disallowed the general and administrative expenses of the dispensary, and additional Cost of Goods Sold expenses of the dispensary.) The dispute ended up in Tax Court.

First, Section 280E is very clear about deductions for illegal drugs:

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.

Marijuana is a Schedule I drug federally; thus, only Cost of Goods Sold can be deducted. The petitioners’ argument that it’s legal on the state level doesn’t hold up; it’s illegal federally. Out go the G&A expenses of the dispensary.

But what about the management company? The IRS argued that the management company was trafficking in controlled substances; the petitioners said it was simply a managing company:

Petitioners argue that, as a management services company, Wellness did not itself engage in the purchase and sale of marijuana. But the only difference between what Alternative did and what Wellness did (since Alternative acted only through Wellness) is that Alternative had title to the marijuana and Wellness did not. Wellness employees were directly involved in the provision of medical marijuana to the patientmembers of Alternative’s dispensary. While Wellness and Alternative were legally separate, Wellness employees were engaged in the purchase and sale of marijuana (albeit on behalf of Alternative); that was Wellness’ primary business. We do not read the term “trafficking” to require Wellness to have had title to the marijuana its employees were purchasing and selling. Neither that section nor the nontax statute on trafficking limits application to sales on one’s own behalf rather than on behalf of another. Without clear authority, we will not read such a limitation into these provisions…

Petitioners also argue that applying section 280E to both Alternative and Wellness is inequitable because deductions for the same activities would be
disallowed twice. These tax consequences are a direct result of the organizational structure petitioners employed, and petitioners have identified no legal basis for remedy.

Thus, the management company (which was an S-Corporation) can’t take business expenses and its shareholders have unreported income.

Overall, the first case was quite inventive in trying to find a way around Section 280E. But once again the deductions went up in smoke.

The second case was looking at another dispensary and whether it was subject to an accuracy-related penalty. The Tax Court had previously ruled that the IRS was correct in disallowing deductions for the dispensary when they tried to capitalize those expenses under Section 263A(a)(2)—another inventive attempt to get around Section 280E that failed.

There wasn’t any dispute that the amount of underreporting was significant enough that this dispensary could be liable for the penalty. Rather, the issue was on whether or not the dispensary’s position on its returns was reasonable. As Judge Holmes notes,

In any event, Olive did not become final and unappealable until years after Harborside filed the last of the returns at issue in these cases. And Harborside also points out that, apart from CHAMP and Olive, there was very limited guidance available to marijuana dispensaries. Harborside correctly points out that the IRS has never promulgated regulations for section 280E and didn’t issue any guidance on marijuana businesses’ capitalization of inventory costs until 2015. See Chief Counsel Advice 201504011 (Jan. 23, 2015).

Judge Holmes draws the conclusion I would draw:

This leads us to the conclusion that Harborside’s reporting position was reasonable. Not only had its main argument for the inapplicability of section 280E to its business not yet been the subject of a final unappealable decision, but as discussed at length in Patients Mutual I, the meaning of “consists of” as used in section 280E is subject to more than one reasonable interpretation. Even by 2012–the last of the tax years at issue here–the only addition to this caselaw was our own opinion in Olive, and it too was still years away from a final appellate decision. [citation omitted]

There’s more:

As to Harborside’s good faith: We released Olive shortly after Harborside’s 2012 tax year ended, and Harborside began allocating a percentage of its operating expenses to a “non-deductible” category starting that year and did not even wait for Olive to be affirmed on appeal…We therefore find that Harborside acted with reasonable cause and in good faith when taking its tax positions for the years at issue. Harborside isn’t liable for penalties.

Another point in their favor: They kept excellent records. This is something I cannot overstate: If you’re in business, you are expected to keep good records. If all of your expenses are substantiated, you will be in much better shape than a business that doesn’t have such substantiation.

So what’s the other takeaway from today’s decisions? First, marijuana dispensaries will likely keep trying to find a way around Section 280E. And the Tax Court will continue to slap such schemes down. It will take Congress to pass a law legalizing marijuana on the federal level before marijuana dispensaries can ignore Section 280E.

Alternative Health Care Advocates, et. al., v Commissioner, 151 T.C. No. 13
Patients Mutual Assistance Collective Corporation v Commissioner, T.C. Memo. 2018-208


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