IRS court ruling

U.S. Tax Court Deals Another Blow To The Cannabis Industry

The Federal Controlled Substances Act (“CSA”) 21 U.S.C. § 812 classifies marijuana as a Schedule 1 substance with a high potential for abuse, no currently accepted medical use in treatment, and lack of accepted safety for use under medical supervision.

Generally, businesses can deduct ordinary and necessary business expenses under I.R.C. §162. This includes wages, rent, supplies, etc. However, in 1982 Congress added I.R.C. §280E. Under §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law.

Under IRC §280E, businesses that are engaged in trafficking controlled substances cannot take regular business deductions, so they end up paying taxes on their gross receipts less their allowed cost of goods sold (COGS). If an expense doesn’t fit into the category of COGS, a company that is considered to be “trafficking” would have to pay taxes as if the expense hadn’t been incurred in the first place. This is why cannabis businesses can end up paying a lot more in taxes than non-cannabis businesses.

One strategy that has been used for cannabis business is to set up operations using multiple companies with one of those companies being a “management company”. Most of the value of having a management company comes from the ability of the management company to get banking and enter into regular electronic transactions with third parties. Also, it was an untested way to avoid the harsh realities of IRC §280E – at least until now…

Alternative Health Care Advocates, et al v. Commissioner Of Internal Revenue

In the case of Alternative Health Care Advocates, et al v. Commissioner Of Internal Revenue, 151 T.C. 13 (Click here for the opinion), Alternative Health Care Advocates, Inc. (“Alternative Health”) operates a medical marijuana dispensary in West Hollywood, California. Related to this corporation is another company, Wellness Management Group, Inc. (“Wellness Management”), which provided management services to Alternative Health. These services included hiring employees and managing HR for those employees, paying wages for those employees, paying advertising expenses, paying rent, etc. Wellness Management did not provide services of that nature or any nature to any other business entity. Wellness Management made money by collecting fees for its services from Alternative Health.

Wellness Management recognized as income the management fees it charged to Alternative Health and Wellness Management deducted its expenses incurred in generating the management fees on the basis that Wellness Management was not engaged in the sale and purchase of marijuana but that it is a management services company that can engage in a separate line of business from the entity it manages.

While Tax Court recognized that Wellness Management and Alternative Health were legally separate entities, it was clear to the Court that Wellness Management’s employees were engaged in the purchase and sale of marijuana (albeit on behalf of Alternative Health); that was Wellness Management’s primary business. The Court did not read the term “trafficking” to require Wellness Management to have had title to the marijuana its employees were purchasing and selling going on further to state that neither IRC §280E nor the nontax statute on trafficking limits application to sales on one’s own behalf rather than on behalf of another. Therefore, the Court concluded that the management service company, Wellness Management, was engaged in the business of “trafficking in controlled substances” during the taxable years at issue and since Wellness Health was unable to identify any portion of its activities being non-related to marijuana activities, none of its expenses would be deductible.

Risk Of Getting A Big Tax Bill From IRS That You Cannot Pay

As long as marijuana remains a Schedule 1 controlled substance under Federal law, dispensaries and other businesses trafficking in marijuana have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses. A cannabis business that has not properly reported its income and expenses and not engaged in the planning to minimize income taxes can face a large liability proposed by IRS reflected on a Notice Of Deficiency or tax bill.

This risk should be risk posing the greatest challenge to any cannabis business as the Federal taxation of cannabis businesses is consistent in all states and not dependent on whether local Federal prosecutors are aggressive in enforcing the illegality of cannabis or the banks unwilling to do business with the cannabis industry. This unexpected liability can put you out of business so it is important to secure qualified tax counsel to be proactive with tax planning to minimize taxes and to defend you in any tax examinations, appeals or litigation with the IRS.


What Should You Do?

While more States are legalizing cannabis, risks to the cannabis industry still exist. Considering this risks of cannabis you need to protect yourself and your investment. Level the playing field and gain the upper hand by engaging the cannabis tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), San Diego County (Carlsbad) and other California locations. We can come up with solutions and strategies to these risks and protect you and your business to maximize your net profits.

IRS tax deductible cannabis business expense court win

Harborside Finally Gets A Win In U.S. Tax Court Getting Tax Penalties Abated

Having been beaten in an opinion issued by the U.S. Tax Court just weeks before where the Court ruled that IRC Section 280E does apply to Harborside (Click here for the Court’s opinion: Patients Mutual Assistance Collective Corp., dba Harborside Health Center v. Commissioner of Internal Revenue, 151 T.C. 11) which Harborside can appeal to the U.S. 9th Circuit Court of Appeals, it was a relief that this same Court ruled that the California dispensary is not liable for accuracy-related 280E penalties. Those penalties would have tacked on another 20% to the tax bill IRS is prepared to send to Harborside if the taxpayer does not appeal the previous decision.

The Anti-Federal U.S. Climate

The Federal Controlled Substances Act (“CSA”) 21 U.S.C. § 812 classifies marijuana as a Schedule 1 substance with a high potential for abuse, no currently accepted medical use in treatment, and lack of accepted safety for use under medical supervision. Although you can still face federal criminal charges for using, growing, or selling weed in a manner that is completely lawful under California law and other states that have legalized cannabis, the federal authorities in the past have pulled back from targeting individuals and businesses engaged in medical marijuana activities. This pull back though has no impact on the IRS which will likely start in 2019 to more aggressively target cannabis businesses with audits.

First Harborside Tax Court Opinion – IRS Code 280E will remain in effect for cannabis businesses

The Harborside case involved a dispute over the deductibility of business expenses taken by Harborside Health Center, recognized as the largest marijuana dispensary in the United States by revenue, and the IRS, which was enforcing the provisions of IRC Section 280E. Congress enacted this section back in the 1980’s so that taxpayers engaged in trafficking in a Schedule I or II controlled substances could not deduct any expenses other than Cost Of Goods Sold.

The Harborside dispensary introduced a novel argument about the inapplicability of IRC Section 280E to its activities and focused on two words in this code section – “consists of” – in making the case that this section of law does not apply to them. The Harborside dispensary highlighted the definition of “consists of” as it is used in IRC Section 280E when describing that business expense deductions are not allowed to taxpayers whose business “consists of” trafficking in a Schedule I or II controlled substance.  The Harborside dispensary pointed out, not without merit, that the phrase “consists of” generally introduces an exhaustive list. What this means is that when something is said to “consist of” a list of items, that list of items is the exclusive, exhaustive list, and no other unmentioned items can be said to be included in that list, since the enumerated list contains everything.

The Tax Court spent a considerable amount of time evaluating this argument and acknowledging that it had some merit based upon a review of the dictionary and other legal sources. However, what doomed the Harborside dispensary was the IRS argument, backed by case law, that a legal statute should not be read in such a constrained way so as to render it completely ineffective and toothless. The Tax Court, in ruling for the IRS on this issue, pointed out that if the Harborside dispensary’s reading of IRC Section 280E were correct, a drug dealer who also sold a single pack of gum could not have this same code section applied to him, as that drug dealer’s business would not consist solely of trafficking in a Schedule I or II controlled substance.

But since the Court did not establish a clear test as to when activities other than the sale of cannabis should be taxed differently that activities involving cannabis, there is still hope for cannabis businesses who invest in proper planning now can have the highest chance of prevailing should their tax returns be selected for audit.

Second Harborside Tax Court Opinion – Abatement Of Penalties

With the Tax Court’s previous ruling that IRC Section 280E denies all standard business deductions to businesses whose operations “consist” of activities that violate the CSA, we now turn to the Tax Court’s second opinion on whether Harborside should be subject to accuracy-related penalties.

IRC Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on the portion of an underpayment attributable to any substantial understatement of income tax or negligence or disregard of rules or regulations. Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Code, and disregard includes any careless, reckless, or intentional disregard. Sec. 6662(c). An understatement of a corporation’s income tax is substantial if it exceeds the lesser of $10 million or “10 percent of the tax required to be shown on the return for the taxable year (or, if greater, $10,000).” Sec. 6662(d)(1)(B). A taxpayer can avoid these penalties by showing that it acted with reasonable cause and in good faith. Sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. To decide whether a taxpayer acted with reasonable cause and in good faith, the Court look at all relevant facts and circumstances, such as the “taxpayer’s effort to assess the taxpayer’s proper tax liability” and his “experience, knowledge, and education.” Sec. 1.6664-4(b)(1), Income Tax Regs.

According to the Opinion issued by the Tax Court (Click here for the opinion: T.C. Memo. 2018-208), Harborside acted “reasonably and in good faith” when taking its tax positions for the years at issue. The Tax Court cited Harborside’s timely filing of its tax returns and its maintenance of accurate financial records as a key strength, along with a persuasive argument from Harborside co-founder and Chairman Emeritus, Steve DeAngelo, that he made good-faith efforts to comply with the law, despite a lack of clear legal authority to guide medical marijuana dispensary taxpayers.

This second ruling is relief for Harborside and shows the importance that with proper planning, taxpayers involved in cannabis should fare better in minimizing liability to IRS.

Risk Of Getting A Big Tax Bill From IRS That You Cannot Pay

Generally, businesses can deduct ordinary and necessary business expenses under I.R.C. §162. This includes wages, rent, supplies, etc. However, in 1982 Congress added I.R.C. §280E. Under §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. Marijuana, including medical marijuana, is a controlled substance. What this means is that dispensaries and other businesses trafficking in marijuana have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses. A cannabis business that has not properly reported its income and expenses and not engaged in the planning to minimize income taxes can face a large liability proposed by IRS reflected on a Notice Of Deficiency or tax bill.

This risk should be risk posing the greatest challenge to any cannabis business as the Federal taxation of cannabis businesses is consistent in all states and not dependent on whether local Federal prosecutors are aggressive in enforcing the illegality of cannabis or the banks unwilling to do business with the cannabis industry. This unexpected liability can put you out of business so it is important to secure qualified tax counsel to be proactive with tax planning to minimize taxes and to defend you in any tax examinations, appeals or litigation with the IRS.


What Should You Do?

While more States are legalizing cannabis, risks to the cannabis industry still exist. Considering this risks of cannabis you need to protect yourself and your investment. Level the playing field and gain the upper hand by engaging the cannabis tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), the Inland Empire (including Ontario and Palm Springs) and other California locations. We can come up with solutions and strategies to these risks and protect you and your business to maximize your net profits.