Interesting New Tax Court Decision on Section 280E
[Updated 1/24/19 to elaborate a bit on my two observations]
Happy (belated) new year!
Back in late November 2018, the United States Tax Court issued a noteworthy decision in a tax proceeding against Harborside Health Center, one of the nation’s largest (if not THE) largest state licensed marijuana suppliers. The full decision in Patients Mutual Assistance Collective Corporation, dba Harborside Health Center v. I.R.S. can be found here. It’s long (62 pages) but well written (and with a dose of humor).
The case is primarily about marijuana suppliers’ tax liability under Section 280E of the Internal Revenue Code (26 U.S.C. §280E). In relevant part, Section 280E provides that,
No deduction or credit shall be allowed for any amount paid or incurred during that taxable year in carrying on any trade or business if such trade or business . . . consists of trafficking in controlled substances . . . which is prohibited by Federal law . . .
I discuss Section 280E in the book (see pages 397-400) and in a previous post, The Corporate Tax Cut Might Have Done More For Marijuana Suppliers than Repealing Section 280E Would Have.
In this post, I’ll discuss two of the Patients Mutual Court’s more noteworthy rulings and make two broader observations about Section 280E.
Let me begin with some background. The case at hand stemmed from an IRS audit of Harborside’s federal tax returns for 2007-2012. Although Harborside paid federal taxes for those years, the IRS claimed the company’s tax payments were deficient (by tens of millions of dollars), for two main reasons. First, the IRS found that Section 280E applied to Harborside, and thus, Harborside had improperly deducted millions in business expenses while calculating its tax liability. Second, the IRS found that Harborside had used the wrong section of the tax code to calculate its Cost of Goods Sold (COGS) and thus, lower its federal tax liability.
The court sided with the IRS on each of these issues.
First, the court rejected Harborside’s claim that Section 280E doesn’t apply to the marijuana dispensary. Harborside acknowledged that it sold marijuana (and lots of it – between 2007-2012, it sold more than $100 million worth). But the company noted that it also engaged in other activities, like selling goods without marijuana (e.g., t-shirts) and offering free therapeutic services to patients (e.g., yoga classes). According to Harborside, performing these other activities brought the company outside the reach of Section 280E. As the court recounts,
Harborside argues that ‘consists of’ [in the language of Section 280E] means an exhaustive list—or in other word that section 280E applies only to businesses that exclusively or solely traffic in controlled substances and not to those that also engage in other activities.
Patients Mutual, p. 25.
Not for the first time, the court rejected this narrow interpretation of Section 280E. But the Patients Mutual decision is noteworthy because it provides the court’s fullest explanation to date for why it refuses to read the tax provision so narrowly.
The main reason is that the court thought Harborside’s interpretation would render Section 280E ineffective and / or lead to absurd results. The court acknowledged that “Dictionaries, the [Tax] Code, and caselaw all show that ‘consists of’ can introduce either an exhaustive list or a nonexhaustive list” of the activities of the taxpayer. Id. at p. 34. However, the court favored the latter interpretation because it “is the only option that doesn’t render section 280E ineffective and absurd.” Id. at pp. 34-35. In particular, the court reasoned that
If [280E] denies deductions only to businesses that exclusively traffic in controlled substances, then any street-level drug dealer could circumvent it by selling a single item that wasn’t a controlled substance–like a pack of gum, or even drug paraphernalia such as a hypodermic needle or a glass pipe. This reading would edge us close to absurdity. . .
Id. at p. 27.
Although the court held that section 280E prevents a marijuana business (like Harborside) “from deducting its business expenses,” id. at 37, the ruling is not quite so onerous as first seems. Namely, the court acknowledged that a marijuana business “can still deduct expenses for any separate, nontrafficking trades or businesses.” Id.
In Harborside’s case, however, this concession was of little import. The court found that Harborside’s other activities (e.g., selling goods without marijuana and providing free therapeutic services) were not sufficiently distinct from its “primary purpose”, that of “selling marijuana and products containing marijuana.” Id. at p. 41. For example, the court noted that Harborside’s sales of marijuana and products containing marijuana generated roughly 99% of the firm’s revenues. By contrast,
Harborside’s sale of items that didn’t contain marijuana–such as branded clothing, hemp bags, books about marijuana, and marijuana paraphernalia such as rolling papers, pipes, and lighters–generated the remaining 0.5% of its revenue. The same Harborside employees who bought, processed, and sold marijuana also sold these items, but selling them took up only 5-10% of their time. The nonmarijuana items occupied only 25% of the sales floor where Harborside sold marijuana, and that sales floor was accessible only to patrons who had already presented their credentials to security–which means that no one who couldn’t buy marijuana could buy these nonmarijuana items. And the record shows no separate entity, management, books, or capital for the nonmarijuana sales.
Id. at pp. 41-42.
Likewise, the court found that the free therapeutic services Harborside offered to patients were merely
incidental; Harborside’s security spent only 5% of its time checking in people for the services, while spending 60% of its time checking in people who were there to buy marijuana. And independent contractors, rather than Harborside’s own employees, provided those services. During the years at issue Harborside paid those contractors a total of only about $680,000–less than 1% of its sales revenue from marijuana.
Id. at pp. 44-45.
For these reasons, the court concluded that Harborside could not deduct expenses related to the sale of non-marijuana goods and the provision of those free therapeutic services.
Second, the court also rejected the method Harborside had used to calculate its COGS and thereby reduce its federal tax liability. Notwithstanding the fact that Section 280E bars drug businesses like Harborside from deducting their business expenses (e.g., sales expenditures), federal tax law does allow such businesses to subtract their COGS from gross revenue when calculating their federal income taxes. As the Patients Mutual Court explains,
The fact that Harborside can’t deduct any of its business expenses doesn’t mean it owes tax on its gross receipts. All taxpayers–even drug traffickers—pay tax only on gross income, which is gross receipts minus the cost of goods sold.
Id. at p. 48.
“COGS is the costs of acquiring inventory, through either purchase or production.” Id. at p. 49. But the Tax Code specifies two different ways to calculate COGS, one for producers and the other for resellers. The method for producers is (ostensibly) more generous. To simplify somewhat, it appears to allow producers to count some “indirect production costs,” including “an appropriate portion of management expenses” as COGS. Id. at p. 51 (quoting regulations). The method for resellers, by contrast, allows them to count only the “price they pay for inventory plus any ‘transportation or other necessary charges incurred in acquiring possession of the goods’”, id. at p. 51 (quoting regulations), which would appear to exclude all indirect expenses.
To take advantage of the more generous method of calculating COGS, Harborside claimed that it was a producer, at least for part of its business—namely for the marijuana bud it bought from growers then sold to patients. As the court explained,
Harborside was without question a reseller of the marijuana edibles and non-marijuana-containing products it bought from third parties and sold at its facility. But the situation is more complex for the marijuana bud it sold. Harborside insists it produced this marijuana and can include in its COGS the indirect inventory costs [allowed by regulations].
Id. at p. 57.
Whether Harborside was a producer or mere reseller of this bud turned on the definition of “production” employed by the Tax Code. The court rejected the definition favored by the IRS, one that defined production as “to change the essential character of . . . merchandise.” Id. at p. 57. (This is probably how most people would define “production.”) Instead, the court found that the Tax Code definition of production “turns on ownership [of the merchandise]–ownership as determined by facts and circumstances, not formal title.” Id. at p. 60. Thus, to be considered a producer of the bud it sold, Harborside had to show that it exercised control over the bud throughout the cultivation process.
Harborside claimed to have satisfied this burden:
It points out that it bought marijuana only from its members, and even then only if the members used Harborside’s clones (which they either bought or received for free), took Harborside’s growing class, followed Harborside’s best practices, and met Harborside’s quality-control standards.
Id. at p. 61.
However, the court found that Harborside had not exercised enough control over the bud to be considered the owner (and thus the producer) thereof. The court emphasized that
Harborside, . . . didn’t create the clones [growers used], maintain tight control over them, order specific quantities, prevent sales to third parties, or take possession of everything produced. Harborside bought clones from nurseries and either sold them to growers with no strings attached or gave clones to growers expecting that they’d sell bud back to Harborside. Nothing prevented either type of grower from selling to another collective. . . Harborside had complete discretion over whether to purchase what bud growers brought in, paid growers only if it purchased their bud, and at times rejected the ‘vast majority’ of its growers’ bud. And Harborside thought growers could do whatever they wanted with the rejected bud.
Id. at pp. 61-62. Thus, Harborside was a reseller—not a producer—for purposes of the Tax Code, and it could not include any indirect expenses in its COGS when calculating its federal tax liability.
The court’s decision on these two matters (among others) means that Harborside is facing a hefty tax bill. It might also face penalties, though the court has yet to make a decision on those.
Now let me make two brief observations about Section 280E
1. Marijuana suppliers probably can’t avoid Section 280E, but the states could do something to lessen the provision’s impact on those suppliers.
Harborside’s lawyers appear to have left no stone unturned in seeking to minimize their client’s exposure to Section 280E (even the 16th Amendment! see the opinion). This suggests it may be impossible for marijuana suppliers to avoid the added tax liability imposed by Section 280E. And since only Congress can revise Section 280E (e.g., the IRS lacks the authority to do so), marijuana suppliers will face this added tax burden until Congress adopts new legislation (either a reform to Section 280E or a proposal like the STATES ACT).
In the meantime, however, I think there may be a way for the states to blunt the impact of this provision: Allow state licensed marijuana suppliers to deduct the marginal cost of Section 280E from their state corporate taxes. In other words, if a Licensee owes the federal government an extra $100,000 because of Section 280E, the state could allow that Licensee to deduct $100,000 (or a portion thereof) from its taxable income for purposes of calculating its state corporate tax liability. (In similar fashion, Congress allows taxpayers to deduct certain state taxes when calculating their federal taxes.) This new deduction would presumably lessen the overall tax paid by the Licensee, with the exact amount depending on factors like the state corporate tax rate.
I’m not saying this is necessarily a good idea; among other things, it would cost the state the foregone tax revenue. But if a state is worried about the financial viability of the marijuana industry, this proposal might help.
2. Section 280E could influence the structure of the marijuana industry.
Prior to Patients Mutual, I had not been aware of the different treatment of producers and resellers under federal tax law. To be sure, the difference may not amount to much – i.e., the expenses producers may include as part of COGS may not be that much greater than the expenses resellers may include. But on the assumption that there is a meaningful difference in the federal tax liability of producers and that of resellers, let me suggest the following: Section 280E (or more precisely, the rules for calculating COGS) may encourage vertical integration in the marijuana industry. (The structure of the marijuana industry and state regulations thereof are discussed in the book on pages 507-517.)
The idea is that a vertically integrated firm may be able to count more indirect expenses as COGS than could two independently operated firms (a producer and a reseller). This means that the total federal tax liability of that integrated firm may be less than the total federal tax liability of the two independent firms combined.
To illustrate. Imagine one vertically integrated marijuana supplier with total sales of 100, direct expenses of 50, and indirect expenses of 40. Suppose this vertically integrated firm it is able to include all of those direct expenses and half of those indirect expenses as COGS, resulting in taxable income of 30 under federal law (100-50-20). Now imagine this company is split into two separate firms – a producer (P) and a reseller (R). Assume that P and R operate as efficiently as the integrated firm does (i.e., there are no economies of scale / scope). R has sales of 100 (the same as the vertically integrated firm), with direct expenses of 70 and indirect expenses of 20. P has sales of 70, with direct expenses of 50 and indirect expenses of 20. Combined, P and R have sales of 170, direct expenses of 120, and indirect expenses of 40. Both P and R are able to count their direct expenses as COGS; but suppose that only P may include any of its indirect expenses in COGS (again, let’s say one-half of those expenses). In this hypothetical, taxable income of the two firms combined (and after COGS) is 35, rather than 30 (for the single, integrated firm). The reason for this increase is that R, as a reseller, can no longer pawn off some of the indirect expenses of supplying marijuana as COGS.
The actual impact of these tax rules on industry structure will, of course, depend on a variety of factors (e.g., the amount of indirect expenses firms actually incur and what portion of those expenses producers — but not resellers — may include in COGS). But it’s some food for thought.
That’s it for now.