In the most recent in a now developing line of Tax Court cases involving the application of Section 280E of the Internal Revenue Code, a hard blow struck the ever-expanding cannabis industry. In Patients Mutual Assistance Collective Corp. (dba Harborside Health Center) (“Harborside”), v. Commissioner, 151 T.C. No. 11 (November 29, 2018), the Tax Court rejected a variety of arguments in support of ordinary and necessary business deductions and costs of goods sold taken by a taxpayer running a California medical-marijuana dispensary.
A little bit of background is in order. Under Section 280E, no “deduction or credit shall be allowed for any amount paid or incurred during the tax year in carrying on any trade or business if such trade or business (or activities which comprise such trade or business) consists of trafficking in controlled substances.” The controlled substances are those within the meaning of Schedule I and Schedule II under Federal law, which include marijuana. Increasingly, many of our state legislatures have enacted laws legalizing the cultivation and sale of marijuana both for medical and recreational purposes.
In the first major medical-marijuana Federal Tax Court case, California Helping to Alleviate Medical Problems, Inc.(“CHAMP”) v. Commissioner, 128 T.C. 173 (2007), the Tax Court, found that CHAMP operated two separate trades or businesses. One, which provided caregiving services and the other sold marijuana. The Tax Court held that because the caregiving services were CHAMP’s primary business and were substantially different from the selling of medical marijuana, the two activities constituted separate trades or businesses. The Tax Court therefore required the taxpayer to allocate its expenses between its two businesses according to the number of employees and to the portion of its facilities dedicated to each business. The Tax Court allowed CHAMP to deduct expenses properly allocated to the caregiving services and denied the deduction of expenses allocated to the sale of marijuana.
In the next major medical-marijuana case, the Tax Court in Olive v. Commissioner, 139 T.C. 19 (2012), held that a medical-marijuana dispensary that earned all of its revenue from the sale of marijuana but also provided free activities and services to its patrons constituted a single trade or business and denied the taxpayer’s expense deductions under Section 280E. In so holding, the Tax Court found that Olive (which by stipulation was in the business of distributing medical-marijuana) “was engaged in one trade or business because its non-marijuana items such as books and socks was an activity incident to its business of distributing medical marijuana.”
In the Harborside case, the taxpayer had four activities, each of which it maintained constituted a separate trade or business.
- The sale of marijuana and marijuana related products, which included edibles, beverages, extracts, etc.
- The sale of non-marijuana products. These included branded clothing, hemp bags, books and other marijuana items, such as rolling papers, pipes, etc.
- Therapeutic services. These included free holistic services including hypnotherapy, acupuncture, group sessions for yoga, etc.
- Brand development. The taxpayer maintained that its branding activities, which operated at a loss, were part of a “unified business enterprises” with its other profit making activities.
The Tax Court held, among other things, that Section 280E prevented Harborside from deducting ordinary necessary business expenses. The taxpayer argued that the words “consist of” in the statute meant that Section 280E applied only to businesses that exclusively and solely traffic in controlled substances and not to those that also engage in other activities. In rejecting the taxpayer’s argument, the Tax Court interpreted Section 280E to read that it denies the deduction of ordinary and necessary business deductions to any trade or business that involves trafficking in controlled substances, even if that trade or business is also engaged in other activities.
The Tax Court also determined that for the years at issue Harborside was engaged in only one trade or business, which was the trafficking in of a controlled substance. The Tax Court found that the marijuana sales accounted for over 99.5% of the taxpayer’s business. Harborside’s other activities were neither economically separate nor substantially different from the sale of marijuana. More specifically, the Tax Court found that “the sale of non-marijuana products had a ‘close and inseparable organizational and economic relationship’ with and was ‘incident to’ [the taxpayer’s] primary business of selling marijuana.” With respect to Harborside’s branding development activities, the Tax Court noted that there was no evidence that these activities were in any way a separate trade or business. Harborside’s branding activities used the same entity, management, capital structure, employees and facilities as the business of selling marijuana.
The Tax Court’s decision in the Harborside case, makes it abundantly clear that taxpayer’s in the medical or recreational marijuana business need to carefully consider how they structure their business operations in order to place themselves in the best position to deduct ordinary and necessary business expenses allocable to their non-marijuana business activities. In this regard, it is important to keep in mind the principles and analysis laid out by the Tax Court in the Harborside case for maintaining activities as separate trades or businesses:
- An activity is a trade or business if the taxpayer engages in the activity in a continuous and regular manner with the intent of making a profit.
- A single taxpayer can have more than one trade or business, or multiple activities that nevertheless constitute one single business.
- Even separate entities can constitute a single trade or business if they are part of a “unified business enterprise” with a single profit motive.
- Whether two activities constitute two separate trades or businesses is a question of fact.
- To address each of the foregoing points, the consideration will be given to the “degree of organizational and economic interrelationship of various undertakings, the business purpose which is (or might be) served by carrying on the various undertakings separately or together, and the similarity of the various undertakings.”
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The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your Wiss advisor.
For further information contact Michael Bodrato, CPA or Arnold Macalintal, CPA at Wiss & Company LLP.