From Daily Tax Report®
December 6, 2018
By Robert Willens
A California marijuana dispensary is a reseller that can only deduct its cost of goods sold—what it paid for inventory plus any transportation or other necessary charges incurred in acquiring possession of the goods, the U.S. Tax Court ruled last week.
Under federal law, marijuana is a “Schedule I controlled substance.” This means that, under federal law, the manufacture, distribution, dispensation, or possession of marijuana is prohibited. Under California law, things are somewhat different. During the tax years at issue the California Compassionate Use Act (CCUA) provided an exemption from California laws penalizing the possession and cultivation of marijuana for patients and their primary caregivers when the possession or cultivation is for the patient’s “personal medical purposes” and was recommended or approved by a physician. California later legalized collective or cooperative cultivation of marijuana for medical purposes.
Harborside Health Center opened its doors in 2006 and grew into “a booming business,” the court said. Harborside sold a wide variety of products: clones, marijuana flowers, marijuana-containing products, and non-marijuana containing products. Harborside is a C corporation for federal tax purposes, but to comply with California’s nonprofit requirement, its bylaws prohibited it from paying dividends or selling equity, and required it to use any excess revenue “for the benefit of its patients or the community.” To this end, Harborside provided its patients with a wide variety of services at no additional cost.
The federal tax code allows a business to deduct all of its ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Not so for taxpayers engaged in the marijuana business. Tax code Section 280E states: “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 … consists of trafficking in controlled substances … which is prohibited by federal law” (emphasis added).
Medical marijuana is a controlled substance and dispensing it pursuant to the CCUA is “trafficking” within the meaning of Section 280E. Harborside focused on the words “consists of” in Section 280E. Harborside argued, not unreasonably, that “consists of” means an exhaustive list—that Section 280E, therefore, applies only to businesses that exclusively or solely traffic in controlled substances and not to those that also engage in other activities. The Internal Revenue Service argued that a single trade or business can have several activities and that Section 280E applies to an entire trade or business if any one of its activities is trafficking in a controlled substance.
Harborside, the court admitted, was correct about the common, ordinary meaning of “consists of.” However, the court noted, following the most common usage of “consists of” would make Section 280E ineffective. “If that section 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 was not a controlled substance,“ the court said.
The court next asked whether “consists of” could ever introduce a non-exhaustive list. None of the dictionary definitions Harborside provided preclude reading “consists of” as setting off a non-exhaustive list. Moreover, the court found, the tax code itself uses “consists of” in more than one way. It sometimes sets off an exhaustive list, but it also sometimes introduces a non-exclusive list. Dictionaries, the tax code, and case law, the court noted, all show that “consists of” can introduce either an exhaustive list or a non-exhaustive list. A non-exhaustive list is the only option that does not render Section 280E ineffective and absurd. Therefore, the court read Section 280E “to deny business expense deductions to any trade or business that involves trafficking in controlled substances, even if that trade or business engages in other activities (emphasis added).”
Harborside, correctly, stated that it can still deduct its expenses for any separate, non-trafficking trades or businesses in which it engages. Unfortunately, it has no other such trades or businesses. A single taxpayer, it goes without saying, can have more than one trade or business. In other cases, the taxpayer will engage in multiple activities that, nevertheless, constitute only a single trade or business. Harborside falls into the latter camp.
Harborside argued that it had four activities, each of which was a separate trade or business: (i) sales of marijuana and products containing marijuana; (ii) sales of products with no marijuana; (iii) therapeutic services; and (iv) brand development. However, the court found that the sale of non-marijuana-containing products (which generated only 0.5 percent of Harborside’s revenues) had a “close and inseparable organizational and economic relationship” with, and was (merely) “incident to” Harborside’s primary business of selling marijuana. The sale of items that are about marijuana, are branded with Harborside’s logo, or enable the use of marijuana is not “substantially different” from the sale of marijuana itself. Accordingly, Harborside’s sale of non-marijuana-containing items is not a separate trade or business.
Just as a bookstore that gives away coffee is still only a bookstore, a marijuana dispensary that gives away services is still only a marijuana dispensary. There were, the court noted, business reasons to offer these therapeutic services alongside marijuana sales: it justified premium pricing and helped Harborside meet the community-benefit standards California law required. Harborside’s “holistic” services were not a separate trade or business. In fact, the court found, Harborside had only a single trade or business—the sale of marijuana. That business is trafficking in a controlled substance under federal law, so Harborside cannot deduct any of its related expenses.
The fact that Harborside cannot deduct any of its business expenses (i.e., its “below-the-line” expenses) does not mean that it owes taxes 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 (COGS). But how to calculate COGS? The IRS thought Harborside needs to follow the rules under tax code Section 471, but Harborside insisted it is subject to the more inclusive rules of tax code Section 263A. The court agreed with the IRS.
Because federal law labels Harborside a drug trafficker, it must calculate its COGS according to tax code Section 471. Accepting this edict, Harborside insisted that it “produced” the marijuana and can therefore include in its COGS the indirect inventory costs that Treasury Regulation Section 1.471-3(c) describes. By contrast, the IRS said that Harborside is a “reseller” and, therefore, under Treas. Reg. Section 1.471-3(b), it can include in COGS only its inventory price and transportation costs.
Harborside, the court found, merely sold or gave its members clones that it had purchased from nurseries and bought back bud if and when it wanted. In between these two steps, it had no interest in marijuana plants. Harborside is therefore a reseller for purposes of Section 471 and, therefore, must adjust its COGS according to Treas. Reg. Section 1.471-3(b), i.e., it may use as COGS the price it paid for inventory plus any transportation or other necessary charges incurred in acquiring possession of the goods. See Suzy’s Zoo v. Commissioner. Not a dollar of overhead can find its way into COGS in the case of a reseller.
Producers, by contrast, capitalize the cost of not only raw materials, but also direct labor and even “indirect production costs incident and necessary for the production of the particular article, including an appropriate portion of management expenses,” according to regulations under tax code Section 471. Harborside, however, could not convince the court it was properly viewed as a producer and thus was denied the opportunity to deduct, in the guise of COGS, many of the expenses for which deductions were denied it under Section 280E. Thus, as seems to be typical in the marijuana industry, the IRS scored a decisive victory as regards Harborside’s tax situation. See Patients Mut. Assistance Collective Corp. v. Commissioner, 151 T.C. No. 11 (11/29/18).
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.