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Cannabis and Taxes – The challenges of non-deductible expenses

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What is Section 280 E?

Section 280E of the Internal Revenue Code forbids businesses from deducting otherwise ordinary business expenses from gross income associated with the “trafficking” of Schedule I or II substances, as defined by the Controlled Substances Act.

Section 280E of the Internal Revenue Code forbids businesses from deducting otherwise ordinary business expenses from gross income associated with the “trafficking” of Schedule I or II substances, as defined by the Controlled Substances Act. The IRS has subsequently applied Section 280E to state-legal cannabis businesses, since cannabis is still a Schedule I substance.

Reagan Era Law

Created during the Reagan Administration, Section 280E originated from a 1981 court case in which a convicted cocaine trafficker asserted his right under federal tax law to deduct ordinary business expenses. In 1982, Congress created 280E to prevent other drug dealers from following suit. It states that no deductions should be allowed on any amount “in carrying on any trade or business if such trade or business consists of trafficking in controlled substances.”

With 23 states and the District of Columbia now allowing some form of legal marijuana, 280E is applied to state-regulated cannabis businesses more often than it is to the types of illegal drug dealers that the provision was intended to penalize.

What types of business expenses are under 280E?

  • Employee salaries
  • Payments to contractors
  • Utility costs
  • Internet
  • Health insurance premiums
  • Advertising costs
  • Repairs and maintenance
  • Rental fees
  • Security
  • and more

What deductions are challenged?

  • General and administrative costs (bookkeeping, legal expenses, technology costs)
  • State excise tax
  • Storage of cannabis
  • Product Purchases
  • Product Depreciation
  • Product Losses
  • Theft
  • and more

2015 IRS Memorandum

2018 US Tax Court

The Tax Court decision in Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner held that the medical marijuana dispensary could not deduct business expenses despite operating its business legally under California law.

The Tax Court denied Harborside’s deductions from 2007 to 2012, citing Code Section 280E, which prevents any trade or business that “consists of trafficking in controlled substances from deducting any business expenses.” Harborside has appealed the decision to the Ninth Circuit.

The Harborside case is not the first time that an entity specializing in the processing, sale or distribution of cannabis has challenged the constitutionality of Code Section 280E, but it is very likely the largest and the most closely watched case. And if the Ninth Circuit agrees with the appellant, it will ultimately be decided by the Supreme Court.

2019 Harborside Inc. Receives Final Ruling by US Tax Court on 280E

OAKLAND, CA and TORONTO, Oct. 21, 2019 /PRNewswire/ – Harborside Inc. (“Harborside” or the “Company”) (CSE: HBOR), today announced that the U.S. Tax Court has issued a final decision under Tax Court Rule 155 on the income tax deficiency for Patients Mutual Assistance Collective Corporation (“PMACC”), the Company’s 100% owned subsidiary and owner of the iconic Harborside Oakland cannabis dispensary. The U.S. Tax Court has ruled that PMACC owes an aggregate tax deficiency of approximately $11.0 million for the fiscal years 2007 through 2012. This amount is consistent with the Company’s one-time provision for its estimated tax obligation for PMACC expensed in its financial results for the three-month period ended June 30, 2019. All dollar amounts in this press release are expressed in U.S. dollars.

“The Tax Court’s final computation of our tax obligation in PMACC’s long-standing 280E case is a good outcome for Harborside shareholders. By challenging the IRS’s overly aggressive interpretation of the tax law as it applies to cannabis businesses operating legally under State law, we have succeeded in reducing Harborside’s liability from the $36 million originally sought by the IRS to approximately $11 million – a $25 million reduction. The reduction includes $6 million in penalties that the court previously ruled we did not need to pay because of the unclear state of the law, and because Harborside acted in good faith,” said Harborside CEO Andrew Berman. “This ruling is also an important one for the cannabis industry in that, through this litigation, the court recognized there are legitimate deductions that legal cannabis companies can take in cost of goods sold. Harborside still intends to appeal the Tax Court’s ruling with regard to aspects of the decision as it pertains to the calculation of cost of goods sold, and has already retained appellate tax counsel.”

Steve DeAngelo, Harborside’s co-founder and Chairman Emeritus, also commented, “Harborside’s policy towards the federal government has always been to exhaust all reasonable available legal options to pursue justice. That policy has been validated by the Tax Court’s downward adjustment of PMACC’s liability. This outcome has strengthened our already strong resolve to continue pursuing justice by appealing the decision, with the goal of modifying or reducing 280E liability for Harborside, and in the future, eliminating it for every other state legal cannabis business in the United States. The issues at stake are of importance to the entire cannabis industry.”

The Company has 90 days within which to file an appeal with the United States Court of Appeals for the Ninth Circuit.

Harborside Inc. Announces Filing Appeal in Tax Case

The Tax Court decision was issued on Nov. 29, 2018. The ruling became final on Oct. 11, 2019, when liability of US$11,013,237 was formally entered by the Tax Court. Harborside is properly filing its appeal within 90 days from that date. 

What impact does this have on the cannabis industry and states attempting to regulate marijuana?

Most cannabis business owners would like to be considered legitimate by paying federal and state taxes. But the current tax scenario has some convinced to ignore 280E on their tax filings, or don’t pay taxes at all. These businesses would rather gamble on the IRS overlooking their filing than see their revenues evaporate due to 280E.

Treasury Inspector General Recommends More Tax Audits for Cannabis

The Treasury Inspector General for Tax Administration (TIGTA) issued a report on March 30, 2020 which made recommendations to the Internal Revenue Service (IRS) regarding tax compliance and the cannabis industry.

The purpose of the report was to “evaluate the IRS’s examination and education approach to certain cash-based industries with an emphasis on legal marijuana operations,” as stated by the TIGTA.

https://www.treasury.gov/tigta/auditreports/2020reports/202030017fr.pdf

KOMORN LAW can help you with these types of issues – Call Our Office to Find Out More Information 248-357-2550

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