During the past several years, the marijuana industry has faced many regulatory challenges, but none greater than that imposed upon them by the impact of Internal Revenue Code Section 280E. This provision of the Internal Revenue Code is one of several "disallowance" provisions found in the same code section. In pertinent part, IRC Section 280E states:
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"no deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying out any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted."
The direct effect of the foregoing provision is that ordinary and necessary business expenses as defined in the Internal Revenue Code under IRC Section 162 and which are allowed for regular "non-trafficking businesses", are denied to marijuana producers. The deductions that readily come to mind are advertising, labor, rent payments, administrative costs, depreciation of equipment and amortization of intangible costs such as leasehold improvements, telephone, sales commissions, and a host of others. At the outset, it should be noted that recent legislation in the regulation of hemp and hemp products does not entirely preclude the assertion by the IRS of its primary weapon (the 280E Disallowance provision). Accordingly, while hemp producers await further regulations from the FDA to differentiate their treatment from THC-based marijuana businesses, the IRS continues to issue challenges to deductions for all marijuana growing and sales businesses.
The IRS has been actively challenging deductions of marijuana businesses using 280E throughout the US with great success, as a result of which marijuana businesses are exposed to paying much higher and in most cases, unanticipated income taxes, penalties, and interest than non-trafficking businesses. This situation has led many marijuana businesses to adopt innovative approaches to reporting expenses incurred in the ordinary course of business in this industry (overall, this process has become known as "living with 280E.")
One of the primary exceptions that has been recognized by the Courts, and the US Tax Court, in particular, is that marijuana producers are allowed to deduct the Cost of Goods Sold (COGS), or direct expenses incurred in producing the prohibited substances, both flower and manufactured goods. This has led to various attempts to categorize or allocate expenses to COGS, as opposed to the disallowed categories of "general and administrative expenses" to preserve the deductions. It is also worthy of note that a reseller of marijuana is basically limited to the price paid for the products plus a reasonable transportation cost to bring the product to market.
Living with 280E has given rise to numerous and innovative attempts to avoid the effect of the statute by, for example, allocating direct costs to COGS for such expenses as rent of the "grow facility" portion of rent, utilities, and labor, since these direct costs are crucial to production of the end product. The innovative approaches have also resulted in attempts to structure marijuana businesses in order to permit capitalizing direct costs into inventory.
The Internal Revenue Service (hereinafter referred to as the IRS or the Service) has consistently prevailed in challenges to deductions claimed by marijuana businesses, most recently in November 29, 2018 in the case of Patients Mutual Assistance Collective Corporation DBA Harborside Center v. Commissioner of Internal Revenue, 151 TC 11 (2018)-"the
Harborside case". In Harborside, the Tax Court considered whether 280E applied to a single marijuana trade or business could have several activities, one of which (growing and selling marijuana) consisted of trafficking in illegal substances. The Court observed that the "other" services must be substantially different from and stood on their own separate and apart from selling marijuana, to be considered another business. The Tax Court identified several factors in determining whether 280E would apply to these "other activities":
- Whether the additional services provided by the entity were merely complementary to the sale of marijuana;
- Whether the other services were separately charged for or whether the price was only charged for marijuana;
- Whether a set price existed based solely on the amount and type of marijuana sold;
- Whether the cost of the "other services" was merely bundled into the price;
- Whether the same employees who provided the "other services" were the same ones who also sold marijuana;
- Whether there were any additional wages, rent or other significant costs connected exclusively with the "other services";
- Whether there was a single book-keeper and tax preparer, and whether a single set of books was maintained or if there were separate books and records kept for the "other activities"; and
- Whether the "other services" were merely incident to the sale of marijuana and the various activities had a close and inseparable organizational and economic relationship.
The Court reviewed all of the facts and circumstances and found that 280E applied to Harborside as a single business, even though the production, manufacture and sale of cannabis (trafficking) was only one of several activities or services offered at Harborside. Of note, however, the Tax Court found that Harborside "acted with reasonable cause and in good faith" when taking tax positions against 280E for the tax years in question, and was, therefore, declared not liable for the accuracy-related penalties (which were quite substantial).
The Tax Court also sallied into the various methods of computing COGS and made further pronouncements concerning what may be allowable in accounting for Cost of Goods Sold, including that when accounting for COGS, the taxpayer has to capitalize an item cost in year of acquisition or production and then either amortize it or wait until the year the items are sold to make the corresponding adjustment to gross income. Overall, another win for the Service, but some significant tax planning opportunities and lessons emerge from a reading of this case. For example: maintaining good (and separate) books and records for various entities which may be related, and using different book-keepers or tax preparers to report the activities, may give rise to a different result than that which obtained in Harborside. Similarly, documenting the reasons for allocations of expense to COGS, even within the "trafficking entity" will certainly provide evidence of reasonableness and good faith which may abate accuracy related penalties, even if the IRS prevails on disallowance of an allocated COGS expense. Furthermore, there is no doubt that attention to legal structure of related (but not integrated) marijuana businesses deserves close attention from legal advisors to the industry. For example, since depreciation deductions for grow equipment may be subject to disallowance, query whether a separately capitalized non-trafficking entity might be established which would be able to rent the acquired equipment to a grow business, thereby allowing direct lease cost deductions for the grow equipment leases but not, of course the admin equipment such as comptuers, office equipment and the like; (the non-trafficking equipment company would have lease income in the entire amount, and have depreciation deductions to shelter the lease income.
There has been much speculation about the future of IRS enforcement of IRC Section 280E. Most observers conclude, however, that until Congress changes the classification of marijuana as a Class I substance under the Controlled Substances Act, the marijuana industry will continue to face challenges to its method of computing taxable income under this Code Section.