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Dan’s newsletter Pilla Talks Taxes is published ten times per year with articles designed to help you stay current on new laws, strategies and defenses. Dan will show you how to protect and defend your clients' rights, new ways to cut taxes and how to avoid problems with the IRS. If it is important for you to know, you will find it in this newsletter! You'll be among the first to know what's going to happen, even before it happens, making you invaluable to your clients.

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Featured Article

Legal May Not Mean “Legal”
by Scott B. MacPherson


At last check, medical marijuana is legal in 33 States, the District of Columbia, and the territories of Guam, Puerto Rico, the Northern Mariana Islands, and the U.S. Virgin Islands. Twelve jurisdictions now allow recreational use of marijuana. However, marijuana still remains illegal under federal law. Until November 2018 it was an open question whether or not a business that is legal under state law, but illegal under federal law, could claim business deductions under federal tax laws for the purpose of computing its federal income tax. On November 29, 2018, the Tax Court handed down the first opinion on that question, in Patients Mutual Assistance Collective Corp. v. Commissioner, 151 T.C. No. 11 (2018). The court held that an illegal business cannot claim expense deductions under §162. 

The Legal Backdrop of the Case 

Harborside Heath Center (Harborside”) was a marijuana dispensary in Oakland, California, structured as non-profit corporation. “[The founder’s] goal was to create a place where marijuana could be distributed responsibly, that was focused on patient care, and that provided benefits to both patients and the community.” Id. at *2. 

This was (and still is) legal in California when the business started in 2005, because in 1996 California voters passed the “Compassionate Use Act” decriminalizing the use of medical marijuana. (Cal. Health & Safety Code §§11362.5.) That Act provides an exemption from state laws that would otherwise penalize 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 is recommended or approved by a physician.[1]

In other words, the possession, use, and distribution of medical marijuana was (and is) legal under California law, and more to the point the exact business of Harborside was (and is) legal under California law. Naturally, Harborside thought all was well and good with the IRS—until it received audit notices for years 2007-2012. Ultimately it received Notices of Deficiency. 

The problem was that under 12 U.S.C. §812, marijuana was (and still is) categorized as a Schedule I controlled substance,” meaning that it has no currently accepted medical use in treatment.” As a consequence, 12 U.S.C. §841(a) criminalizes the manufacture, distribution, dispensation, or possession of marijuana. As a consequence of that, the IRS took the position that Harborside cannot claim any business expenses under §162. The Notices of Deficiency disallowed all such deductions, and to add insult to injury, the Commissioner asserted accuracy-related penalties. 

Section 280e Does Not Apply to Dispensaries

 It Does Not Matter That the DEA Will Not Prosecute 

         Before dealing with the IRS, Harborside dealt with the Department of Justice. The U.S. government filed a civil forfeiture action against the business property on the theory that the property was subject to forfeiture because the business operated in violation of 21 U.S.C. §§841(a) and 856 (drug trafficking). 

That action was dismissed with prejudice by stipulation of the parties in 2016.[2] Harborside’s first argument to the Tax Court was res judicata—that the stipulated dismissal meant that the U.S. Government agreed it was not a distributer of controlled substances under federal law. In strained logic, the Tax Court held that the civil forfeiture action for “distributing or dispensing controlled substances” and the proposed denial of business deductions for “trafficking in controlled substances” did not arise from the same transactional nucleus of fact. Id. at *7. 

A Marijuana Dispensary Cannot Deduct Its “Ordinary and Necessary Expenses” 

         Harborside next argued that tax code §162(a) 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.” The IRS did not deny that Harborside’s claimed expenses were ordinary and necessary. Rather, at trial it argued that tax code §280E makes an exception to that rule: 

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 (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. [Emphasis added.] 

The issue before the Tax Court was those two words “consists of” in §280E. Harborside did more than just grow and sell marijuana. It also sold retail items (eg., shirts, hats, socks, books, lighters) and it offered several forms of therapy (e.g., addiction counseling, hypnotherapy, naturopathy, yoga, tai chi). Coming from that context, Harborside argued that consists of” means an exhaustive list; that is, §280E applies only to businesses that exclusively traffic in controlled substances, and not to those that also engage in other (legal) activities. The IRS argued that §280E applies to a given business if any of its activities is trafficking in a controlled substance. 

The Tax Court spent an inordinate amount of time explaining that §280E is ambiguous, before holding that the IRS was correct: a marijuana dispensary traffics in a controlled substance, and §280E applies to any and every trade or business that traffics in a controlled substance, period. Thus, it prevents Harborside, and by extension all marijuana dispensaries, from deducting business expenses under §162. Patients Mutual at *12. 

But What About the Retail and Therapeutic Side of the Business? 

        Harborside then argued that §280E should not apply to the non-marijuana side of its business. It argued that a single taxpayer can have more than one trade or business, and as noted above, Harborside sold products and services that are not illegal under federal (or state) law. The Tax Court agreed that a taxpayer can have more than one trade or business, and it agreed that §280E would not limit a non-trafficking trade or business, but it added that: 

Whether two activities are two trades or businesses or only one is a question of fact. See, e.g., CHAMP, 128 T.C. at 183; Owens v. Commissioner, T.C. Memo. 2017-157, at *21. To answer it, we primarily consider 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 undertakings. Patients Mutual at *12 (internal quotation omitted). 

The court then put much weight on the fact that at Harborside, marijuana products covered 75% of the physical sales floor; that its employees spent at least 80% of their time with those marijuana products; and that marijuana-related sales generated at least 98.7% of the company’s revenue. “This leads us to find that the sale of non-marijuana-containing products had a close and inseparable organizational and economic relationship with, and was incident to, Harborside’s primary business of selling marijuana.” Id. at *14 (internal quotation omitted). 

And the court added, 

We also find that the sale of items that are about marijuana, are branded with Harborside’s logo, or enable use of marijuana is not “substantially different” from the sale of marijuana itself. Id. 

In other words, despite all the retail sales of shirts and hats, and despite all the counseling and yoga classes, Harborside really had only a single trade or business—the sale of marijuana. “That’s trafficking in a controlled substance under federal law, so Harborside cannot deduct any of its related expenses.” Patients Mutual at *15.

 COGS Are Severely Limited 

But the arguments were not over. “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 (COGS).” Patients Mutual at *16. 

Thus, the court turned its eye to cost of goods sold. “COGS is the costs of acquiring inventory, through either purchase or production.” Patients Mutual at *16. Said another way, COGS is expenditures necessary to acquire, construct or extract a physical product which is to be sold.” Id. (internal quotation omitted). 

As compared to §162 deductions, the difference is timing: 

Taxpayers can usually claim at least part of a deductible expense for the year they incur it. [Citation omitted.] But when accounting for COGS they have to capitalize an item’s cost in the year of acquisition or production and either amortize it or wait until the year the item’s sold to make the corresponding adjustment to gross income. Id. at 16. 

In other words, whereas §162 deductions are taken in the year in which the expense occurs, COGS are deferred until the product is sold, which could occur in a future year. So, “[b]y renaming COGS what had been deductions, Congress made it possible for [drug] traffickers to adjust for expenses that they couldn’t previously claim. They have to make those adjustments in the later year when the inventory is sold, but later is better than never.” Id. at *17. 

Except that the Tax Court held that the COGS deduction will mostly never be taken. In 1988 Congress amended §263A(a)(2), adding flush language that says: 

Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.” TAMRA §1008(b)(1).

The regulations show that cost” here means expenses that would otherwise be deductible. See §1.263A-1(c) (2), Income Tax Regs. So if something wasn’t deductible before Congress enacted §263A, taxpayers cannot use that section to capitalize it. Section 263A makes taxpayers defer the benefit of what used to be deductions—it doesn’t shower that as grace on those previously damned. Id. at *17 (emphasis added). 

Meaning: because a marijuana dispensary cannot get the §162 expense deductions, it cannot deduct all of its costs of production, either. 

What a Dispensary Can Always Deduct 

Harborside of course objected. It argued that not letting marijuana dispensaries use §263A forces them to pay tax on more than their gross income, and that is a 16th Amendment violation. The court disagreed, saying that the Constitution limits Congress to taxing only gross income, but gross income is gross receipts minus direct costs. “Harborside, like all taxpayers, can still adjust for its direct costs--or, to use its terminology, ‘the actual cost used to purchase inventory.’ It therefore pays tax only on the amount it realizes on sales, which is what the Constitution requires.”  Id. at *18. 

Specifically, Harborside (and by extension, any marijuana dispensary) must follow tax code §471. “The Code tells taxpayers what to include in COGS. See, e.g., secs. 263, 263A, 471.” Patients Mutual at *17.  

In short, all taxpayers can deductthe actual cost used to purchase inventory,” whether or not the nature of the business is legal under federal law. “Harborside would get COGS adjustments for its direct inventory costs no matter what—even if it was trafficking cocaine or any other controlled substance not legal under California law. The only things Harborside doesn’t get are indirect inventory costs granted as deductions and then deferred under section 263A.” Id. at *18. Continuing: 

The section 263A capitalization rules don’t apply to drug traffickers. Unlike most businesses, drug traffickers can’t capitalize indirect expenses beyond what’s listed in the section 471 regulations. Section 263A expressly prohibits capitalizing expenses that wouldn’t otherwise be deductible, and drug traffickers don’t get deductions. Because federal law labels Harborside a drug trafficker, it must calculate its COGS according to §471. Id. at *18. 

The next question was whether Harborside was just a retailer, or also a grower. This distinction directly feeds into the COGS calculations under §471. The IRS argued the former, and the court agreed. The holding turned on the meaning of “produce” in §471. “Production” means “manufacturing,” the IRS said, and manufacturing requires a change to the essential character of the merchandise. Id. at *19. 

Harborside argued that recent case law expanded that definition to include growing plants, and put the focus on ownership. The court actually agreed with Harborside as a statement of law that “[f]or purposes of section 471, production turns on ownership—ownership as determined by facts and circumstances, not formal title.” Id. at *19. 

However, on the facts of the case before it, the court held that Harborside was not the owner or producer of the marijuana buds it sold. “Harborside is therefore a reseller for purposes of §471 and must adjust for its COGS according to section 1.471-3(b), Income Tax Regs.” Id. at *21. Consequently, Harborside can include only its inventory price and transportation costs in the COGS calculations, whereas if it was the owner or producer, it would get the advantage of the expanded set of COGS expenses under Reg. 1.471-3(c). Id. at *19. 


Although it is possible that the next Tax Court judge to face this issue will rule opposite this opinion, that is not likely. The Tax Court is notoriously illogical and notoriously goes out of its way to favor the IRS. So, we instead need to focus on helping our dispensary clients increase the only deduction that this court allowed. 

That can be accomplished in two ways, the first being diversification. The court put much weight on the imbalance between marijuana products and non-marijuana products sold by Harborside, e.g., 75% of the retail space and 80% of the employees’ time was spent on marijuana sales. The more balance a company can introduce into its sales, the more likely a court is to say that there is in fact more than one trade or business operating. Section 280E would not limit the non-marijuana side of the operation. Id. at *12. 

The second way our clients can increase their deductions is by putting extra attention on the costs of acquiring inventory. Per the Patients Mutual holding, “any expenditure necessary to acquire, construct or extract a physical product which is to be sold” is deductible against gross receipts. “All taxpayers—even drug traffickers—pay tax only on gross income, which is gross receipts minus the cost of goods sold (COGS).” 

The operative word there, obviously, is the word “any.” And notably, the court actually pointed out that there are more costs to deduct when a dispensary owns the marijuana “clones” from which it grows the “bulbs” that it sells. If Harborside, 1) grew its own clones rather than buying them wholesale to sell at retail, or 2) maintained tight ownership control over the clones it used, or 3) ordered specific quantities of marijuana buds from its sources, or 4) prevented its sources from selling buds to third parties, or 5) took possession of all of the buds it was offered, the court might have held that it owned or produced the marijuana plants behind its marijuana sales. Patients Mutual at *20-21. 

That would have entitled Harborside to use the indirect inventory costs of Reg. §1.471-3(c) when calculating COGS. Id. at *19. Indirect costs include the cost of raw materials, expenditures for direct labor, and indirect production costs incident to and necessary for the production of the particular article including an appropriate portion of management expenses. Id. at 17. (See Reg. §1.471-11(b).) 

Obviously these added expenses would act to reduce gross income, which means a substantial reduction in tax owed.

[1]  In 2016, after the years at issue, California legalized recreational growing and use of marijuana. And in the interest of clarity, the following year California expressly legalized cooperative cultivation of marijuana for medicinal purposes. (Cal. Health & Safety Code § 11362.775.)

 * Scott MacPherson is a tax attorney licensed in Arizona and California. He is the son of Mac MacPherson and as such, is a second-generation Tax Freedom Institute member. Scott can be reached at 310-773-2042, or by email at This email address is being protected from spambots. You need JavaScript enabled to view it..

[1]  In 2016, after the years at issue, California legalized recreational growing and use of marijuana. And in the interest of clarity, the following year California expressly legalized cooperative cultivation of marijuana for medicinal purposes. (Cal. Health & Safety Code § 11362.775.)

[2] The following year, Congress passed a spending rider that prevents the Department from using any funds to prosecute individuals who comply with state medical-marijuana laws. Id. at *5. 

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Article taken from June 2019ssue of "Pilla Talks Taxes."


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