In November 2018, the US Tax Court issued its decision in Patients Mutual Assistance Collective Corporation, dba Harborside Health Center v. Commissioner (Harborside), a case involving the applicability of the provisions of IRC Section 280E to an entity engaged in both cannabis and non-cannabis business activities. This article addresses the significance of the Harborside decision and how it will likely impact the Legal Cannabis Industry in the near term.
IRC Section 280E
Congress enacted IRC Section 280E in 1982 to reverse the Tax Court decision in Jeffrey Edmonson v. Commissioner (1981), which permitted the seller of cocaine, amphetamines and cannabis to deduct most business expenses, cost of goods sold, packaging, home, phone and automobile expenses relating to the seller’s illegal business.
IRC Section 280E denies sellers of Schedule 1 or 2 controlled substances the ability to deduct business expenses. Under the Controlled Substances Act, the federal government defines Schedule 1 drugs as drugs that have no currently acceptable medical use and a high potential for abuse. Since cannabis is classified as a Schedule 1 drug, cannabis businesses are unable to deduct ordinary business expenses.
In relevant part, IRC Section 280E provides that,
No deduction or credit shall be allowed for any amount paid or incurred during that 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 . . .
The Harborside Decision
In ruling that IRC Section 280E applies to both the cannabis and non-cannabis activities of a taxpayer where the taxpayer is primarily engaged in a cannabis business, the Court provided insight into to how it intends to apply the provisions of IRC Section 280E in similar cases.
First, the Court noted that it strongly favored a broad interpretation of the 280E provisions, citing its belief that to narrowly interpret IRC Section 280E would render it ineffective and/or lead to absurd results. In accordance, unless or until 280E is repealed or amended, the Court intends to interpret 280E to apply to any taxpayer that is primarily engaged in a cannabis business, regardless of whether that same taxpayer or a related taxpayer is also engaged in a non-cannabis business activity.
Second, the Court outlined how it would determine whether a particular taxpayer was primarily engaged in a cannabis business so as to subject both its cannabis and non-cannabis business activities to the provisions of IRC Section 280E. Specifically, the Court stated that – “…Whether two activities are two trades or businesses or only one is a question of fact. 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 various undertakings.”
- Gross Sales Comparison. Of particular importance was the percentage of gross sales produced by each activity to the overall gross sales produced as a whole. In Harborside, the taxpayer generated nearly 99% of its total revenue from cannabis sales. The Court noted that non-cannabis sales revenue constituted only .05% of the total sales revenue. The significant disparity in gross sales revenue lead the Court to conclude that Harborside’s non-cannabis activities were merely incidental to its cannabis related activities, thereby subjecting both activities to the provisions of IRC Section 280E.
- Independent Sales Activity. The Court noted that the non-cannabis products were only available for sale in Harborside’s retail dispensaries and only accessible after a customer had presented his or her credentials at a security gate in order to gain access to the retail space. This further supported the conclusion that the non-cannabis activities were merely incidental to Harborside’s cannabis activities, thereby subjecting that activity to IRC Section 280E.
- Use of Common Employees. The Court noted that Harborside’s employees were engaged in both the cannabis and non-cannabis activities and, that they spent less than 10% of their time working on non-cannabis activities. In accordance, the Court determined that Harborside’s non-cannabis activities were merely incidental to its cannabis activities. It is important to note that in CHAMP v. Commissioner (2007), the single decision favorable to the industry in the past 12 years, the Court noted that the Taxpayer employed separate staff to operate the cannabis business activities.
- Use of Single Entity, Books & Records. The Court noted that Harborside did not establish a separate entity, maintain separate management for the two activities, maintain separate books and records, or, maintain separate capital for the operation of the non-cannabis business operations. Note that in part, this finding contradicts the Court’s decision in CHAMP, where the taxpayer operated its cannabis and non-cannabis business activities within a single entity. But for its reference to the single entity, the Court cited substance over form in determining that Harborside was primarily engaged in a cannabis business activity, finding that – “A single taxpayer can have more than one trade or business, or multiple activities that nevertheless are only a single trade or business… Even separate entities’ activities can be a single trade or business if they’re part of a ‘unified business enterprise’ with a single profit motive.”
Understanding the Harborside Decision
The Harborside decision reflects the US Tax Court’s clear intent to apply the provisions of IRC Section 280E to non-cannabis business activities, if those activities are merely incidental to a taxpayer’s cannabis activities. Non-cannabis activities will be found to be incidental if they are part of a unified business enterprise with a single profit motive.
In determining whether a taxpayer’s cannabis and non-cannabis business activities are part of a unified business enterprise, the Court will analyze the following operating metrics – (1) Comparison of Gross Sales Revenues, (2) Employee & Operational Segmentation, (3) Degree of Administrative Separation and, (4) Existence of Separate Business Entities.
Although the Court did not cite a specific minimum percentage with respect to its comparison of gross sales between the cannabis and non-cannabis activities, it is clear that if non-cannabis gross sales reflect a nominal percentage of a taxpayer’s total sales, the Court will likely find that the non-cannabis activities are merely incidental to the taxpayer’s cannabis activities and apply the provisions of IRC Section 280E to the entire business enterprise. It appears likely that the non-cannabis business activities would be required to generate more than 33% and preferably greater than 50% of the taxpayer’s gross sales revenue in order to clear this hurdle.
The degree to which the cannabis and non-cannabis business activities operate independent from one another is a key factor in determining whether the two are part of a unified business enterprise. Maintaining completely separate management, staffing, and capital structures for the two activities will support the position that the two activities are not part of a unified business enterprise. Conversely, comingling these operational elements will tend to demonstrate that the two activities are unified, potentially subjecting both to the provisions of IRC Section 280E.
The degree to which the cannabis and non-cannabis business activities are integrated for purposes of facilitating and reporting sales and inventory is a key factor in determining whether the two activities are unified. Maintaining a separate marketing and promotional platform, POS system, payroll processing system, accounting system and, inventory tracking system, for each of the two activities would support the position that the cannabis and non-cannabis business activities are not part of a unified business enterprise.
Armed with the Court’s ruling in Harborside, the IRS will likely step up its audit activity with respect to taxpayers engaged in business within the Industry. Consequently, it is now more important than ever to ensure that companies operating in the US legal Cannabis Industry are in compliance with the provisions of IRC Section 280E.
The Baker Davis MRB Group understands the Cannabis Industry. If you are interested in how we can help your business, please call us at (949) 565-4649, or via email us at [email protected]