Harborside Strikes Back, Wins Big In Tax Court

U.S. Tax Court Declines to Issue Penalties in Harborside 280E Case, Saving Industry Tens of Millions

CALIFORNIA: In a historic landmark decision that will save Harborside and the legal cannabis industry millions of dollars, the U.S. Tax Court has ruled that the California dispensary is not liable for accuracy-related 280E penalties. 280E is a tax code provision that denies all standard business deductions to businesses whose operations “consist” of activities that violate the Controlled Substances Act.

According to the Opinion issued by the Court, Harborside acted “reasonably and in good faith” when taking its tax positions for the years at issue. The Court cited Harborside’s timely filing of its tax returns and its maintenance of accurate financial records as a key strength, along with a persuasive argument from Harborside co-founder and Chairman Emeritus, Steve DeAngelo, that he made good-faith efforts to comply with the law, despite a lack of clear legal authority to guide medical marijuana dispensary taxpayers.

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The ruling comes just a few weeks after the same Court ruled that 280E itself does apply to Harborside — a ruling Harborside intends to appeal to the U.S. 9th Circuit Court of Appeals.

“We’re still working on knocking out 280E entirely, but at least for now we have established that cannabis businesses who operate in reasonable, good faith compliance with existing law will not suffer from additional unjust penalties,” said DeAngelo. “This ruling could save the legal cannabis industry tens of millions of dollars— dollars that ultimately come out of the pockets of cannabis consumers. What we are asking for is simple and fair: for the IRS to treat us like every other legal, tax paying business in the United States. Since the IRS has made it clear they are unwilling to do that on their own, Congress should step in and pass clear 280E reform legislation.”

The decision highlights Harborside’s historic role as an advocate and defender of the legal cannabis industry, and is just one of several victories it has scored since its founding in 2006. “Harborside never has, and never will, give up in its pursuit of justice for cannabis consumers and the legal industry that serves them,” said DeAngelo.

In 2016, the U.S. Department of Justice gave up on a years-long attempt to seize the properties where Harborside does business, dismissing a pending civil forfeiture action initiated 2012, when California’s four U.S. Attorneys mounted a statewide campaign to shutter California’s medical cannabis industry. The campaign had succeeded in closing 600 dispensaries— one third of the dispensaries in the state—but ended after Harborside won multiple legal victories in both state and federal courts.

“The penalties ruling strengthens Harborside’s financial position and helps clears the path for future industry growth,” said Andrew Berman, CEO of Harborside. “It’s a huge win for Harborside and the entire cannabis industry. We applaud the Court’s well-reasoned opinion, and appreciate the Court recognizing our commitment to compliance and operating in good faith.”

The 280e Cannabis Conundrum

By  Keith Richards 

If you are in the Cannabis industry and are not already familiar with IRS Code section 280e, then you are likely going to face a rude awakening this tax season.  Even with all the noise about this issue, it is still surprising to find operators that are not paying attention to some basic business principles such as knowing how costs (in this case taxes) will affect their business. It doesn’t mean that you have to become a CPA because the rules are fairly straight forward and there is significant literature addressing the topic.  However, using a trusted advisor to navigate areas of unfamiliarity (taxes and otherwise) would be the most beneficial way to insure that that you don’t go out of business due to the burden of unexpected taxes or worse, end up in jail ala Al Capone.

First, let’s understand the law:

Internal Revenue Code section 280e specifically 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 (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.”

Whew….what does that mean? The IRS is a group of clever individuals whose job is to maximize revenue to the United States by taxing income.  They are not concerned whether the income was derived legally or illegally, but whether you pay your taxes on the income generated. Federally, Cannabis is still a controlled substance and illegal and therefore falls under the provisions of IRS Code section 280e. Per the provision, unlike “ordinary” companies that are able to deduct expenses in determining taxable income, 280e related entities (Cannabis being one type) cannot deduction normal and ordinary operating expenses.  The result is that a Cannabis related entity will be denied these deductions, will report higher taxable income and of course pay more taxes. This is where many operators are getting themselves in trouble.  They fail to realize and account for the additional tax burden that will be imposed and then either don’t have the cash to pay or simple didn’t know the law and fail under audit. Under 280e Instead of paying a tax rate of 30% or 40% a Cannabis business might end up paying 60% to 90% in taxes.

Second, understand your cost of goods sold:

From a retail standpoint Cost of Goods Sold (COGS) are the costs that a business incurs such as materials, certain labor and the wholesale price of goods purchased that are subsequently retailed.  From a grower standpoint, COGS can include additional components that are directly related to production such as seeds, nutrients, electricity for grow lighting, supplies etc.  COGS is considered an adjustment to revenue as opposed to an expense deduction and as such does not fall under the provisions of 280e.  Consequently, while a Cannabis company cannot deduct operating expenses, it can adjust revenue for cost of goods sold. Therefore, it would be prudent for an operator to have a good understanding all of the components of COGS.

 

Third, develop a strategy:

Given that Cannabis related entities are limited on expense deductions but can adjust for COGS, in order to minimize the tax burden, hiring professional advice is a relatively small expense when compared to the potential exposure.  That being said, here are a few tips that each Cannapreneur should consider and discuss with their trusted advisor:

Diversify your services – consider offering additional services such as Yoga, or meditation, or stress counseling.  You may be able to allocate some of your operating expenses to these other services and take them as deductions against these goods and services.

Use IRS Code 263a to capitalize costs to inventory – Code Section 263a allows an organization to capitalize certain expenses which then become a component of inventory.  Once the inventory is sold and run through COGS these previously disallowed expenses now become an adjustment to revenue (as opposed to a disallowed expense) as a component of inventory and COGS.

Correct legal entity – A regular S-Corp is required to pay a fair wage to the owners and operators of the entity, yet these wages would be considered a non-deductible expense under 280e. On the other hand, a Limited Liability Corporation (LLC) is not required to pay the owner a salary and instead the earnings of the LLC are the owner’s taxable earnings. The owners would report net income allocated as opposed to salary and therefore there is no salary expense that would be disallowed.

Fourth – Stay well informed of potential law changes

In 2011, a bill called “The Small Business Tax Equity Act” was introduced to congress.  Essentially, the bill attempted to resolve the difference between state and federal law allowing for an exemption from section 280e for medical marijuana entrepreneurs as long they were in compliance with State law. The 2011 bill died and was reintroduced in 2013 emphasizing all marijuana businesses but it died as well.  In April 2015, a pair of congressmen (Rep. Earl Blumenauer and Sen. Ron Wyden of Oregon) have reintroduced the bill for a third time. This legislation is gaining widespread support by organizations such as Americans for Tax Reform, the National Cannabis Industry Association, Drug Policy Alliance, Marijuana Policy Project, Americans for Safe Access, and NORML.  Given the amount of attention and support this topic has garnered, there is hope that “third time’s a charm” and marijuana businesses will finally become exempt from 280e.  However, with congress one never really knows.

Finally – change is a constant:

Cannapreneurs need to recognize that the Cannabis industry is going through growing pains in the same way that many other first time industries have developed. There are many factions, special interest groups and profiteers that are each trying to influence the future direction to their benefit and as such the rules to the game are continually changing. For that reason it is important to stay abreast of change and surround yourself with solid professional advice that can help along the way.  Be sure to consult with your tax and legal advisors and make solid informed decisions for the long term.

 

Keith Richards is a successful CEO/COO & CFO.  Currently he is a Partner with the Newport Board Group, a national professional services firm of strategic advisors. He’s also a Director with Integral Edge Partners focusing on high performance leadership transformation and corporate culture development. He is a regular commentator on a variety of business radio programs, keynote speaker and blog author. Keith can be reached at keith.richards@newportboardgroup.com followed on LinkedIn at www.linkedin.com/in/keitharichards and on twitter @KRLeadership.