Harborside decisions provide guidance on IRC 280E

Tax court refutes arguments in case that could have repercussions throughout the industry

Harborside, one of the most well-known and iconic cannabis dispensaries in the country, recently found itself on the wrong side of two U.S. Tax Court opinions that will reverberate through the entire cannabis industry.

On Nov. 29, 2018, the tax court issued the first opinion regarding the Oakland-based retailer’s deduction of operating expenses and its computation of cost of goods sold on its federal tax return (Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner of Internal Revenue). In December, the court issued a second opinion, this time addressing penalties.


Broad application of 280E

In the first opinion, the court held that language contained in IRC Section 280E must be interpreted to deny deductions to any trade or business that involves trafficking in a controlled substance even if that business also engages in other activities.

Harborside argued that Section 280E disallowed expenses to a business that “consists of trafficking” in a controlled substance and that this language limited the application of Section 280E to the single activity of selling cannabis (in other words, drug dealers) and not to cannabis retailers that provided other services. The court looked to historic usage in dictionaries, the use of the phrase in other sections of the Internal Revenue Code and case law. Finding ambiguity in all three sources, the court held that Section 280E must be read to deny deductions to any trade or business involved in trafficking, even if it is also engaged in other activities.

The court clarified that Section 280E applies to cannabis cultivation, manufacturing and sales. As a practical matter, the court shuts down arguments that Section 280E should not apply because of legislative history, state legalization of cannabis or risks created by an IRS audit.

(The court also held that the government’s previous dismissal of a civil forfeiture action against Harborside does not prevent the IRS from auditing Harborside and assessing additional income tax. This issue is unique to Harborside and is not discussed further in this article.)


A Single Trade or Business

Harborside also argued that in addition to selling cannabis to patients, the company sold branded merchandise (clothes and paraphernalia) and provided therapeutic services free of charge. Harborside argued those activities are separate businesses and therefore outside the reach of Section 280E. Accordingly, Harborside argued that these expenses are fully deductible, however, the court rejected that argument. In determining that Harborside had one trade or business, the court applied the reasoning of the U.S. Court of Appeals for the 9th Circuit in the 2015 case Olive v. Commissioner of Internal Revenue, regarding a San Francisco dispensary that offered services such as yoga, movies and massage therapy and provided complimentary tea, water and snacks.

In Olive, the tax court created an analogy of a hypothetical bookstore — Bookstore A — that sold books and gave away coffee to attract customers. Bookstore A has only one trade or business, whereas Bookstore B, a hypothetical shop that sold books and coffee, would have two trades or businesses. Using that analogy, the tax court in Olive determined that the services provided by the cannabis dispensary was to attract customers; therefore, its only trade or business was trafficking cannabis, so Section 280E disallowed all operating expenses.

In the Harborside case, the tax court created a third hypothetical, Bookstore C. In that hypothetical, Bookstore C derives less than 1% of its revenue from the sales of stationery, bookmarks and T-shirts, using the same employees, sales floor, management, ledgers and business entity.

Applying that analogy to Harborside, the tax court maintained that Harborside had one trade or business — the sale of cannabis. The tax court used the following factors in determining that Harborside had one trade or business:

– sales of paraphernalia were less than 1% of revenue;

– it used the same facilities and management;

– it used the same accounting records; customers went through the same security check (security staff spent only 5% of their time checking service-only customers);

– and there were economic and business reasons to bundle services with the sale of cannabis.

The tax court also clarified that services provided to customers free-of-charge, but which attract customers, is not a separate trade or business. In the tax court’s own words, “Just as a bookstore that gives away coffee is still only a bookstore, a marijuana dispensary that gives away services is still only a marijuana dispensary.”

Harborside also made a unique argument with respect to branding, arguing that brand-development activity was a separate trade or business, despite it generating no revenue during the years under audit. Harborside argued that branding activities were part of a unified business enterprise with revenue-generating activities (meaning the sales of cannabis). In other words, strong branding directly links to strong sales.

Once again, the tax court disagreed, noting that its branding activity was performed using the same legal entity, management and capital structure. Harborside’s branding activity was not different from the sale of cannabis but necessarily entwined with it. Furthermore, most of Harborside’s resources were dedicated to the sale of cannabis, generating 99.5% of its revenue.

Because of this, cannabis businesses should consider holding intellectual property, including brands, in a separate legal entity with independent business activity.


Cost of Goods Sold 

Cannabis businesses pay tax on their gross income, not gross receipts. Gross income is defined as gross receipts less cost of goods sold (COGS). COGS are defined as costs of acquiring inventory either through purchase or production.

Section 280E disallows deductions from gross income. Deductions are granted or prohibited by Congress, and the courts have given Congress broad authority to determine what costs are deductible.

The computation of COGS is determined by two sections of the Internal Revenue Code: Section 471 and Section 263A. For retailers, Section 471 includes in COGS the purchase price of inventory plus transportation or other acquisition costs. In 1986, Congress added Section 263A, which includes a wider variety of costs compared to Section 471, to include additional indirect costs in COGS.

Harborside argued that the more favorable Section 263A should be used to included certain indirect costs in the company’s COGS. Moreover, Harborside argued that the U.S. Constitution required that Section 263A be used to determine COGS.

The tax court again disagreed, noting that the express language of Section 263A prohibits a taxpayer from including in COGS any cost that could not otherwise be deducted and could not transform a cost not already deductible under Section 280E into a cost included in COGS. The tax court’s ruling clarifies that Section 263A may not be used to determine the COGS of a cannabis business.

Finally, Harborside argued that it was a producer — because of its requirement to only purchase cannabis from members that used Harborside clones and followed Harborside’s best practices — and included a variety of indirect costs in COGS. Again, the tax court disagreed, noting that Harborside did not own or control the cannabis during the grow process. Therefore, Harborside could only include in COGS the purchase price of cannabis plus transportation costs. The court’s holding is clear that applying Section 263A (and perhaps other allocation methods) in determining the inventory of a cannabis business is not acceptable.



Generally, taxpayers are subject to a 20% penalty on underpayments of tax. A taxpayer can avoid penalties if they can show that they acted reasonably and in good faith. The determination of reasonableness and good faith depends on each taxpayer’s facts and circumstances. After an analysis of Harborside’s facts, the court held that Harborside acted reasonably and in good faith so the company was not subject to the 20% penalty, noting the lack of guidance available during the tax years at issue (2007-2012).

First, the IRS has never promulgated regulations regarding Section 280E; the only other guidance the IRS offered marijuana businesses regarding inventory was issued in 2015, well after the due dates of Harborside’s returns.

Second, the relevant case law available during the preparation of Harborside’s tax returns was either favorable to a cannabis dispensary (Californians Helping to Alleviate Medical Problems (CHAMP) v. Commissioner) or under appeal (Olive). In CHAMP, the tax court allowed a marijuana dispensary to deduct non-trafficking expenses, and the IRS conceded penalties. In the first Harborside opinion, the court discussed Olive in detail and ultimately rejected the company’s interpretation. Nonetheless, the court in its second opinion made two important points: First, the court acknowledged that Harborside’s analysis of Olive had merit and was a reasonable effort to push the court for a “more elaborate judicial analysis” of a cannabis business with some additional revenue from non-cannabis sales. Second, the court acknowledged that Olive was not final until after Harborside filed its tax returns under audit.

Accordingly, the court held that Harborside’s tax return reporting position was reasonable, considering the lack of clear guidance given at the time Harborside’s tax returns were filed.


Good Faith

In determining whether Harborside acted in good faith, the court noted that:

– Harborside substantiated all claimed deductions and had excellent books and records;

– The testimony of key management supported Harborside’s overall effort to comply with California law and federal case law;

– Harborside mitigated its tax return position by allocating some expenses as non-deductible after the tax court’s 2012 decision in Olive; and

– Harborside provided a significant degree of meaningful services.

Accordingly, the court held that Harborside’s reporting positions were both reasonable and taken in good faith. and Harborside was not subject to the 20% penalty.


It is important to note that the tax court issued a memoranda decision, which are limited to the facts of the specific taxpayer. The second Harborside case does offer some guidance regarding penalty relief, however, the IRS will still look at the facts and circumstances of each individual taxpayer when considering granting penalty relief.

In conclusion, the Harborside decisions clarify that Section 280E is here to stay, but they do offer some guidance on avoiding penalties. Going forward, cannabis businesses must include the application of Section 280E in their business planning, and they should examine prior tax filings to determine if amended returns are warranted.


Dean Guske is a licensed CPA with more than 30 years of experience in the areas of taxation, accounting and business consulting. He serves several hundred clients in the cannabis industry and is at the forefront of developing successful tax strategies for industry entrepreneurs. He is also a frequent speaker and author on the complex tax issues facing the industry. Guske holds a master’s degree in taxation from Golden Gate University and a bachelor’s degree in business from the University of Washington.

Jim Hunt is with Guske & Company, Inc. He has more than 30 years of experience advising individuals, nonprofit organizations, closely held and public companies on federal and multi-state tax issues and compliance. He is a frequent speaker on state and federal tax issues affecting the cannabis industry and has represented clients in all sectors of the cannabis industry. He holds a J.D. from the University of Iowa and a bachelor’s degree from Northern Illinois University. He is licensed to practice law in Illinois and Washington. He is admitted to practice before the U.S. Tax Court and holds a CPA certificate from the state of Illinois.


One response to “Harborside decisions provide guidance on IRC 280E”

  1. The situation in California gets even worse in years after 2017 due to Bureau of Cannabis Control restrictions that preclude Dispensaries from being involved in the packaging. labeling and testing of cannabis. Those functions are reserved for DIstributors. Mr. Hunt good to see where you wound up.

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