Harborside tax case hinges on definition of ‘consists of’

Cannabis dispensary was interpreted to have one single business

The end of 2018 brought with it an interesting U.S. Tax Court case affecting the cannabis industry. Though not a pro-taxpayer case — the IRS won on the major counts — the Harborside case provides some insight into structuring cannabis-related businesses with a view to deduction of business expenses.

The taxpayer in the case, Patients Mutual Assistance Collective Corporation (doing business as Harborside Health Center), was a medical marijuana dispensary that sold a wide variety of marijuana-related products and products not related to marijuana, as well as providing patients with services such as hypnotherapy, acupuncture and yoga.

The case arose from the IRS denying most of Harborside’s deductions and cost of goods sold for six tax years. The primary reason for the disallowance came straight from Internal Revenue Code Section 280E: “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.”

Marijuana is currently a controlled substance under Section 280E.

Section 280E operates as an exception to the general rule of the code in Section 162 which allows a business to deduct all “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Accordingly, the application of Section 280E clearly impacts a cannabis business in its computation of taxable income since it cannot deduct most business expenses under Section 162.

The crux of the Harborside opinion lies in the interpretation of the words “consists of” from Section 280E. Harborside argued that “consists of” should be interpreted as an “exhaustive list,” meaning that it applies only to businesses that “exclusively or solely traffic in controlled substances and not to those that also engage in other activities.” The government took the position that a single business with several activities can still be seen as “consisting of” trafficking if any of its activities are trafficking. The opinion provides an interesting and detailed discussion of this phrase, mostly centering on the fact that the code itself, as well as case law, all seem to show that “consists of” can introduce either an exhaustive list or a non-exhaustive list of items when dealing with tax issues. The court concluded that a non-exhaustive list was the appropriate option for maintaining the effectiveness of Section 280E. Thus, Section 280E was meant to deny business expense deductions to any business involved in trafficking controlled substances, even if its business included other activities.

As such, Harborside was interpreted to have one single business — trafficking in controlled substances — and could not deduct business expenses related to its non-cannabis businesses such as apparel and wellness services. The court also held that Harborside could not apply the rules of Section 263A to permit its costs to instead be capitalized as part of its inventory.

The Harborside opinion is interesting, especially considering the recent passage of the Agriculture Improvement Act of 2018, which removes hemp from the controlled substances schedule. Cannabis-related businesses should be aware of the Harborside opinion and discuss with their tax advisers their ability to separate different lines of businesses to segregate expenses and better navigate the IRS waters.

Melinda Fellner Bramwit is a partner at Rimon Law who represents clients in federal, state and international tax issues. Her recent work includes assisting cannabis businesses and investors navigate complex tax and regulatory legal issues. She can be reached at  melinda.bramwit@rimonlaw.com.

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