Harborside’s Battle with Section 280e

Written by Abraham Finberg, CPA and Simon Menkes, CPA

In December of 2018, the Grinch visited more than just a few unlucky homes in America.  He also appeared in the guise of a couple of judges who ruled on the Harborside and Alternative/Wellness (Donald Duncan) cases.

The Harborside Case in a Nutshell:

In the Harborside case, we woke up to find that, yes, the IRS gets to decide if Harborside is a drug trafficker.  Also, if you have non-cannabis products, you better make sure the non-cannabis activities are clearly separate from the cannabis activities. And finally, Cost of Goods Sold for retailers is truly just the cost of the product without labor and overhead.

Want more details on Harborside, here you go:

Section 280e of the Internal Revenue Code (IRC)  basically says, if someone is a drug trafficker according to the Controlled Substances Act (CSA) they can only deduct cost of goods sold to lower their tax liability.  Harborside claimed the US Attorney dismissed the civil forfeiture case against them, so they are not drug traffickers. In other words, they argued the IRS can’t state someone is a drug trafficker since the IRS doesn’t regulate the CSA.  This is somewhat similar to another case, Feinberg vs. Commissioner. Harborside claimed, not only can’t the IRS determine they are drug traffickers, but they have proof they are not drug traffickers since their case was dismissed. The judge wasn’t buying it, however.  Bottom line: the IRS can decide the activity is drug trafficking according to this case.

What about Harborside’s non-cannabis activities?  Harborside was very diligent about proving they received payments for offering services such as yoga, chiropractic etc. as well as books, clothing, etc.  The Ninth Circuit Court Of Appeals in Olive v Commissioner even provided a hypothetical example of separate business lines in one store, a bookstore that also charged for coffee (think Barnes and Noble).  The judge didn’t buy this argument either; it was a small amount of sales (less than 2% of total sales), and the sales were economically interconnected, so it’s all one business line. This seems to contradict the Ninth Circuit COA’s ruling, since a bookstore selling coffee is also interconnected but … bottom line, separate business lines need to be very separate.

As for Cost of Goods Sold, Harborside would cultivate and give product to patient vendors and buy the product back from them.  Harborside would then package the product. The judge decided since they gave title to the patients and bought the product back from the patients, Harborside is not a manufacturer and packaging is an aspect of retailing.  Bottom line, only material costs are Cost of Goods Sold for Harborside.

Alternative Health Care (Donald Duncan) Case in a Nutshell:

Here, we learned that if your employees touch the product, your management company is a drug trafficker too. Again, everything must be completely separate. There must be no cannabis-touching activities in your non-cannabis entity! However, it’s also important to note this lower court ruling does not take precedent and will (hopefully and successfully) be appealed!

Want more details on Alternative Health Care (Donald Duncan), here you go:

Many cannabis companies have hired an outside management company in order to outsource the federally non-deductible aspects of their business: hiring of employees, marketing, etc., for which the cannabis companies have paid hefty fees. The management company, not subject to 280e, has deducted these expenses on their IRS return. All has been deemed kosher … until now.

In December 2018, a tax court judge ruled in Alternative Healthcare Advocates, et al v Commissioner that if your employees run the cannabis company (touch the product), your company is a drug trafficker. And if all the management company is doing is managing the retail outlet, they’re essentially one business and an attempt is being made to evade taxes (penalties!!!) Additionally, if your management company flows through to you personally ( S Corps, Partnerships etc.), you will personally owe taxes.

So what do we do?

Take away from all of this: keep your management company a C Corp, don’t have your employees touch the product and keep your non-cannabis products and activities clearly separate from your cannabis ones.

And for those who imbibe, perhaps now would be a good time to relax for a moment, take a hit or nibble a cookie with an eye towards Washington, and hope the winds of change that have swept our nation finally blow down those dusty corridors!

Disclaimer: This article has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice.