On November 29, 2018, the United States Tax Court (“Tax Court”) handed down a highly-anticipated decision in Patients Mutual Assistance Collective Corporation dba Harborside Health Center v. Commissioner (“Harborside”). The Harborside case involved a dispute over the deductibility of business expenses taken by Harborside Health Center (“Harborside dispensary”), recognized as the largest marijuana dispensary in the United States by revenue, and the IRS, which was enforcing the provisions of Code Section 280E, a 1980s-era law enacted in response to a court case awarding the tax deductibility of multiple expenses incurred by a drug dealer, which disallows the deduction of any business expenses incurred by a taxpayer engaged in trafficking in a Schedule I or II controlled substance. The IRS, aided by prior court victories on this same issue raised by other marijuana dispensaries in the past, won on all counts in the Harborside case. Even so, there were many takeaways from this case, expounded upon below, that marijuana dispensaries can glean from this most recent ruling.
Claim Preclusion (Res Judicata)
One interesting fact about the Harborside case not present in prior marijuana dispensary tax cases involved a civil forfeiture action filed against the Harborside dispensary in July 2012, a legal action which persisted for nearly 4 years until being dropped by the US Department of Justice in May 2016. The Harborside dispensary’s counsel argued in Tax Court that the IRS pursuit of additional taxes via Section 280E was effectively a reenactment of the civil forfeiture case under another banner. Given that there was legal finality to the civil forfeiture case, the Harborside dispensary argued that the IRS was barred from pursuing its tax case against them pursuant to the legal doctrine of claim preclusion, known by its Latin term res judicata. Res judicata, in summary, prevents a litigant from renewing litigation against another party on an issue that, for those same two parties, has already been previously decided in court. The Harborside dispensary’s argument, therefore, was that the IRS was renewing their litigation of the civil forfeiture case previously decided in favor of the dispensary and doing so under the guise of an income tax examination.
While the Tax Court ruled in favor of the IRS on this issue, it did not rule out the possibility that a future set of different facts may work out in a different dispensary’s favor. The Court carefully analyzed what standards must be met for res judicatato be successfully claimed, and found that the Harborside dispensary didn’t meet those standards. Dispensaries which have previously succeeded on non-tax legal issues brought by the federal government should carefully evaluate whether an unrelated (related?) IRS examination is an illegal continuance of a prior legal settlement.
Proper Interpretation of Section 280E
The Harborside dispensary introduced a novel argument about the inapplicability of Code Section 280E to its activities and focused on two words in this code section – consists of – in making the case that this section of law does not apply to them. The Harborside dispensary highlighted the definition of “consists of” as it is used in Section 280E when describing that business expense deductions are not allowed to taxpayers whose business “consists of” trafficking in a Schedule I or II controlled substance. The Harborside dispensary pointed out, not without merit, that the phrase “consists of” generally introduces an exhaustive list. What this means is that when something is said to “consist of” a list of items, that list of items is the exclusive, exhaustive list, and no other unmentioned items can be said to be included in that list, since the enumerated list contains everything.
What does that mean with respect to the Harborside dispensary and the application of Code Section 280E? The Harborside dispensary, in addition to selling medical marijuana, also has ancillary sales of clothing, paraphernalia, and other non-marijuana-related items. The Harborside dispensary’s reading of Code Section 280E was that a taxpayer whose business “consists of” trafficking in a Schedule I or II controlled substance must, by following the definition of “consists of”, consist only of trafficking in a Schedule I or II controlled substance. Therefore, because the Harborside dispensary didn’t meet that standard due to its ancillary non-marijuana sales, Code Section 280E would therefore not apply to them.
The Tax Court spent a considerable amount of time evaluating this argument and acknowledging that it had some merit based upon a review of the dictionary and other legal sources. However, what doomed the Harborside dispensary was the IRS argument, backed by case law, that a legal statute should not be read in such a constrained way so as to render it completely ineffective and toothless. The Tax Court, in ruling for the IRS on this issue, pointed out that if the Harborside dispensary’s reading of Code Section 280E were correct, a drug dealer who also sold a single pack of gum could not have this same code section applied to him, as that drug dealer’s business would not consist solely of trafficking in a Schedule I or II controlled substance.
That being said, taxpayers who are marijuana dispensaries or closely connected to them in some way should carefully evaluate the definition and meaning of the words of Code Section 280E to determine its applicability to them. Many businesses that are not dispensaries but closely connected to them may find by doing so that Code Section 280E doesn’t reach as far as the IRS may like it to. For example, the Tax Court previously ruled in CHAMP that the word “trafficking” in Code Section 280E is defined as follows: “to engage in commercial activity: buy and sell regularly.” Therefore, if one’s business, by way of just one example, is a delivery service which contracts with dispensaries to deliver purchased marijuana to its patients, can the delivery service be said to be “trafficking” in a Schedule I or II controlled substance if they never regularly buy or sell marijuana at all?
Capitalization of Inventory Costs
The Harborside dispensary was the first to raise the issue of using Code Section 263A against the IRS as a way of bypassing Code Section 280E. This code section, in summary, imposes inventory capitalization requirements on certain manufacturers and wholesalers that require affected taxpayers to capitalize certain expenses as an inventory cost that only gets recognized when the underlying inventory is sold. This provision, which ultimately delays the timing of deducting certain expenses, was seen by the Harborside dispensary as a vehicle to bypass Section 280E, since Section 280E does not disallow the deduction for cost of goods sold as previously determined in a prior Tax Court case. Therefore, the Harborside dispensary looked to Code Section 263A as a way to effectively convert expenses not allowed under Code Section 280E and capitalize them in inventory, where their eventual release as cost of goods sold could not be constrained by Code Section 280E in the same manner.
While the IRS Chief Counsel previously addressed this issue in a memorandum dated back to January 2015, the Tax Court ultimately pointed to Code Section 263A itself without referring to the prior Chief Counsel advice in disallowing the Harborside dispensary’s claim towards the deduction of these expenses. Pointing to subsection 263A(a)(2), the Tax Court pointed out that costs which cannot be used in determining taxable income are ineligible to be capitalized under Section 263A. The Tax Court did clarify that dispensaries must look to Code Section 471 in determining its capitalized inventory costs. This code section and its regulations have ambiguity that dispensaries should closely evaluate in determining which of its costs can be included in cost of goods sold.
Harborside provided more of the same as it relates to marijuana dispensary tax law, yet also illuminated new, unexplored areas that dispensaries should look to take advantage of while Code Section 280E remains the law of the land. There is much to be learned from the Harborside case that can help dispensaries moving forward in mitigating and addressing the effects of Code Section.