Daniel T. McKillop
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201-896-7115 dmckillop@sh-law.comNinth Circuit Denies Cannabis Company’s 280E Tax Arguments
Author: Daniel T. McKillop|May 7, 2021
The Ninth Circuit Court of Appeals recently confirmed that because marijuana remains illegal under the federal Controlled Substances Act (CSA) cannabis businesses are prohibited from deducting business expenses pursuant to section 280E of the Internal Revenue Code...
Ninth Circuit Denies Cannabis Company’s 280E Tax Arguments
The Ninth Circuit Court of Appeals recently confirmed that because marijuana remains illegal under the federal Controlled Substances Act (CSA) cannabis businesses are prohibited from deducting business expenses pursuant to section 280E of the Internal Revenue Code...
The Ninth Circuit Court of Appeals recently confirmed that because marijuana remains illegal under the federal Controlled Substances Act (CSA) cannabis businesses are prohibited from deducting business expenses pursuant to section 280E of the Internal Revenue Code...
The Ninth Circuit Court of Appeals recently confirmed that because marijuana remains illegal under the federal Controlled Substances Act (CSA) cannabis businesses are prohibited from deducting business expenses pursuant to section 280E of the Internal Revenue Code. In Harborside v. IRS, the appeals court also rejected the company’s attempt to exclude its purchasing and processing costs as inventory costs under section 471.
Section 280E of the Internal Revenue Code
Most corporations can claim deductions for “ordinary and necessary expenses” that are “paid or incurred during the taxable year in carrying on any trade or business.” However, because marijuana remains a Schedule I controlled substance under the CSA, the Internal Revenue Service (IRS) has relied on Section 280E to refuse to recognize tax deductions taken by state-legal cannabis businesses because of their illegal operation under federal law.
Section 280E of the Internal Revenue Code prohibits businesses from deducting otherwise valid business expenses where the business “consists of” dealing in controlled substances set forth in Schedules I or II of the Controlled Substance Act. I.R.C. § 280E expressly 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.
Section 280E applies only to deductions attributable to a taxpayer’s drug-related trade or business. Accordingly, the provision does not generally disallow deductions attributable to a taxpayer’s non-drug-related business.
Legal Challenge in Harborside v. IRS
Patients Mutual Assistance Collective Corporation, d/b/a Harborside Health Center (Harborside), is one of the largest marijuana dispensaries in the country. For the years at issue, Harborside was a not-for-profit corporation and medicinal cannabis collective that operated a retail cannabis dispensary under California state law.
Harborside sold several categories of products, including “buds,” or cannabis flowers, which Harborside purchased from its patients-growers. Harborside also purchased from nurseries marijuana “clones,” i.e., “cuttings from a female cannabis plant that can be transplanted and used to cultivate marijuana.” After acquiring clones, Harborside stored, cared for, and repackaged them before sale. Additionally, Harborside purchased and resold other marijuana-containing products, such as extracts and oils, which it purchased from other marijuana collectives, as well as non-marijuana products such as branded shirts and various marijuana-related paraphernalia.
On its tax returns for the years at issue, Harborside claimed tens of millions of dollars in exclusions for the cost of goods sold and business expense deductions. The Commissioner of Internal Revenue disallowed nearly all those exclusions and deductions and issued Harborside notices of deficiency showing over $29 million in tax deficiencies for those years. On a petition for redetermination of the deficiencies, the Tax Court ruled in favor of the Commissioner. On appeal to the Ninth Circuit, Harborside argued that section 280E is unconstitutional under the Sixteenth Amendment. In the alternative, it argued that some of what it can’t deduct under section 280E should instead be treated as cost of goods sold excludible from gross receipts.
Ninth Circuit’s Decision
The Ninth Circuit affirmed.“At its core, this dispute reflects the latest attempt by a medical marijuana retailer to ameliorate the significant tax consequences Congress has prescribed for businesses that Congress regards as trafficking in controlled substances,” Judge Daniel Bress wrote. “Under federal law, those prohibited substances include marijuana, even though some states have more recently legalized its sale. This disharmony between federal and state law produces the multimillion-dollar tax controversy before us. Ultimately, we hold that the taxpayer’s arguments either are without merit or were not preserved for our review.”
The Ninth Circuit first considered Harborside’s constitutional argument. It ultimately declined to consider the argument because the taxpayer had not raised its challenge in the Tax Court. “Harborside argues that the corporate income tax, as modified by section 280E, is a ‘direct tax’ that taxes more than ‘incomes,’ in violation of the Sixteenth Amendment,” Judge Bess wrote. “The most immediate problem, however, is that Harborside did not raise this constitutional challenge in the Tax Court.”
The Ninth Circuit next turned to Harborside’s argument that some of its expenditures, if they can’t be deducted, are actually part of its inventory cost under the general inventory tax accounting rules of 26 U.S. Code section 471. It held that the Tax Court did not err in concluding that Harborside’s inventory cost for each of the years at issue is determined by 26 CFR § 1.471-3(b), which defines the types of outlays associated with purchased merchandise that a taxpayer can treat as inventory costs.
The Ninth Circuit also rejected Harborside’s argument that subsection (d) of section 1.471-3 exempts it from the requirements of subsection (b) and permits it to include its purchasing and processing costs in its inventory cost. As highlighted by the court, 1.471-3(d) applies only to industries “in which the usual rules for computation of cost of production are inapplicable.”
“Harborside presents no cogent argument for why a marijuana dispensary cannot compute its ‘cost of production’ under the usual rules that apply to a retailer. And it does not claim that it is a ‘retail merchant’ that uses the ‘retail method’ in its cost accounting,” Judge Bress wrote. “Harborside’s only argument appears to be that because its expenditures would be disallowed as deductions under section 280E, it instead should be allowed to exclude those amounts as costs by electing to proceed under section 1.471-3(d) rather than section 1.471-3(b). But Harborside does not ground this entitlement to different treatment in any statutory or regulatory authority. That the normal inventory accounting rules may be unfavorable to Harborside does not make them inapplicable to it. Section 1.471-3(d) therefore bears no relevance to Harborside’s tax liabilities for the years at issue.”
Key Takeaway
The federal courts of appeal continue to reject the arguments raised by cannabis companies regarding the application of Section 280E. In Harborside v. IRS, the Ninth Circuit did not reach the constitutional issues. However, it did reject the company’s attempt to find other ways to exclude its expenses. As a result, federal tax law continues to present problems for cannabis companies and may spur Congressional intervention.
If you have questions, please contact us
If you have any questions or if you would like to discuss the matter further, please contact me, Dan McKillop, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.
This article is a part of a series pertaining to cannabis legalization in New Jersey and the United States at large. Prior articles in this series are below:
- With the CRC Operational, When Will Recreational Cannabis Licenses Be Available in New Jersey?
- Understanding How New Jersey’s Recreational Cannabis Law Impacts Employers
- Will New York Legalize Recreational Marijuana This Week?
Disclaimer: Possession, use, distribution, and/or sale of cannabis is a Federal crime and is subject to related Federal policy. Legal advice provided by Scarinci Hollenbeck, LLC is designed to counsel clients regarding the validity, scope, meaning, and application of existing and/or proposed cannabis law. Scarinci Hollenbeck, LLC will not provide assistance in circumventing Federal or state cannabis law or policy, and advice provided by our office should not be construed as such.
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Ninth Circuit Denies Cannabis Company’s 280E Tax Arguments
Author: Daniel T. McKillop
The Ninth Circuit Court of Appeals recently confirmed that because marijuana remains illegal under the federal Controlled Substances Act (CSA) cannabis businesses are prohibited from deducting business expenses pursuant to section 280E of the Internal Revenue Code...
The Ninth Circuit Court of Appeals recently confirmed that because marijuana remains illegal under the federal Controlled Substances Act (CSA) cannabis businesses are prohibited from deducting business expenses pursuant to section 280E of the Internal Revenue Code. In Harborside v. IRS, the appeals court also rejected the company’s attempt to exclude its purchasing and processing costs as inventory costs under section 471.
Section 280E of the Internal Revenue Code
Most corporations can claim deductions for “ordinary and necessary expenses” that are “paid or incurred during the taxable year in carrying on any trade or business.” However, because marijuana remains a Schedule I controlled substance under the CSA, the Internal Revenue Service (IRS) has relied on Section 280E to refuse to recognize tax deductions taken by state-legal cannabis businesses because of their illegal operation under federal law.
Section 280E of the Internal Revenue Code prohibits businesses from deducting otherwise valid business expenses where the business “consists of” dealing in controlled substances set forth in Schedules I or II of the Controlled Substance Act. I.R.C. § 280E expressly 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.
Section 280E applies only to deductions attributable to a taxpayer’s drug-related trade or business. Accordingly, the provision does not generally disallow deductions attributable to a taxpayer’s non-drug-related business.
Legal Challenge in Harborside v. IRS
Patients Mutual Assistance Collective Corporation, d/b/a Harborside Health Center (Harborside), is one of the largest marijuana dispensaries in the country. For the years at issue, Harborside was a not-for-profit corporation and medicinal cannabis collective that operated a retail cannabis dispensary under California state law.
Harborside sold several categories of products, including “buds,” or cannabis flowers, which Harborside purchased from its patients-growers. Harborside also purchased from nurseries marijuana “clones,” i.e., “cuttings from a female cannabis plant that can be transplanted and used to cultivate marijuana.” After acquiring clones, Harborside stored, cared for, and repackaged them before sale. Additionally, Harborside purchased and resold other marijuana-containing products, such as extracts and oils, which it purchased from other marijuana collectives, as well as non-marijuana products such as branded shirts and various marijuana-related paraphernalia.
On its tax returns for the years at issue, Harborside claimed tens of millions of dollars in exclusions for the cost of goods sold and business expense deductions. The Commissioner of Internal Revenue disallowed nearly all those exclusions and deductions and issued Harborside notices of deficiency showing over $29 million in tax deficiencies for those years. On a petition for redetermination of the deficiencies, the Tax Court ruled in favor of the Commissioner. On appeal to the Ninth Circuit, Harborside argued that section 280E is unconstitutional under the Sixteenth Amendment. In the alternative, it argued that some of what it can’t deduct under section 280E should instead be treated as cost of goods sold excludible from gross receipts.
Ninth Circuit’s Decision
The Ninth Circuit affirmed.“At its core, this dispute reflects the latest attempt by a medical marijuana retailer to ameliorate the significant tax consequences Congress has prescribed for businesses that Congress regards as trafficking in controlled substances,” Judge Daniel Bress wrote. “Under federal law, those prohibited substances include marijuana, even though some states have more recently legalized its sale. This disharmony between federal and state law produces the multimillion-dollar tax controversy before us. Ultimately, we hold that the taxpayer’s arguments either are without merit or were not preserved for our review.”
The Ninth Circuit first considered Harborside’s constitutional argument. It ultimately declined to consider the argument because the taxpayer had not raised its challenge in the Tax Court. “Harborside argues that the corporate income tax, as modified by section 280E, is a ‘direct tax’ that taxes more than ‘incomes,’ in violation of the Sixteenth Amendment,” Judge Bess wrote. “The most immediate problem, however, is that Harborside did not raise this constitutional challenge in the Tax Court.”
The Ninth Circuit next turned to Harborside’s argument that some of its expenditures, if they can’t be deducted, are actually part of its inventory cost under the general inventory tax accounting rules of 26 U.S. Code section 471. It held that the Tax Court did not err in concluding that Harborside’s inventory cost for each of the years at issue is determined by 26 CFR § 1.471-3(b), which defines the types of outlays associated with purchased merchandise that a taxpayer can treat as inventory costs.
The Ninth Circuit also rejected Harborside’s argument that subsection (d) of section 1.471-3 exempts it from the requirements of subsection (b) and permits it to include its purchasing and processing costs in its inventory cost. As highlighted by the court, 1.471-3(d) applies only to industries “in which the usual rules for computation of cost of production are inapplicable.”
“Harborside presents no cogent argument for why a marijuana dispensary cannot compute its ‘cost of production’ under the usual rules that apply to a retailer. And it does not claim that it is a ‘retail merchant’ that uses the ‘retail method’ in its cost accounting,” Judge Bress wrote. “Harborside’s only argument appears to be that because its expenditures would be disallowed as deductions under section 280E, it instead should be allowed to exclude those amounts as costs by electing to proceed under section 1.471-3(d) rather than section 1.471-3(b). But Harborside does not ground this entitlement to different treatment in any statutory or regulatory authority. That the normal inventory accounting rules may be unfavorable to Harborside does not make them inapplicable to it. Section 1.471-3(d) therefore bears no relevance to Harborside’s tax liabilities for the years at issue.”
Key Takeaway
The federal courts of appeal continue to reject the arguments raised by cannabis companies regarding the application of Section 280E. In Harborside v. IRS, the Ninth Circuit did not reach the constitutional issues. However, it did reject the company’s attempt to find other ways to exclude its expenses. As a result, federal tax law continues to present problems for cannabis companies and may spur Congressional intervention.
If you have questions, please contact us
If you have any questions or if you would like to discuss the matter further, please contact me, Dan McKillop, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.
This article is a part of a series pertaining to cannabis legalization in New Jersey and the United States at large. Prior articles in this series are below:
- With the CRC Operational, When Will Recreational Cannabis Licenses Be Available in New Jersey?
- Understanding How New Jersey’s Recreational Cannabis Law Impacts Employers
- Will New York Legalize Recreational Marijuana This Week?
Disclaimer: Possession, use, distribution, and/or sale of cannabis is a Federal crime and is subject to related Federal policy. Legal advice provided by Scarinci Hollenbeck, LLC is designed to counsel clients regarding the validity, scope, meaning, and application of existing and/or proposed cannabis law. Scarinci Hollenbeck, LLC will not provide assistance in circumventing Federal or state cannabis law or policy, and advice provided by our office should not be construed as such.
