It’s a new year, but why not live in the past just long enough to talk briefly about that last couple of Section 280E cases that trickled in at the end of 2018? Today, I’m reviewing the two Harborside cases.
Weighing in at 60-plus pages, and paraphrasing Shakespeare, it’s a wonder that we didn’t learn much more from the first Harborside opinion. Harborside is a medical marijuana dispensary located in California whose 2007 through 2012 tax years were audited, with the IRS issuing deficiency notices covering all six years. The deficiency notices disallowed the company’s Section 162 expense deductions pursuant to Section 280E, and made adjustments to costs of goods sold. Of importance to one of Harborside’s arguments in the case, the business had also been the subject of a civil-forfeiture action filed in 2012, stemming from what the federal law continues to view as its illegal drug-trafficking activities. That action was subsequently dismissed with prejudice in 2016.
In its petition, Harborside asked the Tax Court to decide whether:
- res judicata precludes the Commissioner from applying Section 280E where the prior civil-forfeiture action was dismissed with prejudice;
- Harborside’s business “consists of” trafficking in a controlled substance under Section 280E, where selling marijuana is not the sole and exclusive activity of Harborside;
- Harborside has more than one trade or business;
- Harborside should have capitalized indirect inventory costs under Section 263A, effectively converting them to COGS; and
- Harborside is liable for accuracy related penalties.
The res judicata issue seemed to be the only somewhat novel one in this case. The court held that, because the tax deficiency claim could not have been raised as part of the prior civil-forfeiture action, res judicata was not applicable with respect to it in the current action. The crux of the application of Section 280E is whether the taxpayer is “trafficking in controlled substances.” It felt like Harborside may have been going for collateral estoppel, but possibly couldn’t get there based on the form or nature of the underlying civil-forfeiture dismissal, and had to settle for an unsuccessful claim preclusion argument. Bottom line: res judicata is unlikely to work in the Section 280E context.
You might think the “consists of” question is also novel, but it seems (at least to me) to simply be an inverted “more than one trade or business” argument. The court spent an inordinate amount of time reaching the conclusion that the phrase “consists of” could signal an exhaustive list, but doesn’t with respect to Section 280E because that would be “absurd” (in the court’s words). I think they could have saved a few paragraphs and simplified the conclusion. If the business’s activities consist of more than trafficking in marijuana, it’s more than one trade or business. If the business’s activities do not give rise to more than one trade or business, it’s simply trafficking in marijuana. This distinction and the relevant factors have been well developed through the prior Section 280E case law. (By the way, court found that, while Harborside’s separate trade or business argument was more compelling than Olive’s [if you recall, the taxpayer in Olive sold marijuana and offered comfortable couches, video games and paraphernalia—its second trade or business], it still failed to live up to the CHAMP standard.)
Harborside also covers COGS and the application (or non-application) of Section 263A to marijuana businesses. If you’ve reviewed IRS Chief Counsel Memorandum 201504011, there isn’t much more to glean from Harborside’s Section 263A discussion. Section 263A’s flush language clearly prohibits capitalization of expenses that wouldn’t otherwise be taken into account when determining taxable income for the year (e.g., business expenses disallowed under Section 280E).
Harborside’s reseller vs. producer discussion likely offers the most practical value for taxpayers. Producers can include indirect inventory costs in COGS. For marijuana businesses, this may salvage some expenses that would otherwise be lost to Section 280E. Harborside claimed to be a producer, based on its providing marijuana plant clippings and offering patients/collective members instruction on how to cultivate marijuana using those clippings. While the court adopted a fairly broad definition for “producer,” it found that Harborside’s activities weren’t sufficient. The court’s discussion provides some valuable bookends for taxpayers to work within if they wish to qualify as a producer for purposes of Section 471.
The accuracy-related penalty question was decided in the subsequently issued opinion. Harborside was successful in asserting its reasonable cause and good faith defense. Harborside’s success with respect to the penalties is largely based on (1) the lack of available guidance related to applying Section 280E during the years at issue, and (2) the fact that Harborside kept very good books and records. Notably, the court concluded that Harborside’s “consists of” argument was reasonable and almost persuasive (harkening back to the opinion on the substantive issues, it was absurd). While this is a great result for Harborside, I think it will be difficult to for taxpayers dealing with more recent tax years to leverage, considering the published case law and IRS Chief Counsel Memorandum 201504011.
I’ll close by highlighting some of the court’s cheeky additions:
- “The Court learned at trial that it’s not the leaves of the marijuana plant, but its flowers—or buds—that people can smoke.” See the accompanying footnote, “The Court suspects, but makes no finding, that this may be why repurposed beer-marketing material—‘This Bud’s for you’—seems to be common where marijuana is sold.” They know so little, but so much . . .
- “’Dabbing’ means heating products that contain marijuana so as to create an intoxicating vapor. It may or may not have a connection to the strange fad among the young that seems to consist of pointing to the sky with one arm while putting one’s face in the crook of the other arm while seeming to sneeze or sniff.”
- Rather than the perfunctory “unless otherwise indicates, all section references are to the Internal Revenue Code,” the court opts for, “Unless we say otherwise, all section references are to the Internal Revenue Code.”
- In reference to Harborside’s “ombuds” department, the court adds a footnote specifically to clarify that this is Harborside’s pun and not a typo.
- Extensive recitation of Shakespeare at notes 19 and 20 (Merchant of Venice and Twelfth Night, respectively) in relation to whether “consists of” introduces an exhaustive or non-exhaustive list.