The Tax Court’s recent decision in Harborside (Patients Mutual Assistance Collective Corp v Commissioner (Patients Mutual 1) 151 T.C. (Nov. 29, 2018)) left open for decision the applicability of penalties. The Internal Revenue Code imposes a 20% penalty on the portion of an underpayment attributable to any substantial understatement of income tax or negligence or disregard of rules or regulations. Negligence includes any failure to make a reasonable attempt to comply with the provisions of the tax code, and disregard includes any careless, reckless, or intentional disregard. The tax code provides that an understatement of a corporation’s income tax is substantial if it exceeds the lesser of $10 million or “10 percent of the tax required to be shown on the return for the taxable year (or, if greater, $10,000).” Harborside’s understatement qualified as substantial.

A taxpayer can avoid these penalties by showing that it acted with reasonable cause and in good faith. The Tax Court held that the penalties did not apply to Harborside. There are two important factors in the Court’s decision:

  • The law was unclear during the tax years in question, 2007 – 2012 – there were no court cases directly on point, there were no regulations under Section 280E, and the IRS position was not even known until the issuance of the Chief Counsel Memorandum in 2015 on capitalization of inventory costs.
  • Harborside acted in good faith to attempt to comply with the tax law. It kept excellent financial books and records and the judge cited the testimony of Steve DeAngelo (Harborside’s co-founder and manager) that he actively tried to comply with federal and California law.

The ruling in Patients Mutual II appears to be consistent with our experiences handling numerous IRS cannabis business tax audits for the years prior to the IRS’s issuance of the Chief Counsel Memorandum in 2015. Prior to its issuance, there appeared significant inconsistency at the examination level of how 280E even applied to a cannabis business operating under state law. In most cases, where a Taxpayer client in good faith attempted to comply with 280E, unless other factors existed, the application of penalties have been waived or not applied, upon the request of the taxpayer or the taxpayer’s counsel. On the other hand, a failure to even attempt to comply with 280E in good faith, could leave a taxpayer exposed to significant penalties.