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Increased Tax Liability for Cannabis Businesses Could Apply Beyond Cultivation and Sales

IRS Code § 280E prohibits deductions and credits for business expenses incurred by businesses engaged in “trafficking of controlled substances.” Despite repeated attempts to declassify cannabis, it remains classified as a schedule I controlled substance. According to Judge Holmes of the US Tax Court, such classification makes dispensaries “giant drug trafficker[s] [that are] unentitled to the usual deductions that legitimate businesses can claim.” In 2018, the Court held that Harborside, a prolific Oakland dispensary, could not deduct business expenses pursuant to § 280E, which resulted in millions of additional tax liability. This is not a new issue, and, as disappointing as it is to continue to have this divergence between federal and state law, the holding was anything but surprising. What is more worrisome is the potential for enforcement of § 280E beyond cultivators and dispensaries.

In another § 280E case, Alternative Health Care Advocates v. Commissioner, the owner of a dispensary formed Wellness Management Group, Inc. (“Wellness”), a legally separate management company, to run the storefront, pay employees, and handle the finances. Notwithstanding this legal separation, the Court held that Wellness was “trafficking in controlled substances” and was therefore not allowed to deduct business expenses under § 280E. The Court reasoned that Wellness employees were directly involved in providing medical marijuana to patients, and that although they were engaged in the purchase and sale of marijuana merely on Alternative’s behalf, the Court had no authority to read such a limitation into the statute. Further, the Court noted that the only difference between the two entities was that “Alternative had title to the marijuana and Wellness did not.” This difference, the Court held, was insufficient to preclude Wellness’s conduct from qualifying as trafficking.

This holding may present risks for other service providers ancillary or adjacent to the cannabis industry. Wellness and Alternative had the same owner, and Wellness had a single client, Alternative. Thus, the two companies were arguably so intertwined that they constituted a single enterprise. But the holding in Alternative may apply to companies with more attenuated connections. For example, consider a property management company that exclusively manages cannabis cultivation, sales, and production sites. And what about an investment group that purchases property and leases to smaller cultivators? With the soaring price of licensing, industry consolidation continuing, and larger companies coming into the market, it is not hard to envision a future where operation management contractors and consulting companies play such roles in dispensary and cultivation operations. These situations could quite fairly be construed as sufficiently analogous to Alternative to warrant the same outcome. Indeed, both the Harborside and Alternative cases cited to Morton v. United States, which held that “separate entities’ activities can be a single trade or business if they’re part of a ‘unified business enterprise’ with a single profit motive.” One could easily describe the arrangements just described as such.

Both Harborside and Alternative Health Care Advocates have notified the tax court of their appeal to the Ninth Circuit as of December of 2019. It will still likely be more than a month before we know the full breadth of issues on appeal.

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