Since the Tax Court’s decision in CHAMP v. Commissioner, cannabis businesses have rarely snagged a tax victory. The Tax Court’s decisions in Patients Mutual v. Commissioner and Alternative Healthcare Advocates v. Commissioner, issued in November and December 2018, respectively, adds to the pile of crushing losses for cannabis business owners.
What is §280E and what how does it apply to cannabis businesses?
Title 26 U.S. Code §280E states:
No deduction or credit shall be allowed for any amount paid or incurred during thetaxable 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.
As cannabis is still classified as a Schedule I drug federally, most cannabis business owners already know, §280E limits the deductions a cannabis business owner can take against his or her gross income.
To ameliorate the harsh results produced by §280E, many cannabis businesses have sought to separate the “plant-touching” businesses from other activities in order to deduct the expenses related to the latter.
For tax purposes, the distinction in business related expenses primarily lies in expenses related to the “cost of goods sold” (COGS), and “ordinary and necessary” expenses. This distinction becomes important because the tax code treats these two types of “expenses” very differently.
While COGS are fully deductible – because taxing them would violate the 16th Amendment of the U.S. Constitution – I.R.C. §280E bars the deduction of ordinary and necessary expenses by (1) a trade or business that is (2) trafficking in (3) a controlled substance.
While there is little dispute that cannabis is a controlled substance, most tax disputes between cannabis businesses and taxpayer hinge on whether a certain activity is a trade or business and whether it trafficks in a controlled substance; because if a certain activity is a separate trade or business from the cannabis business, and that business activity does not “traffick” in a controlled substance, then it is not subject to the harsh tax consequences provided in I.R.C. §280E.
A Series of Blows to Cannabis Businesses
CHAMP v. Commissioner
In the seminal case on point, CHAMP v. Commissioner, the court held that expenses related to a “separate trade or business” within the cannabis business, which was unrelated to cannabis business, were deductible. In that case, the taxpayer provided mainly caregiving services to individuals afflicted with AIDS, but also sold marijuana to its patrons. The IRS lost on the argument that taxpayer’s principal business was the provision of marijuana and that all related activities were merely “incidental” to that business. The court reasoned that whether an activity is a “separate trade or business” depends on “the degree of economic interrelationship between the two undertakings.”
In holding that the caregiving activity was a separate trade or business from the provision of marijuana business, the court relied on the following facts, which indicated an economic separation between the two businesses: Marijuana was sold only on 10% of the taxpayer’s three facilities, 7 employees strictly sold marijuana, while 18 were strictly employed in the caregiving activities, taxpayer regularly provided caregiving services such as supplying food and medicine and hosting social and educational events.
Olive v. Commissioner
A few years later, in Olive v. Commissioner, the court reached the opposite conclusion – on facts vastly different from CHAMP. In Olive, the court found that the taxpayer, who sold medical marijuana and provided complimentary additional services – such as movies, board games, yoga classes, massages, snacks, personal counseling, etc., – had a single trade or business, all of which was subject to §280E. In reaching this result, the court reasoned that the additional services provided by the taxpayer were merely incidental to the sale of marijuana. Some of the key facts the court relied on were: Olive charged a single fee for marijuana and complimentary services, same employees provided marijuana and complimentary services, no additional expenses were associates with the provision of complimentary services, etc.
CHAMP and its progeny prompted cannabis entrepreneurs, desperate to ameliorate the harsh results of §280E, to legally and factually separate their various business “activities.” They began keeping separate books and records for the various “non-touching” activities and formed legal entities to operate the non-touching businesses. The IRS challenges soon followed.
Loughman v. Commissioner
In June 2018, in one of the very first Tax Court opinions on the issue, Loughman v. Commissioner, the Tax Court decided against the taxpayers who had formed an S Corporation to operate the cannabis business. In that case, the taxpayers had paid themselves wages from the S corp., as required by tax laws, on which they paid federal income taxes. The IRS disallowed the S corp. the wages paid deduction, and taxed the same income to the S corp: subjecting the wages paid amount to taxation twice – once as flow through income from the S corp. and again as wage income.
Patients Mutual Assistance Collective Corporation v. Commissioner
Several months later, in November 2018, the court decided Patients Mutual Assistance Collective Corporation v. Commissioner. In Patients Mutual, the taxpayer advanced various technical arguments which were summarily rejected by the court. However, the court laid the groundwork for any subsequent challenges by clarifying what constitutes separate business activities and whether having separate legal entities help taxpayers in avoiding §280E. The court stated that:
A single taxpayer can have more than one trade or business, or multiple activities that nevertheless are only a single trade or business. (citation omitted). Even separate entities’ activities can be a single trade or business if they’re part of a ‘unified business enterprise’ with a single profit motive. Whether two activities are two trades or businesses or only one is a question of fact. To answer it, we primarily consider the ‘degree of organizational and economic interrelationship of various undertakings, the business purpose which is (or might be) served by carrying on the various undertakings separately or together, and the similarity of the various undertakings. (emphasis supplied).
Alternative Healthcare Advocates v. Commissioner
Similarly, in December 2018, the tax court reached the conclusion that separating businesses activities into separate entities would not prevent the harsh results of §280E. In Alternative Healthcare Advocates v. Commissioner, a cannabis dispensary owner formed an S corp. to handle the daily operations for the dispensary. The S corp. performed various functions for the dispensary, such as hiring employees, paying expenses for advertising, wages, and rent, etc. The S corp. provided services solely for the dispensary and was owned by the same owners as the dispensary.
When Alternative’s S corporation filed its tax returns, it almost “broke even” after paying the various expenses which included expenses for compensation to officers, salaries and wages, rent, taxes and licensing fees, advertising, etc. The IRS disallowed all expenses claimed by the S corp. and determined that the owners of the dispensary and the S corp. had unreported income in the amounts of the disallowed expenses. Tax Court litigation soon followed.
In deciding against the taxpayers on the argument that the S corp. was a separate “non-touching” entity not subject to §280E, the court reasoned that the only difference between the dispensary and the non-touching business was that the latter did not have title to marijuana. The fact that that it was part and parcel of a cannabis business meant that it was still subject to §280E.
The court ultimately held that both the dispensary and the S corp. formed to manage it were in the business of trafficking a controlled substances – subjecting both to §280E and disallowing all expenses for both. In response to taxpayer’s argument that the Tax Court’s holding will subject them to double taxation on the same income, the court commented that “[t]hese tax consequences are a direct result of the organizational structure petitioners employed, and petitioners have identified no legal basis for remedy.” Alternative Health Care at 10.
The latest Tax Court decisions have dealt a crushing blow to cannabis businesses. For now, it is back to the drawing board for many of these businesses until congress steps in to provide relief to the inequities produced by §280E.