Last year was a rough one for cannabis companies in Tax Court. Now one of them is fighting back.
Harborside Inc., which went public on Canada’s stock exchange earlier this year, plans to appeal its November 2018 Tax Court ruling, the official decision and penalties for which should come any day now, according to the company’s counsel. The court sided with the government and is expected to charge Harborside between $11 million and $13 million in back taxes under a drug war-era tax policy that’s become the bane of pot company CPAs’ existence: Section 280E.
A successful appeal wouldn’t do away with that hated paragraph in the tax code, but could shield cannabis businesses with other activities that aren’t illegal under the Controlled Substances Act from Section 280E and make it a bit easier for cannabis accountants to comply.
“We also expect it would—or certainly hope it would—lead to the industry collectively saving millions and millions of dollars, potentially hundreds of millions of dollars,” said co-founder Steve DeAngelo, who refers to himself as the company’s chairman emeritus.
The relief would come as little progress is made on legalization bills and legislation shielding from federal rules businesses in states where the drug is legal.
This section, enacted in 1982, bars those “trafficking” in Schedule I and II substances from taking the deductions afforded to most federally legal enterprises, such as rent, equipment costs, and employee benefits, unless those expenses are used to build up inventory.
Fast-forward nearly four decades later—with hemp legal federally; recreational marijuana legal in 11 states and Washington, D.C.; and medicinal marijuana allowed in 33 states plus the nation’s capital—and legal weed businesses are struggling to stay afloat in the face of 70% effective tax rates and the looming threat of an Internal Revenue Service audit.
‘This Big Mess’
To avoid allegations of a 16th Amendment violation, lawmakers back in 1982 allowed Schedule I and II drug sellers to reduce their taxable income by the cost of their inventories, known as “cost of goods sold.” That’s the price of anything that went into the product, which can mean a lot for producers making their goods from scratch and, for straight retailers, little more than the item set for resale.
Still, what counts as “cost of goods sold” isn’t totally clear, and Harborside has become the poster child for this lack of clarity.
“There are no regs. That is the real injustice of Harborside—Steve DeAngelo did everything right,” said the company’s new counsel, Greenspoon Marder LLP partner James Mann, a former assistant deputy attorney general in the Justice Department’s Tax Division.
“Because there’s no written guidance, not only do taxpayers not know what to do, but they say one thing here and another thing there,” he said, referring to the IRS.
Mann isn’t looking to topple Section 280E; Congress will have to do that, and some members are trying to. Mann is engaging the IRS in a semantics argument that, if things go Harborside’s way, should at least require less guesswork by cannabis companies’ tax preparers who want to help their clients avoid sky-high tax rates and getting slapped with an audit.
“It’s very confusing, as a tax practitioner, to advise a client on how the IRS might come down on this,” said Justin Hobson, co-chair of Lane Powell’s cannabis practice team in Portland, Ore. “From a practitioner’s standpoint, it would be good for a court to come down and say, ‘cost of goods sold is this.’”
Rachel Gillette, Mann’s colleague at Greenspoon Marder who chairs the firm’s cannabis law practice, described situations in which businesses had to divvy up the cost of product tracking systems or employee wages based on their involvement with inventory.
“I think they understand how silly it is,” she said of the IRS, stuck with assessing those taxpayers’ compliance. “It’s this big mess.”
A spokesperson for the IRS said the agency would decline to comment.
War of the Words
In 2018, the Tax Court ruled in the IRS’s favor against three companies in cases involving Section 280E. Harborside was one of them.
The company classified itself as a producer, rather than a reseller, and used Section 263A—rather than solely Section 471, which also relates to inventory costs but allows for a narrower list of expenses—to determine its cost of goods sold for tax years spanning 2007 through 2012.
Harborside is renewing its argument that 280E’s language—which says the restriction applies to a business that “consists of” violating the Controlled Substances Act, rather than “includes” such activities—should make the limit on deductions strictly applicable to companies that only traffick in cannabis, not those that engage in other, federally-legal activities.
“We aim high,” said DeAngelo, adding that the language indicated Congress intended to apply the code section to a “very narrow class” of business activities.
The company’s previous counsel, San Francisco-based attorney Henry Wykowski, argued that the IRS’s denial of Harborside’s taxable income reductions under Section 263A—which can include costs indirectly related to inventory as well as directly related—were a violation of the 16th Amendment, which limits Congress’s ability to tax gross income.
The court said in its opinion that the 16th Amendment didn’t change when the section was enacted in 1986, and that Section 471 wasn’t found unconstitutional in the years before. Wykowski didn’t respond to requests for comment.
“Harborside would get COGS adjustments for its direct inventory costs no matter what—even if it was trafficking cocaine or any other controlled substance not legal under California law,” wrote judge Mark Holmes. “The Section 263A capitalization rules don’t apply to drug traffickers.”
Mann is disputing a similar argument the IRS made in a 2015 IRS memo on Section 280E. The memo cites language added to Section 263A via a 1988 technical corrections law. That new language was meant to reel in businesses’ potential abuses of their newfound ability to reduce income by the amount of indirect costs related to inventory, as apparently permitted by the section’s creation in the 1986 tax reform law.
The memo uses the change as a rationale to restrict cannabis businesses’ use of Section 263A when calculating cost of goods sold as well. It also classifies expenses under that section as deductions, rather than reductions in gross income, and says cannabis businesses must therefore reduce taxable income by the cost of a more limited list of items under Section 471.
But Mann argues that because Section 263A items aren’t used to reduce income immediately when the costs are incurred, like deductions, but instead subtracted from the gross income of the product the items created, those expenses are reductions in income, not deductions, and ought to be available to cannabis businesses.
Gillette said she was optimistic, but that her colleague faced an uphill battle. Hobson agreed with Mann’s position.
“It has to be an item for a taxpayer to reduce topline revenue,” he said of Section 263A expenses. He later added, “It’ll be interesting to see how deep into the weeds—no pun intended—the appeals court would go.”