California-based Harborside Health Center, one of the country’s largest dispensaries, is challenging an industry-hated section of the tax code in federal court.
Last week, the company appealed a 2019 U.S. Tax Court ruling that found it had underpaid its taxes by $11M between 2007 and 2012. The discrepancy relates to section 280E of the federal tax code which denies tax deductions and credits to businesses dealing in illegal drugs. The cannabis industry has long fought 280E since it blocks deductions that other businesses can take and results in a far higher tax rate.
The dispensary wants the U.S. Court of Appeals for the Ninth Circuit to rule 280E unconstitutional. “Harborside wants to be treated just like Whole Foods or Kroger,” said Harborside’s attorney James Mann, a partner at Greenspoon Marder LLP.
Trade groups joined the fray with supportive briefs they filed at the court on Tuesday.
The appeal argues that applying 280E to Harborside “results in a tax liability that is inconsistent with the U.S. Constitution.” That’s because the 16th Amendment only lets Congress levy non-apportioned taxes on “income,” defined as gain from labor and capital.
“However, taxpayers subject to 280E can be forced to pay tax even in the absence of gain. Harborside is forced to pay taxes in years when it is losing money,” the appeal argues. 280E “fabricates gain where there was none and imposes a tax based on artificial income.”
“If more than Harborside’s income is being taxed, then it’s not an income tax and it’s unconstitutional,” the appeal says.
Mann argues 280E contradicts the idea of income—gain—as used in the 16th Amendment. But even if the court doesn’t strike it down, Harborside should be able to calculate its cost of goods sold “in a way that any other business outside of cannabis is allowed to.”
280E disallows all deductions, such as rent and utilities. As a result, the only way cannabis businesses can reduce their income–the amount taxed– is by categorizing certain expenses as Cost of Goods Sold (COGS). Harborside’s appeal argues the Tax Court erred in finding that Harborside incorrectly calculated its COGS for the 2007 to 2012 period.
According to the appeal, 280E should not affect Harborside’s COGS calculation. For those subject to 280E, an expense is allocated either to the COGS, or as a deductible expense that 280E denies. The appeal objects to the finding that some of Harborside’s COGS deductions should be treated as ordinary deductions, and therefore not be deductible. Instead it argues other parts of the law permit allocating certain expenses to COGS, rather than as deductible business expenses.
For Harborside, COGS includes various expenses related to buying flower, checking for contaminants, testing, processing, packaging and storing, plus the labor costs connected to that work. Harborside says those expenses are part of acquiring inventory and preparing it for sale, but the Tax Court disagreed.
The appeal asks the court to reverse the Tax Court decision because 280E violates the 16th Amendment that prohibits taxing income that is not gain. Alternatively, it asks the court to reverse the Tax Court decision and to determine Harborside’s COGS using Harborside’s accounting methods.
If the court finds 280E unconstitutional, “that might bring Congress to its senses” and they might repeal it, Mann said.
Trade groups backed the appeal.
In a brief to the court, the National Cannabis Industry Association argued Harborside operates legally in California. It adds that Congress has forbidden the U.S. Department of Justice from taking federal criminal enforcement action against state-legal MED operators.
“Yet, when it comes time to issue tax bills, the Commissioner of the Internal Revenue Service treats the businesses in this lawful industry no differently than common criminals,” NCIA states.
That’s because 280E, passed during the height of the Reagan Administration’s “war on drugs,” sought to punish criminal drug operators by stripping their ability to claim deductions. It results in subjecting state-sanctioned marijuana businesses like Harborside to “unprecedentedly high effective tax rates of up to 75%.”
Punitive taxation is a threat to the industry and will help the illegal, unregulated market expand, NCIA says. And that market does not generate economic gains that the legal one does.
NCIA also argued 280E violates the 8th Amendment’s excessive fines clause, because it’s punitive and imposes a punishment grossly disproportional to the offense—and with legal marijuana sales, there is no offense.
Noting that Congress passed 280E before state-legal marijuana businesses existed, the groups argued businesses can still reduce their taxable income with inventory costs. Those are expenses that may or may not fall into the COGS category but that can still reduce gross receipts. For the groups’ members, any cost not categorized as an inventory cost will not reduce taxable income.
Businesses subject to 280E rigorously track inventory costs—and use the most expansive inventory accounting methods possible, the brief says. It argues the IRS’ resistance to applying otherwise acceptable inventory methods leads to litigation like this and thousands of audits and controversies for businesses, along with tremendous additional costs.
“No other industry is the subject of such a broad tax sanction,” the brief states.
Jennifer Benda, a tax attorney and shareholder at Hall Estill who represents the two groups, said she regularly deals with the IRS on cannabis business tax issues. The agency relies on the Tax Court opinion on Harborside to deny expenses. Overturning that decision and expanding the amount of inventory costs that Harborside can include would provide guidance for other businesses, Benda said.
“This will help the industry if we can get some guidance,” she said.
Parties will continue to file briefs. It could be several months before the Ninth Circuit Court hears arguments. The court likely would not issue an opinion until well into 2021, Mann said.