The complexities of tax law can be bewildering. But the federal government’s case against Harborside, the Oakland, Calif.-based dispensary chain, is actually pretty simple, according to Harborside’s lawyer, James Mann. So, he said, are the arguments against it.
In 2019, the U.S. Tax Court ruled in favor of the Internal Revenue Service, finding that Harborside had improperly deducted expenses on its tax returns from 2007 through 2012, and is thus on the hook for $11M that it had underpaid as a result. The case against Harborside hinges on a section of the U.S. Tax Code known as 280E, which forbids companies from taking deductions if they’re involved in the sale of illegal narcotics, which is how the federal government classifies weed in the criminal code.
Then this June, Mann filed a brief to the U.S. Court of Appeals for the Ninth Circuit, hoping for a reversal. “It’s very simple,” Mann said. “But it took me 35 pages to put it into legalese.” Last week in this space, I took a look at the case, as well as a possible tax loophole for smaller cannabis companies. This week, I talked to Mann to delve into his arguments, and about that loophole.
Given the language of 280E, the government’s case sounds like it should be open-and-shut, since Harborside is very much in the business of selling weed. But Mann says it should be an open-and-shut case in the opposite direction.
His case hinges on two arguments, one constitutional and one having to do with accounting technicalities. And he’s right: neither of them is particularly complex.
Deduction vs. reduction
According to Mann, the 16th Amendment to the U.S. Constitution, which created the federal income tax, makes it clear that only “income” may be taxed. But for the years in question, before California legalized REC, Harborside had little or no income to be taxed. Some years it lost money.
It had revenue, of course, but little or no profit, which is a synonym for “income,” and the basis for taxation. “The common sense definition is the technical definition,” Mann said. “It’s what it meant in 1913 [when the 16th Amendment was passed] and it’s what it means now.” The IRS, in essence, is trying to levy a tax on nothing, he said.
The second argument rests on the definition of “cost of goods sold,” or COGS. Companies deduct expenses directly related to those costs to arrive at their taxable income. It generally includes things like the goods themselves, shipping, and the salaries of people involved in producing and preparing the goods for sale. It generally does not include things like rent, utilities, and administrative costs such as the salaries of human-resources personnel.
Think of it as the difference between a “deduction,” which is subtracted from taxable income, and a “reduction,” which is subtracted from gross income to determine taxable income. Section 280E only applies to deductions. The IRS alleges that Harborside improperly categorized deductions as reductions, or as COGS.
But those expenses, Mann argues, were all directly related to COGS. They included the salary of an “inventory acquisition specialist” (that is, a buyer) and the costs of testing and moisture control. To Mann, the bottom line is that, in the absence of those activities, Harborside would have had nothing to sell. Obviously, weed has to be procured, it must be made salable by moistening or drying it, and by state law, it must be tested for potency and purity. They are direct costs of the good sold. “It’s really no more complicated than that,” Mann said.
The Harborside case may drag on for quite a while yet. The government’s response is due Aug. 24, but could be delayed again. Then Harborside will file a counter-response within a few weeks. Normally, a decision might be expected about six months later, but with Covid slowing the courts, Mann thinks it might be another year before the appeals court reaches a decision.
Whatever that decision is will have huge implications for the cannabis business. Even if weed is legalized by then, and as a result treated just like every other tax-paying industry, the IRS can always bring more cases based on previous years. “Tax laws change only prospectively,” Mann noted. In other words, there will likely be no “expungement”-like programs for people accused in federal tax cases.
Last week’s column also discussed another section of the Tax Code, this one much newer. In the 2018 Tax Cuts and Jobs Act, Congress included a provision, Section 471C, which allows all companies with less than $25M in revenue to apply all their expenses to COGS. I quoted lawyers and tax professionals on both sides of the question of whether this amounts to a loophole for cannabis companies to get around 280E.
Mann thinks it does, though it wouldn’t apply to Harborside (the law wasn’t passed until after the years in which it alleges Harborside underpaid its taxes; also, Harborside isn’t small enough anymore to be eligible). For smaller companies, though, Mann believes the 2018 law supersedes 280E. “A notable feature of tax law is that it applies to all taxpayers equally,” he said. “Section 471C was written to apply to all small businesses, including cannabis.”
The matter hasn’t been adjudicated, and some lawyers still advise that a cannabis company applying, say, its rent to COGS might draw unwanted attention from the IRS. Mann’s response? “That’s just silly.”
Maybe, but it might be a good idea to talk to a tax lawyer before claiming it.
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