Late last year, the Tax Court published its opinion in Patients Mutual Assistance Collective Corp. (d.b.a. Harborside Health Center) v. Commissioner, 151 T.C. 11 (2018). Harborside is a medical cannabis dispensary operating legally under California law and treated as a C-corporation for federal income tax purposes. On Nov. 29, 2018, the Tax Court analyzed the application of IRC §280E (which generally disallows business expense deductions for cannabis companies) to a cannabis community health organization in California. The decision applies the case of Californians Helping to Alleviate Med. Problems, Inc. (CHAMP), v. Commissioner, 128 T.C. 173 (2007) to one of the largest cannabis dispensaries in the U.S. CHAMP held that, in the right circumstances, a taxpayer could deduct expenses that were unrelated to cannabis activities.
Harborside argued that it had several lines of business and that it should be allowed to deduct expenses from the non-cannabis businesses.
The Tax Court ruled against Harborside on all issues, ruling that:
- It did not have separate trades or businesses, so it could not deduct non-cannabis business expenses;
- It could not apply uniform capitalization under §263A (UNICAP) to increase its cost of goods sold; and
- It must apply less-favorable tax inventory rules for distributors since it is not a cannabis producer.
The Tax Court’s decision in Harborside could replace CHAMP as the preeminent court opinion for cannabis companies since Harborside’s operations are like business lines and structures seen in the market. Given the ruling, companies, and investors:
- Should be cautious when relying on CHAMP, and should not liberally interpret CHAMP.
- Should only separate non-cannabis activities from the cannabis business if provided a very strong factual support for that position.
- Should not apply uniform capitalization UNICAP to determine the cost of goods sold (COGS). UNICAP generally requires additional indirect costs to be capitalized to ending inventory, which would have allowed cannabis businesses a greater cost recovery. The ruling does not allow that position.
Pay close attention to compliance in all areas and follow best practices, because there is a significant risk of IRS oversight.
Companies should examine prior-year tax returns to make sure they were filed per the Harborside decision. Primarily, it is important to check that UNICAP was not applied to ending inventory to increase the cost of goods sold. If any business expenses were deducted, make sure those business lines are factually separate from the cannabis business. If a company has IRS exposure, it ought to consider filing amended returns.
This case could also affect mergers and acquisitions of cannabis companies, as the increased IRS risk exposure might result in deals not closing.
For tax return preparers, making recommendations contrary to the Harborside case could subject preparers to penalties and even loss of ability to practice before the IRS, not to mention the potential for malpractice lawsuits.
Full story is available here.