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In the latest Tax Court opinion addressing the application of Section 280E to cannabis businesses there is no good news. However, there is some new guidance.  In Patients Mutual Assistance Collective Corp. v. Comm’r, 151 T.C. No. 11, the taxpayer made a litany of arguments to convince the court that their business, or a portion of their business was not subject to Section 280E.  These include arguments we have seen before, including (1) that the business was not trafficking in controlled substances, here, because the government had abandoned a civil forfeiture action, and (2) that because a portion of the business involved branding and the sales of non-marijuana products, deductions related to these operations should not be subject to Section 280E.  These arguments failed and only make it clear that similar arguments are likely to be unavailing.  In fact, the Court spends ten pages discussing why the entire business is integrated and subject to Section 280E.  Taxpayers hoping to establish a separate trade or business that is not subject to Section 280E now have clarity, but also an extremely high bar.

New Holdings:  Inventory Accounting Rules

The new developments addressed in this case involve the application of inventory rules to cannabis businesses.  Previous cases focused primarily on the previously discussed arguments and failed to give any detailed guidance on how to apply the inventory rules.  The Court clearly and strongly concluded that the more expansive Section 263A  inventory cost rules do not apply to businesses subject to Section 280E.  The Court reasoned that “if something wasn’t deductible before Congress enacted section 263A, taxpayers cannot use that section to capitalize it. Section 263A makes taxpayers defer the benefit of what used to be deductions-it doesn’t shower that as grace on those previously damned.”  Slip Op. at 53.

The Court’s conclusion is based on the notion that we go back in time to 1982 to determine what is includible in inventory costs.  The Court refers to Treas. Reg. section 1.263A-1(c)(2) which states:

Any cost which (but for section 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale under section 263A and the regulations thereunder. Thus, for example, if a business meal deduction is limited by section 274(n) to 80 percent of the cost of the meal, the amount properly allocable to property produced or acquired for resale under section 263A is also limited to 80 percent of the cost of the meal.

While this reasoning is understandable, if we turn the question on its head, we could also ask whether the section 280E disallowance is determined before or after inventory costs are calculated.  For example, even if there is a meals and entertainment expense that is clearly includible in inventory costs, no one is going to argue that 100% of meals and entertainment is includible in inventory costs.  In this case, you are determining inventory costs and deductions, and then applying Section 274.   So, it is easy to see how those provisions overlap.  However, if inventory costs are determined based on the applicable inventory rules and then Section 280E is applied, then you have a different result because Section 263A expands what can be included in inventory costs, and the remaining deductions are subject to Section 280E.  That result is not inconsistent with the notion that items such as meals and entertainment and penalties are not deducted in determining taxable income regardless of whether they are a deduction under Section 162 or an inventory cost under Section 471 or 263A.

The Harsh Result

It is important to note that the Court analyzed and concluded that the taxpayer was a reseller and not a producer.  Because the taxpayer did not itself grow marijuana, this is not surprising.  The Section 471 rules that apply to resellers do not allow for extensive indirect costs to be included in inventory.  Thus, for businesses that do not produce or manufacture, they will continue to face significant challenges by the IRS if they are including indirect costs in inventory costs.  For cultivators and producers, careful consideration should be given to how the 471 rules apply, depending on the activities of the business.

Still to Come

The Court reserved its analysis of whether penalties apply for a opinion to be issued at a later date.  However, the Court hints that there might be some relief when it states that the overlap between Section 280E and 263A created a “confusing legal environment.”  One can hope that given the lack of guidance addressing the specifics of how the inventory rules apply to cannabis businesses, the IRS and the court will give taxpayers  doing their best to apply Section 280E the benefit of reprieve from penalties.

Other Notes

If you are entertained by Judge Holmes’ opinions, be sure you read the footnotes.  Footnotes 3 and 6 are my favorites.

Nevada legalized the recreational adult-use of marijuana on July 1, 2017 and the state has generated millions in tax revenue as a result. Nonetheless, the Nevada Regulation and Taxation of Marijuana Act (the “Act”) provides that until November 2018, only registered marijuana certificate holders may apply for recreational retail marijuana establishment licenses. The Nevada Department of Taxation (the “Department”) ceased accepting applications at 2017 year’s end.

Nevada state flag on cannabis backgroundThe Act further provides that at least once a year, the Department will determine whether additional marijuana establishments are necessary to support the demand in the state. It was anticipated the Department would begin accepting recreational retail marijuana establishment licenses again in November 2018.

On July 6, 2018, the Department issued a notice of its intent to begin accepting applications for recreational retail marijuana establishment licenses. The notice came sooner than expected, but there’s a catch! The Department is accepting applications under two (2) conditions: (1) the applicant must be a registered medical marijuana establishment certificate holder; and (2) the applicant must be in “good standing” with the Department. The plus side is that such applicants may apply for one (1) or more recreational retail marijuana establishment licenses.

For those prospective applicants meeting the two (2) foregoing conditions, they must act fast. The application acceptance period lasts only ten (10) days – from September 7-20, 2018 (excluding weekend days).

In addition, prospective applicants should not expect to be open for business anytime soon. The application review period begins September 7, 2018 and extends to December 5, 2018. The Department will award conditional licenses no later than December 5, 2018.

There’s another catch! Conditional license holders must be fully operational no later than twelve (12) months following the issuance of a conditional license. If the establishment is not fully operational after twelve (12) months following the issuance of a conditional license, the establishment must surrender the license to the Department, unless an extenuating circumstance applies.

The application can be found on the Nevada Department of Taxation website.

In November 2018, the Department may open up the applicant pool to all persons interested in submitting an application to operate a recreational marijuana establishment – emphasis on may.

Tax and calculator buttonsToday, the Tax Court issued its opinion in Feinberg v. Commissioner, a case involving an ongoing and hard fought battle between the IRS and a medical marijuana dispensary, Total Health Concepts, LLC.  The IRS examined THC’s 2009 through 2011 tax returns.  As a result of the examination, the IRS adjusted the member taxpayers’ returns to reflect a cost of goods sold allowance in excess of the amount originally claimed on the return by reclassifying expenses that were originally claimed as below-the-line expenses.  However, the IRS also disallowed expenses not reclassified as cost of goods sold.  Accordingly, the IRS computed deficiencies on the member’s individual tax returns.

During earlier phases of this case, the taxpayer argued that the Commissioner did not have jurisdiction to administratively determine whether petitioners committed a federal crime outside of the U.S. tax code, that section 280E as applied by the Commissioner is unconstitutional as it violates petitioners rights against self-incrimination under the Fifth Amendment of the Constitution, and that section 280E exceeds the authority granted to Congress under the Sixteenth Amendment of the Constitution.  The Tax Court denied the taxpayer’s request for summary judgment and compelled them to respond to IRS discovery requests.  The taxpayer’s sought a writ of mandamus, seeking review of the Tax Court’s order compelling them to produce documents.  The Tenth Circuit determined that if the discovery request harmed them, the proper time to address that harm would be after the Tax Court case was fully resolved.  As a result, the taxpayer’s case proceeded to trial.

At trial, the taxpayer did not submit documentation to substantiate the cost of goods sold allowance or the ordinary and necessary business expenses.  Instead, an expert report was submitted to substantiate a cost of goods sold allowance in excess of what the IRS allowed during the examination.  The Tax Court ruled that the expert report was unreliable because it contained statements which failed to refer to underlying source information, failed to include underlying source information which the expert relied upon, and failed to include sufficient information and data to support the report’s conclusions.  As a result, the expert report was inadmissible.

Next, the court looked to evidence which would support a higher cost of goods sold allowance than the allowance determined in the IRS report.  Without documentation, the court concluded that the IRS determination of cost of goods sold would stand.  Further, because there was no substantiation of ordinary and necessary business expenses claimed under Section 162, the court determined that it did not need to address the application of Section 280E (the code section which disallows ordinary and necessary business deductions for businesses trafficking in controlled substances).

What is the lesson here?  This case provides no guidance on the limits that will be applied to cannabis companies in determining cost of goods sold.  Rather, this case tells us that a cannabis company should prepare for an IRS examination the same way any other taxpayer should, by maintaining documentation to support the deductions claimed on the return and by provided that documentation when the IRS requests it.  This is especially true in this case, where the court determined that “there was not enough evidence in the record to make a finding of fact that THC sold medical marijuana.”  Based on this statement, if the taxpayer would have substantiated its below-the-line expenses, they would not have been subject to Section 280E, which would have been a huge win for the taxpayer.

In advance of a Senate Judiciary Committee hearing held June 19, 2017, New Jersey State Senator Nick Scutari released the text of Senate, No. 3195, or SB 3195, the long-awaited bill legalizing cannabis in New Jersey. In a statement announcing the bill in mid-May, Senator Scutari, the bill’s sponsor, stated, “Now is the time to begin shaping New Jersey’s recreational marijuana program. We will have a new governor next year and we should be prepared to move forward with a program that ends the prohibition on marijuana and that treats our residents fairly and humanely.”

New Jersey map outline
Copyright: adamgolabek / 123RF Stock Photo

Governor Chris Christie, an ardent opponent of legalization, once famously remarked that tax revenue generated by legalization of marijuana should be considered “blood money.” As a result, the legislature is not expected to vote on the bill until 2018, when Governor Christie is out of office.

Senator Scutari and other New Jersey legislators took trips to Colorado to see their legalization framework firsthand. The effect is a bill that closely resembles Colorado’s version. SB 3195 proposes the following:

  • Legalizing the possession of one ounce of marijuana flower, seven ounces of concentrate, 16 ounces of edible products infused with cannabis, seven grams of cannabis concentrate, and 72 ounces of infused liquid for adults over 21 years of age
  • Elimination of sales tax on medical cannabis purchases and installing a staggered sales tax schedule on recreational purchases. The tax rate the first year is proposed to be 7%, 10% in year two, and then increase by 5% each year after that until reaching 25%
  • Expunging criminal charges related to possession of marijuana
  • Creating a new division within the Office of the Attorney General that would be specifically charged with overseeing the legalization program

As drafted, SB 3195 prohibits home cultivation of cannabis. While stating that he would be open to negotiating that element of the bill, Senator Scutari noted the difficulties that Colorado and other states have experienced in regulating and controlling home cultivation. Those states impose limits on home cultivation, but enforcement of those limits has proven challenging.

A study by New Jersey Policy Perspective and New Jersey United for Marijuana Reform estimated that legalizing cannabis could bring $300 million in new tax revenue in year one.

See my posts here, here, and here regarding the Florida Legislature’s efforts to pass laws to implement Amendment 2 (medical marijuana passed by Florida’s voters in November 2016).

Unless a special session is called, the Florida Legislature closes out this session with no agreement on medical marijuana.  Issues related to the number of grower licenses and how those licenses would be linked to storefronts created an insurmountable disagreement.

Supposedly and ironically, the pro-cannabis powers were instrumental in the demise of medical marijuana in the legislature.  The issue of  how many storefronts the current license holders (7 at present) could operate has been a large part of the debate.  The Senate wanted to cap the number of retail locations for each license holder so that these 7 license holders could not consolidate too much market power.

With the failure by the Florida Legislature, that means Florida’s Department of Health, under Governor Rick Scott, will now be responsible for creating regulations for Amendment 2.  That does not bode well for the cannabis industry or patients, since Gov. Scott is anti-medical marijuana.

24982680 - state supreme court building in tallahassee, florida.

Also expected, fierce litigation from patients, physicians and businesses now that the legislature has failed.

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Dori K. Stibolt is a West Palm Beach, Florida based partner with the law firm of Fox Rothschild LLP.  She focuses her practice on litigation and labor and employment issues.  You can contact Dori at 561-804-4417 or dstibolt@foxrothschild.com.

With time running out in the session, Florida’s Senate passed SB 406 (regulations to implement Amendment 2) late last night.  Now, the Florida Senate and House need to work out their differences, see my recent post on the House Bill.

Florida’s Senate and House have reached agreement on the following:

  • No smoking, but yes to vaping and edibles.
  • A House requirement that doctors must wait 90 days after meeting with a patient to issue a prescription has now been eliminated.

5904975 - the old florida state capital building in tallahassee sits in front of the new modern capital building which can be seen rising in the background. the old capital building is now a museum.

The ban on smoking remains controversial.  My own state senator, Jeff Clemens, remains critical and had this to say.

There are people out there who this is still not going to help, there are people who only get the relief that they need through smoking.

The differences that need to be worked out between the House and Senate include the big issue of the number of licenses allowed for growers/distributors.  As I noted in my earlier post, the House’s Bill included unlimited retail locations for license holders, but limited the number of licenses.  To force the House on the issue of limited licenses, and to limit any one company from becoming too dominant, the Senate put a cap on the number of retail dispensaries each license holder can operate.

Florida for Care, the group that led the campaign to pass the marijuana amendment, supports the Senate’s position on the number of licenses noting the Senate Bill:

would allow for the marijuana industry to grow alongside the patient population, providing competition and reasonable access.

The House and Senate also disagree on the tax treatment for medical marijuana, the House proposes it be tax free.

With just a couple days left in the session, we’ll see if the differences can be ironed out between the two bills.  Either way, litigation is likely.  If the Florida legislature fails to pass a bill implementing Amendment 2, any Floridian can sue.  Litigation is also likely if the Florida legislature passes a bill that bans smoking of medical marijuana or overly limits the number of licenses.

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Dori K. Stibolt is a West Palm Beach, Florida based partner with the law firm of Fox Rothschild LLP.  She focuses her practice on litigation and labor and employment issues.  You can contact Dori at 561-804-4417 or dstibolt@foxrothschild.com.