Considerations for Cannabis Companies and Investors Following Tax Court Decision on Harborside Health Center
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 it is treated as a C-corporation for federal income tax purposes. On November 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. This decision applies the case of Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner, 128 T.C. 173 (2007) (“CHAMP”) 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 the 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:
1. It did not have separate trades or businesses, so it could not deduct non-cannabis business expenses;
2. It could not apply uniform capitalization under § 263A (“UNICAP”) to increase its cost of goods sold; and
3. 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 that we see in the market. Given this ruling, companies and investors:
1. Should be cautious when relying on CHAMP and should not liberally interpret CHAMP.
2. Should only separate the non-cannabis activities from the cannabis business if you have a very strong factual support for this position.
3. Should not apply uniform capitalization UNICAP to determine 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. This ruling does not allow that position.
4. 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 you have an IRS exposure, you should 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.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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