Any news article focused on "section 280E of the Internal Revenue Code" is bound to sound like a snooze. But in a case involving the Oakland-headquartered Harborside cannabis dispensary, that part of the U.S. tax code reveals the perversity of cannabis being illegal at the federal level, but legal in numerous states. How the courts decide the case will have ramifications throughout the legal cannabis industry.Eleven million dollars is at stake for Harborside, which deducted expenses on its 2007–2012 tax forms. In 2018 the U.S. Tax Court ruled Harborside was liable for $11 million in illegal deductions. Section 280E disallows deductions and credits for income gained from the sale of illegal controlled substances. That pot was not only legal in California and 10 other states, but also had official government sanction at the state level, had no bearing on the matter.
Harborside filed an appeal last month, asking the Ninth Circuit Federal Court of Appeals to reverse the tax court's decision. The National Cannabis Industry Association, the Marijuana Industry Group and the Cannabis Trade Federation all filed briefs on the case in support of Harborside.
By some estimates, Section 280E yields an effective tax rate of 70 percent on cannabis businesses.
Harborside bases its appeal on the U.S. Constitution. The 16th Amendment allows the federal government to tax "income." In disallowing basic deductions, like those for business expenses, the government forces Harborside and other cannabis businesses to pay taxes "even in the absence of gain," according to the appeal. "Harborside is forced to pay taxes in years when it is losing money," and the IRS rule "fabricates gain where there was none and imposes a tax based on artificial income."
At the core of the case is which expenses can be considered "cost of goods sold." Normally, this includes shipping and expenses directly related to getting merchandise on the shelves. Earlier case law concluded cannabis companies are allowed to take deductions on the cost of goods sold. But which expenses are and are not allowed to be used for these deductions remains a point of contention. In recent years, the IRS stepped up audits of cannabis companies, in part looking for deductions that may run afoul of 280E. So merciless has the agency been that a former IRS official, William Fowler, in a March column for Marijuana Business Daily, advised cannabis companies to fold. If the government says you owe money, he advises: "Settle with the IRS rather than going to battle in U.S.Tax Court." The expense and inevitable loss aren't worth it, he wrote.
Harborside didn't get the memo, and probably would have torn it up if it had.
The government's response to the appeal is expected next month.
Harborside suffered big losses in May and early June, when it was looted during protests. Before that, it struggled from its ill-fated merger with a Canadian cannabis company, as well as with high taxes and illicit weed sellers who offer much lower prices. CEO Andrew Berman left the company last fall, as Harborside and the rest of the industry suffered from a shortfall of revenues and an absence of profits. He was replaced by interim CEO Peter Bilodeau.
Harborside's revenues increased by 16 percent in 2019, but only part of that was from retail sales, which grew by just 5 percent. The rest of the increase came from its wholesale operations, which rose 99 percent over 2018. The company is not profitable and reports that it has about $12 million in cash on hand—just $1 million more than what the government says it owes.