In brief, the California medical marijuana dispensary was deducting business expenses and capitalizing indirect COGS. The court had determined that the dispensary’s sole business was trafficking a schedule I narcotic, and section 280e prevented it from deducting those expenses. Additionally, the dispensary was considered a reseller and should have been calculating COGS using section 471 and was liable for inaccuracy-related penalties.
The dispensary argued that it was a legitimate business and should be able to deduct expenses, as it was legal in California. However, the Commissioner stated that the business was just a large drug trafficker and unentitled to the normal business deductions, unable to capitalize its indirect costs into its inventory, and subject to penalties for taking those deductions. Harborside stated that the commissioner should not pursue something that was dropped by the Federal government. Under the Federal marijuana laws, even medical marijuana prescribed by a physician is considered prohibited. California law differs.
California law provides an exemption for those who are using marijuana for medicinal purpose that was prescribed/approved by a physician. This is known as the California Compassionate Use Act of 1996 (CCUA). In 2006, Harborside opened its doors to the medical marijuana market. The business grew to about 100,000 patients per year. While it was a dispensary, it operated much like a clinical setting. The revenues generated were phenominal. It operated within the laws of California and made all efforts to divert from the illegal market.
All seemed well, until 2012, when the federal government filed a civil forfeiture action. The case was dropped by stipulation of the parties. This brought on the attention of the IRS. The IRS defended 280e, while Harborside defended 280e is predated and not relevant to the current position. Congress asked the IRS to provide updated guidelines for 280e; however, the IRS said that it could not do that unless Congress amended the Controlled Substances Act.
Harborside said that it was still allowed to take expense deductions as a normal business due to the numerous operations it had; however, the opinion was that each of the operations could not profit as a stand-alone entity. Harborside had a retail operation where it sold hats, t-shirts, etc. Each operation under the parent company must be able to operate as a stand-alone business. While Harborside argued successfully to each of its operations as a stand-alone entity, the IRS was still pursuing inaccuracy-related penalties on how the COGS was recorded in books/tax. As a result, the taxes as penalties were lowered than originally sought. The hope of Harborside was that other cannabis business could avoid the teeth of the 280e audit in states where cannabis has been legalized. To ensure you are 280e audit compliant, call us for a free consultation.