Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner
This text of 151 T.C. No. 11 (Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner) is published on Counsel Stack Legal Research, covering United States Tax Court primary law. Counsel Stack provides free access to over 12 million legal documents including statutes, case law, regulations, and constitutions.
Opinion
151 T.C. No. 11
UNITED STATES TAX COURT
PATIENTS MUTUAL ASSISTANCE COLLECTIVE CORPORATION d.b.a. HARBORSIDE HEALTH CENTER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 29212-11, 30851-12, Filed November 29, 2018. 14776-14.1
California medical-marijuana dispensary P deducted I.R.C. section 162 business expenses and adjusted for indirect COGS per the I.R.C. section 263A UNICAP rules for producers. R determined that P’s sole trade or business was trafficking in a controlled substance and that I.R.C. section 280E prevented it from deducting business expenses. R also determined that P had to calculate COGS using the I.R.C. section 471 regulations for resellers and was liable for accuracy-related penalties. P argued that I.R.C. section 280E didn’t apply to it, that it was a producer, and that a dismissed civil-forfeiture action precluded a deficiency action.
1 We consolidated the cases at docket numbers 29212-11, 30851-12, and 14776-14 for trial, briefing, and opinion. -2-
Held: The Government’s dismissal with prejudice of a civil- forfeiture action against P does not bar deficiency determinations.
Held, further, I.R.C. section 280E prevents P from deducting ordinary and necessary business expenses.
Held, further, during the years at issue P was engaged in only one trade or business, which was trafficking in a controlled substance.
Held, further, P must adjust for COGS according to the I.R.C. section 471 regulations for resellers.
Henry G. Wykowski and Christopher A. Wood, for petitioner.
Nicholas J. Singer and Julie Ann Fields, for respondent.
HOLMES, Judge: Patients Mutual owns what may well be the largest
marijuana dispensary in America. To the Commissioner that just makes it a giant
drug trafficker, unentitled to the usual deductions that legitimate businesses can
claim, unable even to capitalize its indirect costs into its inventory, and subject to
penalties for taking contrary positions on its tax returns for the tax years ending
July 31, 2007 through 2012. Patients Mutual wants to be treated like any other
business because it follows California law, it does more than distribute marijuana,
and the federal government already decided not to pursue a civil-forfeiture action
against it. -3-
FINDINGS OF FACT
I. California Medical-Marijuana Law
Under federal law marijuana is a Schedule I controlled substance. See
Controlled Substances Act, Pub. L. No. 91-513, sec. 202, 84 Stat. at 1249
(codified as amended at 21 U.S.C. sec. 812 (2012)). This means that under federal
law the manufacture, distribution, dispensation, or possession of marijuana--even
medical marijuana recommended by a physician--is prohibited. See id. sec.
841(a); Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner
(CHAMP), 128 T.C. 173, 181 (2007) (citing United States v. Oakland Cannabis
Buyers’ Coop., 532 U.S. 483 (2001)).
Under California law, things are somewhat different. In 1996 California
voters adopted Proposition 215--the California Compassionate Use Act of 1996
(CCUA)--to “ensure that seriously ill Californians have the right to obtain and use
marijuana for medical purposes.” See Cal. Health & Safety Code sec.
11362.5(b)(1)(A) (West 2007). The CCUA provides an exemption from
California laws penalizing the possession and cultivation of marijuana for patients
and their primary caregivers when the possession or cultivation is for the patient’s
personal medical purposes and recommended or approved by a physician. Id. sec.
11362.5(d). California later legalized collective or cooperative cultivation of -4-
marijuana for medicinal purposes. Id. sec. 11362.775; see also People v. Colvin,
137 Cal. Rptr. 3d 856, 860 (Ct. App. 2012). These laws led to the formation of the
first marijuana dispensaries.2
II. DeAngelo and Harborside
Steve DeAngelo saw these early dispensaries--which he described as being
run by either well-meaning marijuana activists with no business experience or
“thug operators”--and realized patients needed a better option. So in 2005
DeAngelo cofounded Patients Mutual Assistance Collective Corporation d.b.a.
Harborside Health Center (Harborside) to be the “gold standard” in medical-
marijuana dispensaries. His goal was to create a place where marijuana could be
distributed responsibly, that was focused on patient care, and that provided
benefits to both patients and the community. Harborside opened its doors in
October 2006 and has grown into a booming business with more than 100,000
patient visits per year. It also generated a gusher of revenue during the years at
issue:
2 On November 8, 2016, California voters adopted Proposition 64, which made recreational marijuana use legal under California law. See Cal. Health & Safety Code sec. 11362.1 (West 2017). -5-
Nonmarijuana Marijuana sales Marijuana Year sales revenue revenue Total revenue percentage 2007 $487 $5,448,635 $5,449,122 99.99 2008 3,990 10,916,914 10,920,904 99.96 2009 16,878 17,334,597 17,351,475 99.90 2010 42,492 22,047,372 22,089,864 99.81 2011 58,588 20,895,823 20,954,411 99.72 2012 320,651 25,199,997 25,520,648 98.74 Total 443,086 101,843,338 102,286,424 99.57
At all relevant times Harborside operated out of an approximately 7,500-square-
foot space that had a reception area, healing room, purchasing office, processing
room, clone room, and multipurpose room. The facility also had a large sales
floor, offices, storage areas, restrooms, and a break room with a kitchen.
But operating a dispensary is no small task. DeAngelo had to make sure
Harborside complied with California and local laws. This included getting proper
permits, running as a nonprofit, and operating under a “closed-loop” system.
Harborside interpreted the “closed-loop” requirement to mean that all of its
marijuana must be provided by its patients; sold exclusively to its patients;
handled only by its employees, all of whom were its patients; and not diverted into
the illegal market. How Harborside achieved all of this is important, so we will
start with how Harborside sourced and processed its inventory. -6-
A. Sourcing and Processing
Harborside sold a wide variety of products, which we will divide into four
main groups--clones, marijuana flowers, marijuana-containing products, and non-
marijuana-containing products.
1. Clones
Clones are cuttings from a female cannabis plant that can be transplanted
and used to cultivate marijuana. Harborside bought clones from clone nurseries,
cared for them while they were in its store, repackaged them, and then sold them
to its patients. It stored the clones in a clone room and sold them at a clone
counter--the portion of the floor space dedicated to clone sales. During the years
at issue Harborside had at least four employees who spent their time entirely in the
purchase and sale of clones.
2. Marijuana Flowers
The Court learned at trial that it’s not the leaves of the marijuana plant, but
its flowers--or buds--that people can smoke.3 Harborside purchased all of its
marijuana flowers from its patient-growers. Some of these growers promised to
sell what they cultivated back to Harborside, and Harborside gave them either
Free access — add to your briefcase to read the full text and ask questions with AI
151 T.C. No. 11
UNITED STATES TAX COURT
PATIENTS MUTUAL ASSISTANCE COLLECTIVE CORPORATION d.b.a. HARBORSIDE HEALTH CENTER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 29212-11, 30851-12, Filed November 29, 2018. 14776-14.1
California medical-marijuana dispensary P deducted I.R.C. section 162 business expenses and adjusted for indirect COGS per the I.R.C. section 263A UNICAP rules for producers. R determined that P’s sole trade or business was trafficking in a controlled substance and that I.R.C. section 280E prevented it from deducting business expenses. R also determined that P had to calculate COGS using the I.R.C. section 471 regulations for resellers and was liable for accuracy-related penalties. P argued that I.R.C. section 280E didn’t apply to it, that it was a producer, and that a dismissed civil-forfeiture action precluded a deficiency action.
1 We consolidated the cases at docket numbers 29212-11, 30851-12, and 14776-14 for trial, briefing, and opinion. -2-
Held: The Government’s dismissal with prejudice of a civil- forfeiture action against P does not bar deficiency determinations.
Held, further, I.R.C. section 280E prevents P from deducting ordinary and necessary business expenses.
Held, further, during the years at issue P was engaged in only one trade or business, which was trafficking in a controlled substance.
Held, further, P must adjust for COGS according to the I.R.C. section 471 regulations for resellers.
Henry G. Wykowski and Christopher A. Wood, for petitioner.
Nicholas J. Singer and Julie Ann Fields, for respondent.
HOLMES, Judge: Patients Mutual owns what may well be the largest
marijuana dispensary in America. To the Commissioner that just makes it a giant
drug trafficker, unentitled to the usual deductions that legitimate businesses can
claim, unable even to capitalize its indirect costs into its inventory, and subject to
penalties for taking contrary positions on its tax returns for the tax years ending
July 31, 2007 through 2012. Patients Mutual wants to be treated like any other
business because it follows California law, it does more than distribute marijuana,
and the federal government already decided not to pursue a civil-forfeiture action
against it. -3-
FINDINGS OF FACT
I. California Medical-Marijuana Law
Under federal law marijuana is a Schedule I controlled substance. See
Controlled Substances Act, Pub. L. No. 91-513, sec. 202, 84 Stat. at 1249
(codified as amended at 21 U.S.C. sec. 812 (2012)). This means that under federal
law the manufacture, distribution, dispensation, or possession of marijuana--even
medical marijuana recommended by a physician--is prohibited. See id. sec.
841(a); Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner
(CHAMP), 128 T.C. 173, 181 (2007) (citing United States v. Oakland Cannabis
Buyers’ Coop., 532 U.S. 483 (2001)).
Under California law, things are somewhat different. In 1996 California
voters adopted Proposition 215--the California Compassionate Use Act of 1996
(CCUA)--to “ensure that seriously ill Californians have the right to obtain and use
marijuana for medical purposes.” See Cal. Health & Safety Code sec.
11362.5(b)(1)(A) (West 2007). The CCUA provides an exemption from
California laws penalizing the possession and cultivation of marijuana for patients
and their primary caregivers when the possession or cultivation is for the patient’s
personal medical purposes and recommended or approved by a physician. Id. sec.
11362.5(d). California later legalized collective or cooperative cultivation of -4-
marijuana for medicinal purposes. Id. sec. 11362.775; see also People v. Colvin,
137 Cal. Rptr. 3d 856, 860 (Ct. App. 2012). These laws led to the formation of the
first marijuana dispensaries.2
II. DeAngelo and Harborside
Steve DeAngelo saw these early dispensaries--which he described as being
run by either well-meaning marijuana activists with no business experience or
“thug operators”--and realized patients needed a better option. So in 2005
DeAngelo cofounded Patients Mutual Assistance Collective Corporation d.b.a.
Harborside Health Center (Harborside) to be the “gold standard” in medical-
marijuana dispensaries. His goal was to create a place where marijuana could be
distributed responsibly, that was focused on patient care, and that provided
benefits to both patients and the community. Harborside opened its doors in
October 2006 and has grown into a booming business with more than 100,000
patient visits per year. It also generated a gusher of revenue during the years at
issue:
2 On November 8, 2016, California voters adopted Proposition 64, which made recreational marijuana use legal under California law. See Cal. Health & Safety Code sec. 11362.1 (West 2017). -5-
Nonmarijuana Marijuana sales Marijuana Year sales revenue revenue Total revenue percentage 2007 $487 $5,448,635 $5,449,122 99.99 2008 3,990 10,916,914 10,920,904 99.96 2009 16,878 17,334,597 17,351,475 99.90 2010 42,492 22,047,372 22,089,864 99.81 2011 58,588 20,895,823 20,954,411 99.72 2012 320,651 25,199,997 25,520,648 98.74 Total 443,086 101,843,338 102,286,424 99.57
At all relevant times Harborside operated out of an approximately 7,500-square-
foot space that had a reception area, healing room, purchasing office, processing
room, clone room, and multipurpose room. The facility also had a large sales
floor, offices, storage areas, restrooms, and a break room with a kitchen.
But operating a dispensary is no small task. DeAngelo had to make sure
Harborside complied with California and local laws. This included getting proper
permits, running as a nonprofit, and operating under a “closed-loop” system.
Harborside interpreted the “closed-loop” requirement to mean that all of its
marijuana must be provided by its patients; sold exclusively to its patients;
handled only by its employees, all of whom were its patients; and not diverted into
the illegal market. How Harborside achieved all of this is important, so we will
start with how Harborside sourced and processed its inventory. -6-
A. Sourcing and Processing
Harborside sold a wide variety of products, which we will divide into four
main groups--clones, marijuana flowers, marijuana-containing products, and non-
marijuana-containing products.
1. Clones
Clones are cuttings from a female cannabis plant that can be transplanted
and used to cultivate marijuana. Harborside bought clones from clone nurseries,
cared for them while they were in its store, repackaged them, and then sold them
to its patients. It stored the clones in a clone room and sold them at a clone
counter--the portion of the floor space dedicated to clone sales. During the years
at issue Harborside had at least four employees who spent their time entirely in the
purchase and sale of clones.
2. Marijuana Flowers
The Court learned at trial that it’s not the leaves of the marijuana plant, but
its flowers--or buds--that people can smoke.3 Harborside purchased all of its
marijuana flowers from its patient-growers. Some of these growers promised to
sell what they cultivated back to Harborside, and Harborside gave them either
3 The Court suspects, but makes no finding, that this may be why repurposed beer-marketing material--“This Bud’s for you”--seems to be common where marijuana is sold. -7-
seeds or clones to get started. Other growers, however, bought seeds and clones
from Harborside. However they acquired their starter supplies, growers who were
interested in selling to Harborside had to sign a cultivation agreement and were
encouraged to take one of Harborside’s free grow classes and follow its best-
practices guides.
Once a grower had cultivated, harvested, trimmed, flushed, dried, and cured
his marijuana buds, he would bring them to Harborside to sell. Harborside had a
purchasing office to inspect and test the incoming marijuana. Harborside would
reject marijuana if it wasn’t properly cured, if it hadn’t been sufficiently trimmed,
if it had an incurable safety issue such as pathogenic mold, or if it didn’t contain
the right “cannabinoid profile.” If, for example, Harborside was in need of a strain
of marijuana that was rich in CBD,4 it might reject a batch of marijuana that was
rich in THC.5 There were times Harborside rejected the “vast majority” of the bud
that growers brought in, and a grower whose marijuana was rejected got no
compensation (though he was free to sell it to another collective if he could).
4 CBD is the abbreviation for cannabidiol, a potent antiinflammatory compound. 5 THC stands for tetrahydrocannabinol, the compound in marijuana believed to be responsible for providing a euphoric effect, or “high”, as users call it. -8-
On the other hand, if Harborside agreed to buy the marijuana, it would
negotiate a price with the grower--typically enough to cover the grower’s actual
growing expenses and a reasonable amount for his time and labor. It stored the
marijuana in a vault--a reinforced concrete room with a bank-vault door and
biometric locks--and sent a sample of the marijuana out for testing by a third-party
laboratory. If all went well, the marijuana would go to a processing room where it
was reinspected, remanicured, retrimmed, and then weighed, packaged, and
labeled. Harborside staff would put it on display on the sales floor or put it back
in the vault until needed. Harborside had at least three employees dedicated to
acquiring inventory, at least four devoted to managing inventory, and still others
whose sole job was to process the bulk marijuana and ready it for resale.
3. Marijuana-Containing Products
Harborside’s marijuana-containing products included edibles, beverages,
extracts, concentrates, oils, topicals, and tinctures--marijuana-infused alcohol,
vinegar, or glycerin. Harborside bought these items from other collectives, tested
them, repackaged them if they came in bulk or needed child-proof packaging,
relabeled them, and then sold them to its own patients. Harborside’s human-
resources director credibly estimated that about 55% to 60% of its employees’ -9-
total time was spent on buying and processing marijuana--both the buds and
marijuana-containing products--and another 25% to 30% selling it.
4. Non-Marijuana-Containing Products
Harborside also sold non-marijuana-containing products. These included
branded gear such as shirts, hats, and pins; nonbranded gear such as socks and
hemp bags; and a variety of other products including books, dabbing equipment,6
rolling papers, and lighters. Harborside bought these items from outside vendors,
stored them, and resold them to patients. Depending on the volume on hand,
Harborside stored the non-marijuana-containing products on the sales floor and in
one or more of its various storage rooms. A little less than 25% of the sales floor
was used to display and sell these items and around 5% to 10% of Harborside’s
employees’ time was dedicated to buying and selling these entirely legal products.
B. Sales and Pricing
Harborside took great care to avoid its marijuana’s leaking into the black
market. For example, no one could enter the sales floor without going through a
“very rigorous identification process.” This process required new patients to
6 “Dabbing” means heating products that contain marijuana so as to create an intoxicating vapor. It may or may not have a connection to the strange fad among the young that seems to consist of pointing to the sky with one arm while putting one’s face in the crook of the other arm while seeming to sneeze or sniff. - 10 -
present valid photo IDs, have written recommendations from physicians licensed
to practice in California, sign a collective cultivation agreement giving other
Harborside patients the right to cultivate marijuana on their behalf, and agree to
abide by Harborside’s rules and regulations. Harborside also sold its marijuana at
a premium above the black-market rate to discourage its patients from reselling it.
The exact method used to determine the sale price is unclear from the record, but
DeAngelo testified that Harborside looked “at [its] general overall picture and
determined the margin that we needed to place on every bit of cannabis that came
in.”
C. Community Outreach
With premium prices, however, come significant profits. Harborside is a C
corporation for federal tax purposes,7 but to comply with California’s nonprofit
requirement,8 its bylaws prohibited it from paying dividends or selling equity, and
7 The IRS has determined that a marijuana dispensary generally cannot qualify as a tax-exempt organization under section 501(c)(3) because it is engaged in what federal law regards as a criminal enterprise and thus is not operated exclusively for charitable purposes. Rev. Rul. 75-384, 1975-2 C.B. 204; see also Priv. Ltr. Rul. 201224036 (June 15, 2012). (Unless we say otherwise, all section references are to the Internal Revenue Code in effect for the years at issue.) 8 California laws decriminalizing medical marijuana specifically stated that they did not “authorize any individual or group to cultivate or distribute cannabis for profit.” Cal. Health & Safety Code sec. 11362.765(a) (West 2007). - 11 -
required it to use any excess revenue for the benefit of its patients or the
community. To this end, Harborside provided its patients with a wide variety of
services at no additional cost. It told patients during their orientation--and again
with signs on the premises--that part of the purchase price of the marijuana would
be used to pay for patient services and community outreach. But patients were not
required to buy marijuana to use the services.
The services included one-on-one therapeutic sessions for reiki,
hypnotherapy, naturopathy, acupuncture, and chiropractic consultations as well as
group sessions for yoga, qigong, the Alexander technique, and tai chi. Harborside
also offered grow classes, support groups, addiction treatment counseling, and a
“sliding scale program” that gave discounts to patients with financial difficulties.
All of the services were coordinated by Harborside’s holistic-services director and
took place in either Harborside’s healing room or its multipurpose room.
Harborside footed the bill and paid the service providers--all of whom were
independent contractors. The total amounts paid were: - 12 -
Year Amount 2007 $30,290 2008 93,341 2009 119,884 2010 144,441 2011 141,926 2012 150,466
D. Administrative Functions
Harborside had other employees in support roles. The security department,
for example, spent most of its time checking in both patients and vendors and then
escorting vendors into the back of the building to meet with a purchasing manager.
Harborside’s human-resources director estimated that the security group spent
60% of its time checking in patients who came to buy marijuana, another 5%
checking in people on site to receive a service, and the rest in assisting vendors.
Harborside also had an administrative group, which included employees in its
ombuds,9 finance, human resources, and facilities departments as well as its
executives.
9 This is not a typo. It’s Harborside’s pun. - 13 -
III. Forfeiture Action
All seemed well until July 2012, when the federal government filed a civil-
forfeiture action in the U.S. District Court for the Northern District of California.
The lawsuit alleged that the property which Harborside rents and on which it
operates its business was subject to forfeiture because it was used to commit the
distribution, cultivation, and possession of marijuana in violation of 21 U.S.C.
sections 841(a)10 and 856.11 The action was dismissed with prejudice in May 2016
by stipulation of the parties.
IV. Tax Returns and Audit
The forfeiture action wasn’t Harborside’s only run-in with the federal
government--it also caught the attention of the IRS. Recall that Harborside is a C
corporation for federal tax purposes with tax years ending July 31. It filed Forms
1120, U.S. Corporation Income Tax Return, for 2007 to 2012 and later amended
its 2007, 2008, and 2009 returns. These returns were selected for audits that led to
10 Title 21 U.S.C. section 841(a)(1) (2012) states that “it shall be unlawful for any person knowingly or intentionally * * * to manufacture, distribute, or dispense, or possess with intent to manufacture, distribute, or dispense, a controlled substance.” 11 21 U.S.C. section 856(a)(1) states that it shall be unlawful to “knowingly open, lease, rent, use, or maintain any place, whether permanently or temporarily, for the purpose of manufacturing, distributing, or using any controlled substance.” - 14 -
the issuance of three notices of deficiency--one for 2007 and 2008, one for 2009
and 2010, and one for 2011 and 2012. The notices denied most of Harborside’s
claimed deductions and costs of goods sold, and asserted tens of millions in
deficiencies and accuracy-related penalties.
The IRS’s primary reason for its adjustments was that “[n]o deduction or
credit shall be allowed for any amount paid or incurred during the taxable year in
carrying on a trade or business that consists of trafficking in controlled
substances.”
Harborside filed timely petitions for all years at issue. Its principal place of
business was in California at all relevant times, so absent a stipulation by the
parties these cases are appealable to the Ninth Circuit. See sec. 7482(b)(1)(B).
OPINION
I. Background
The CCUA did not decriminalize marijuana in California. See, e.g., People
v. Harris, 52 Cal. Rptr. 3d 577, 582 (Ct. App. 2006) (marijuana remained a
controlled substance under California law). It instead created an affirmative
defense to charges of possessing or cultivating marijuana for persons who did so
for personal, physician-approved use. Cal. Health & Safety Code sec. 11362.5(d); - 15 -
People v. Wright, 146 P.3d 531, 533 (Cal. 2006). Primary caregivers of such
persons could also raise the defense. Cal. Health & Safety Code sec. 11362.5(d).
In 2003 California enacted the Medical Marijuana Program Act (MMPA),
also known as Senate Bill 420 and now codified at California Health and Safety
Code sections 11362.7-11362.83. The MMPA extended the CCUA’s affirmative
defense to charges of transporting marijuana for patients and primary caregivers
who “associate within the State of California in order collectively or cooperatively
to cultivate marijuana for medical purposes.”12 Cal. Health & Safety Code sec.
11362.775; People v. Urziceanu, 33 Cal. Rptr. 3d 859, 883-84 (Ct. App. 2005). It
also instructed California’s attorney general to develop guidelines to “ensure the
security and nondiversion of marijuana grown for medical use.” Cal. Health &
Safety Code sec. 11362.81(d). Those guidelines stated that medical-marijuana
cooperatives should be formally organized, not operate for profit, maintain
business licenses and permits, pay tax, verify each member’s status as a patient,
execute an agreement with each member regarding the use and distribution of
12 The MMPA also set per-person quantity limits for harvested marijuana and marijuana plants, although the California Supreme Court invalidated these as impermissible amendments to the CCUA. People v. Kelley, 222 P.3d 186, 197- 200, 213-14 (Cal. 2010). Patients and caregivers were thereafter allowed to possess, cultivate, or transport whatever amount of marijuana was “reasonably related to the patient’s current medical needs.” Id. at 188 (quoting People v. Trippet, 66 Cal. Rptr. 2d 559, 570 (Ct. App. 1997)). - 16 -
marijuana, keep records of distribution, and neither buy marijuana from nor
distribute marijuana to nonmembers. Qualified Patients Assoc. v. City of
Anaheim, 115 Cal. Rptr. 3d 89, 97-98 (Ct. App. 2010); People v. Hochanadel, 98
Cal. Rptr. 3d 347, 356-58 (Ct. App. 2009); Cal. Att’y Gen., Guidelines for the
Security and Non-Diversion of Marijuana Grown for Medical Use 8-10 (2008).
Federal law did not follow. The conflict between federal and state law went
to the Supreme Court in 2005 when two California medical-marijuana users tried
to enjoin the U.S. Attorney General and the Drug Enforcement Agency from
enforcing federal marijuana law against them. See Gonzales v. Raich, 545 U.S. 1,
7 (2005). The Court upheld the federal prohibition on marijuana sale and
possession with respect to medical-marijuana users, both under the Commerce
Clause, U.S. Const. art. I, sec. 8, cl. 3, and the Supremacy Clause, U.S. Const. art.
VI, cl. 2. Raich, 545 U.S. at 22, 29.
One might think the Supremacy Clause would have stifled the spread of
state attempts at legalizing what remained illegal under federal law. But one
would be wrong. And Congress complicated the situation by enacting a series of
appropriations riders that prevent the Department of Justice (DOJ) from using any
funds “to prevent * * * [States that permit medical-marijuana use] from
implementing their own laws that authorize the use, distribution, possession, or - 17 -
cultivation of medical marijuana.” Consolidated Appropriations Act, 2017, Pub.
L. No. 115-31, sec. 537, 131 Stat. at 228; see also Consolidated Appropriations
Act, 2016, Pub. L. No. 114-113, sec. 542, 129 Stat. at 2332-33 (2015);
Consolidated and Further Continuing Appropriations Act, 2015, Pub. L. No. 113-
235, sec. 538, 128 Stat. at 2217 (2014). When interpreting such a rider, the Ninth
Circuit said that DOJ prosecutions of individuals who complied with state
medical-marijuana laws interfered with the implementation of such laws and were
therefore impermissible. United States v. McIntosh, 833 F.3d 1163, 1177-78 (9th - 18 -
Cir. 2016).13 So, medical marijuana is illegal under federal law, but the statutes
criminalizing it may not be enforced--at least not by the DOJ.
But the IRS is part of the Department of the Treasury, and marijuana sellers
must still contend with the Code. Here their major problem is section 280E, which
prevents any trade or business that “consists of trafficking in controlled
substances” from deducting any business expenses. Congress enacted this section
in 1982 as a response to our decision in Edmondson v. Commissioner, T.C. Memo.
1981-623, where we allowed a cocaine dealer to deduct the ordinary and necessary
expenses of his illicit trade. See S. Rept. No. 97-494, at 309 (1982), 1982
13 Note as well that these appropriations riders limit DOJ prosecutions of activity that would be legal under medical-marijuana laws. Thirty-three states now allow medical marijuana use: Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Illinois, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Missouri, Montana, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Utah, Vermont, Washington, and West Virginia. Nat’l Conference of State Legislatures, State Medical Marijuana Laws, Tbl. 1 (last updated Nov. 8, 2018), http://www.ncsl.org/research/health/ state-medical-marijuana-laws.aspx. So do the District of Columbia, Guam, and Puerto Rico. Id. Thirteen states permit medical use of some low-potency marijuana products: Alabama, Georgia, Iowa, Indiana, Kentucky, Mississippi, North Carolina, South Carolina, Tennessee, Texas, Virginia, Wisconsin, and Wyoming. Id. Tbl. 2. Alaska, California, Colorado, Maine, Massachusetts, Michigan, Nevada, Oregon, Vermont, Washington, the District of Columbia, and the Northern Mariana Islands have repealed bans on recreational marijuana use. Id. Tbl. 1. No caselaw on how these appropriations riders will affect federal enforcement of federal law in these states has yet emerged. - 19 -
U.S.C.C.A.N. 781, 1050. In 1986 new uniform capitalization (UNICAP) rules
under section 263A raised the possibility that traffickers of controlled substances
could capitalize indirect inventory costs that section 280E prevented them from
deducting as expenses. See Tax Reform Act of 1986 (TRA), Pub. L. No. 99-514,
sec. 803, 100 Stat. at 2350. But in 1988 Congress amended section 263A(a)(2) to
say that taxpayers couldn’t capitalize costs that were otherwise nondeductible.
See Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Pub. L. No.
100-647, sec. 1008(b)(1), 102 Stat. at 3437. It’s within this confusing legal
environment that Harborside operated.
Given this state of the law it’s perhaps not surprising that Harborside isn’t
the first marijuana dispensary to appear in our Court. In our first major medical-
marijuana case, we found that the taxpayer operated two separate trades or
businesses--one that provided caregiving services and one that sold marijuana.
CHAMP, 128 T.C. at 183-84. We therefore required the taxpayer to allocate its
expenses between its two businesses according to the number of its employees and
the portion of its facilities devoted to each. Id. at 185. We allowed it to deduct the
expenses that it properly allocated to its caregiving business, but not those
allocated to its marijuana-sales business. Id. at 173-74. - 20 -
In our next medical-marijuana case, Olive v. Commissioner, 139 T.C. 19, 42
(2012), aff’d, 792 F.3d 1146 (9th Cir. 2015), we held that a dispensary that
derived all its revenue from marijuana sales but also provided free activities and
services to its patrons was but a single trade or business. Because that single trade
or business was selling marijuana, we also held that section 280E precluded the
deduction of any of the taxpayer’s operating expenses, but did not prevent the
taxpayer from adjusting for costs of goods sold, id. at 32-36, 38 n.19. And in
Canna Care, Inc. v. Commissioner, T.C. Memo. 2015-206, at *12, aff’d, 694 F.
App’x 570 (9th Cir. 2017), we found that the taxpayer--which stipulated that it
was “in the business of distributing medical marijuana”--was engaged in one trade
or business because its sale of nonmarijuana items such as books and socks “was
an activity incident to its business of distributing medical marijuana.” We
therefore held that section 280E banned deductions for any of its business
expenses. Id. at *13.
While Harborside raises some of the same issues we addressed in these
cases, it also presents some new ones. Here we are asked to decide
• whether res judicata precludes the Commissioner from arguing Harborside was engaged in trafficking in a controlled substance;
• whether Harborside’s business “consists of” trafficking in a controlled substance under section 280E; - 21 -
• whether Harborside has more than one trade or business;
• what Harborside may include in its cost of goods sold; and
• whether Harborside is liable for accuracy-related penalties.
We will take each in turn.
II. Res Judicata
Harborside first argues that res judicata is a complete defense to its tax
woes. Its position is that these cases and the 2012 civil-forfeiture action are all
based on the same claim--that Harborside was trafficking in a controlled
substance. It argues that the U.S. attorney’s decision to dismiss the forfeiture
action with prejudice means that as a matter of law Harborside was not a drug
trafficker and cannot be subject to section 280E.
Res judicata--or claim preclusion--is an affirmative defense that bars suits
on the same cause of action, and it does apply to tax litigation. See Russell v.
Commissioner, 678 F.2d 782, 785-86 (9th Cir. 1982); Koprowski v.
Commissioner, 138 T.C. 54, 59-60 (2012). The rule is easy to state:
[W]hen a court of competent jurisdiction has entered a final judgment on the merits of a cause of action, the parties to the suit and their privies are thereafter bound “not only as to every matter which was offered and received to sustain or defeat the claim or demand, but as to any other admissible matter which might have been offered for that purpose.” - 22 -
Commissioner v. Sunnen, 333 U.S. 591, 597 (1948) (quoting Cromwell v. County
of Sac, 94 U.S. 351, 352 (1876)). To successfully assert a res judicata claim,
Harborside would have to clear these hurdles:
• an identity of claims between the actions;
• privity between the parties in the actions; and
• a final judgment on the merits in the civil-forfeiture action.
See Tahoe-Sierra Pres. Council, Inc. v. Tahoe Reg’l Planning Agency, 322 F.3d
1064, 1077 (9th Cir. 2003).
We think Harborside smashes right into the first. For there to be an identity
of claims, two cases must “arise out of the same transactional nucleus of facts.”
Cent. Delta Water Agency v. United States, 306 F.3d 938, 952 (9th Cir. 2002)
(quoting Fund for Animals v. Lujan, 962 F.2d 1391, 1398 (9th Cir. 1992)).14 This
almost always means that res judicata applies only when the second claim could
have been asserted in the previous action. See Tahoe-Sierra Pres. Council, 322
F.3d at 1078; Sawyer Tr. of May 1992 v. Commissioner, 133 T.C. 60, 77-78
14 Other questions that affect a decision about whether two claims share a single identity are whether: (1) “rights or interests established in the prior judgment would be destroyed or impaired by prosecution of the second action;” (2) “substantially the same evidence is presented in the two actions;” and (3) “the two suits involve infringement of the same right.” Cent. Delta Water Agency, 306 F.3d at 952 n.11 (quoting Fund for Animals, 962 F.2d at 1398). - 23 -
(2009). Harborside’s cases here are about its tax deficiencies, and the parties
agree that the government could not have brought such actions as part of the civil-
forfeiture case in district court.
Harborside insists, however, this doesn’t matter and points to United States
v. Liquidators of European Fed. Credit Bank, 630 F.3d 1139 (9th Cir. 2011). In
Liquidators, the Ninth Circuit explained that in most cases the answer to the
question of whether two cases share the “same transactional nucleus of facts” will
be synonymous with the question of whether the contested claim in the second
case could have been brought in the first. Id. at 1151. But it found an exception
when it looked closely at forfeiture actions, and it held that res judicata barred a
later criminal-forfeiture claim against the same property that had been the object
of an earlier civil-forfeiture case. Id. at 1151-52. It reasoned that the two types of
forfeiture actions always seek exactly the same result, arise from exactly the same
facts, and offer the government two paths to reach the same goal. Id. at 1152
(which might have led one to think that the doctrine to apply was “election of
remedy” rather than res judicata). But whether one looks at this puzzle as one of
election of remedy or res judicata doesn’t matter here. The forfeiture action in
district court sought just that--the forfeiture of the property leased by Harborside--
whereas these cases seek to impose a civil tax liability. And while the two actions - 24 -
share some of the same facts, they are not--unlike civil and criminal forfeiture--
different paths to the same goal. We will therefore decline to extend Liquidators
beyond the “peculiarities of the forfeiture context.” See United States v. Wanland,
830 F.3d 947, 957 (9th Cir. 2016). Instead we hold that these deficiency cases
could not have been raised in the same case, and did not arise from the same
transactional nucleus of fact. Identity of claims does not exist here and res
judicata does not bar the Commissioner’s deficiency actions. See Sawyer Tr., 133
T.C. at 78.
III. Section 280E
The Code allows a business to deduct all of its “ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or
business.” Sec. 162(a). But it also has exceptions, one of which is section 280E.
See Olive, 792 F.3d at 1148 (noting that sections 261 through 280H list “Items
Not Deductible”). Section 280E states:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted. [Emphasis added.] - 25 -
Medical marijuana is a Schedule I controlled substance, and dispensing it pursuant
to the CCUA is “trafficking” within the meaning of section 280E. See CHAMP,
128 T.C. at 182-83; Beck v. Commissioner, T.C. Memo. 2015-149, at *15. But
Harborside asks us to focus on the two words that we’ve italicized above: What
does it mean for a business to consist of trafficking?
Harborside argues that “consists of” means an exhaustive list--or in other
words that section 280E applies only to businesses that exclusively or solely traffic
in controlled substances and not to those that also engage in other activities. The
Commissioner argues that a single trade or business can have several activities and
that section 280E applies to an entire trade or business if any one of its activities is
trafficking in a controlled substance. Both parties say their interpretations match
other Code sections’ use of “consists of” and best fit section 280E’s purpose.
We’ve seen Harborside’s argument before. In Olive, 139 T.C. at 39, the
taxpayer made a nearly identical argument, which we cursorily rejected.15 And, on
appeal, the Ninth Circuit focused on the taxpayer’s misuse of CHAMP. See Olive,
792 F.3d at 1149-50. We could stop there with a nod to stare decisis, but the
parties argue the question at great length and, given the importance of these cases
15 We note that this part of Harborside’s brief repeats verbatim part of the taxpayer’s brief in Olive. - 26 -
to the industry, we will similarly explain our reasoning at greater length than we
did when we first considered it.
A. Statutory Interpretation
Harborside begins with an appeal to the “ordinary, everyday usage” of the
phrase. And we do agree that Harborside is right about the meaning of “consists
of” in everyday use: For example, one says “The AFC East consists of the Bills,
Patriots, Jets, and Dolphins,” and anyone fluent in English would understand that
to mean that those are both all, and the only, teams in that division. Harborside
also has some excellent secondary sources behind it on this point. See, e.g.,
Antonin Scalia & Bryan A. Garner, Reading Law: The Interpretation of Legal
Texts 132 (2012) (contrasting “includes”, which sets off a nonexhaustive list, with
“consists of” or “comprises”, each of which generally introduces an exhaustive
list); Black’s Law Dictionary 279 (5th ed. 1979) (explaining that “consisting” “is
not synonymous with ‘including’” because “including”, when used in connection
with a number of specified objects, always connotes incompleteness). This might
seem as though it should be the end of our analysis--after all, “[t]he ordinary-
meaning rule is the most fundamental semantic rule of interpretation.” Scalia &
Garner, supra, at 69. - 27 -
Another fundamental canon of construction, however, tells us to prefer
textually permissible readings that don’t render a statute ineffective.16 Id. at 63
(citing Citizens Bank of Bryan v. First State Bank, 580 S.W.2d 344, 348 (Tex.
1979) (“[I]f the language is susceptible of two constructions, one of which will
carry out and the other defeat * * * [the statute’s] object, it should receive the
former construction.”)). Following the most common usage of “consists of,” as
Harborside suggests, would indeed make section 280E ineffective. If that section
denies deductions only to businesses that exclusively traffic in controlled
substances, then any street-level drug dealer could circumvent it by selling a single
item that wasn’t a controlled substance--like a pack of gum, or even drug
paraphernalia such as a hypodermic needle or a glass pipe. This reading would
edge us close to absurdity, which is another result our reading of a statute should
avoid if possible. See id. at 234-35.
One might imagine--as a strictly theoretical matter--that a legislature might
enact an absurdity, and our job as judges would be to enforce it. But the
Commissioner reminds us that we shouldn’t do so if there is an effective-and-not-
absurd meaning that is also permissible. We must both avoid “a sterile literalism
16 When canons of construction compete with one another, we must decide which is most appropriate under the circumstances. See Antonin Scalia & Bryan A. Garner, Reading Law: The Interpretation of Legal Texts 59 (2012). - 28 -
which loses sight of the forest for the trees” and maintain “a proper scruple against
imputing meanings for which the words give no warrant.” N.Y. Tr. Co. v.
Commissioner, 68 F.2d 19, 20 (2d Cir. 1933) (L. Hand, J.), aff’d sub nom.
Helvering v. N.Y. Tr. Co., 292 U.S. 455 (1934); see also Scalia & Garner, supra,
at 356.
But can “consists of” ever introduce a nonexhaustive list?
1. Dictionaries
Harborside says “no”, and urges us to take a hint from the fourth edition of
the American Heritage Dictionary. Harborside quotes a usage note in the entry for
“include”. See American Heritage Dictionary 887 (4th ed. 2006). The note
explains that “include” connotes, but does not necessarily mean, that a list
immediately following it is incomplete. Id. It also suggests that authors
introducing exhaustive lists use “comprise” or “consist of” instead. Id. It doesn’t
say, however, that “consists of” necessarily introduces an exhaustive list. See id.
And the dictionary’s definition of “consist” is “[t]o be made up of or composed,”
“[t]o have a basis; reside or lie,” or “[t]o be compatible.” Id. at 392.
Harborside’s other dictionary citation is similarly ambiguous. An old
edition of Black’s Law Dictionary defines “consisting” as “[b]eing composed or - 29 -
made up of.” Black’s Law Dictionary 279 (5th ed. 1979).17 It also explains that
“consisting” is not synonymous with “including” because “including” always
connotes incompleteness, and “consisting” doesn’t. Id. The entry doesn’t say that
“consisting” and “including” are antonyms; that is, although “consisting” doesn’t
connote an incomplete list, it also doesn’t connote an exhaustive list. Id. And
even if “consisting” were the antonym of “including”, that would mean only that it
connotes completeness--not that it necessarily means completeness. Harborside
doesn’t mention it, but the same dictionary also defines “consist” as “[t]o stand
together, to be composed of or made up of.” Id.
Harborside even points us to an odd opinion that cites a precursor of the
Oxford English Dictionary18 that says “‘[c]onsisting of’ can have the meaning of
‘to have its essential character in’ or ‘foundation in.’” Madison Teachers, Inc. v.
Madison Metro. Sch. Dist., 541 N.W.2d 786, 801 (Wis. Ct. App. 1995) (Sundby,
J., concurring in part and dissenting in part) (citing IIC A New English Dictionary
17 The seventh, eighth, and ninth editions of Black’s Law Dictionary don’t define “consisting” at all. See Black’s Law Dictionary 303 (7th ed. 1999); Black’s Law Dictionary 327 (8th ed. 2004); Black’s Law Dictionary 350 (9th ed. 2009). The tenth edition defines “consisting of,” but only for the specialized purposes of patent law. Black’s Law Dictionary 373 (10th ed. 2014). 18 See OED, History of the OED, http://public.oed.com/history-of-the-oed/ (last visited Nov. 2, 2018). - 30 -
on Historical Principles 861-62 (1893)).19 The takeaway here is that none of the
dictionary definitions that Harborside provides preclude reading “consists of” as
setting off a nonexhaustive list.
2. The Code
But this is a tax case, and before we go too far afield in dictionaries or
literature, we should draw back to other sections of the law we have to apply to
these cases. See, e.g., United States v. Olympic Radio & Television, Inc., 349
U.S. 232, 236 (1955) (interpreting phrase consistently within Code chapter and
saying courts should give Code “as great an internal symmetry and consistency as
its words permit”). But see Util. Air Regulatory Grp. v. EPA, 573 U.S. , ,
134 S. Ct. 2427, 2441 (2014) (“the presumption of consistent usage ‘readily
yields’ to context” (quoting Environmental Defense v. Duke Energy Corp., 549
U.S. 561, 574 (2007))). What does the Code itself tell us about how to read
“consists of”?
19 See, e.g.,William Shakespeare, The Merchant of Venice act 3, sc. 3 (“The duke cannot deny the course of law: / For the commodity that strangers have / With us in Venice, if it be denied, / Will much impeach the justice of his state; / Since that the trade and profit of the city / Consisteth of all nations” -- Venice being open to foreign trade, or depending on foreign trade, but not literally trading with every nation in the world.) - 31 -
There are some similar phrases. Section 401(a)(22) says that if more than
10% of the assets in an employee’s defined-contribution plan account are stock in
his closely held employer, section 409(e)’s voting-rights rules don’t apply so long
as “the trade or business of such employer consists of publishing on a regular basis
a newspaper for general circulation.” Section 451(i)(3)(B) provides an optional
rule for determining in what year income is realized for “any stock or partnership
interest in a corporation or partnership * * * whose principal trade or business
consists of providing electric transmission services.” And section 513(h)(1)(B)
excludes from the definition of unrelated trade or business “any trade or business
which consists of” exchanging or renting donor and member lists among
nonprofits. We haven’t found any cases construing what “consists of” means in
any of these sections.
Harborside points out that in many Code sections Congress used the phrase
“consists of” but then modified it--as it did in the electricity-related section above
--to clarify that it doesn’t mean “is composed entirely of.” See, e.g., sec. 581 (“a
substantial part of the business of which consists of”); sec. 181(e)(2)(E) (added by
the Consolidated Appropriations Act, 2016, sec. 169(c), 129 Stat. at 3067
(“includes or consists of”)). Harborside suggests that Congress could have
similarly modified “consists of” in section 280E if it had intended to set off a - 32 -
nonexhaustive list there. The Commissioner, on the other hand, points to several
Code sections where Congress used the phrase “consists of” but then modified it
to clarify that it meant “is composed entirely of.” See, e.g., sec. 444(d)(3)(B)
(“consists only of”); sec. 416(g)(4)(H) (“consists solely of”). He suggests that
Congress would have done the same for section 280E if it had meant to indicate an
exhaustive list there.
Unmodified uses of “consists of” do sometimes seem to introduce
exhaustive lists. See, e.g., sec. 108(e)(4)(B) (“family of an individual consists of
the individual’s spouse, the individual’s children, grandchildren, and parents, and
any spouse of the individual’s children or grandchildren”). But in other places
“consists of” would lead to an absurd result if it indicated an exhaustive list. The
Commissioner points us to a glaring example: A “computer” eligible for
accelerated depreciation “consists of a central processing unit containing extensive
storage, logic, arithmetic, and control capabilities.” Sec. 168(i)(2)(B)(ii)(II)
(emphasis added). Here, Harborside’s reading of “consists of” would mean that
anything other than a central processing unit isn’t a computer. Surely something
wouldn’t fail to be a computer because it had a monitor, a keyboard, a mouse, or a
power cord. See Dunford v. Commissioner, T.C. Memo. 2013-189, at *30-*31
(referring to a laptop as a “computer” when determining depreciation eligibility). - 33 -
These examples show, we think, that the Code uses “consists of” in more
than one way. It sometimes sets off an exhaustive list, but it also sometimes
introduces a nonexclusive list.
3. Caselaw
That leaves us with caselaw. Each party has precedent here, too.
Harborside’s chief example is one from Wisconsin which held that a statute
preventing “a collective bargaining unit consisting of school district professional
employees” from arbitrating certain issues didn’t preclude arbitration by a unit that
mainly had such employees but also had some other types of employees. Madison
Teachers, Inc., 541 N.W.2d at 790-91, 793-94. That court said that a “decent
respect for language makes it impossible to read ‘consisting of’ in the inclusive
sense.” Id. at 794. But it also explained that none of the 482 occurrences of the
phrase “consisting of” in Wisconsin’s statutes introduced nonexhaustive lists, and
it pointed out that the Wisconsin legislature was careful to modify that phrase
whenever it meant to use it inclusively. Id. Apparently Wisconsin’s code enjoys a
consistency missing from the Internal Revenue Code, which as we’ve seen uses
“consists of” multiple ways. It’s therefore hard for us--despite what we hope is
our decent respect for language--to do as Harborside asks and interpret the phrase
as mechanically as the Wisconsin Court of Appeals has. - 34 -
The Commissioner, for his part, points us to a case that dealt with a section
of the Code itself--a statute excluding for tax purposes from a tax-exempt
organization’s unrelated trade or business “any trade or business which consists of
conducting bingo games.” Julius M. Israel Lodge of B’nai B’rith No. 2113 v.
Commissioner, T.C. Memo. 1995-439, 1995 WL 544877, at *3, aff’d, 98 F.3d 190
(5th Cir. 1996); see also sec. 513(f). But that case holds that “instant bingo” isn’t
“bingo” for section 513(f); it doesn’t explicitly address what it means to “consist[]
of conducting bingo games.” See Julius M. Israel Lodge, 1995 WL 544877, at *7
(although it implicitly suggests the same entity can have two businesses in that
situation, much as we did in CHAMP). It’s therefore of limited use here. Caselaw
doesn’t settle the meaning of “consists of” any better than the Code itself does.
Dictionaries, the Code, and caselaw all show that “consists of” can
introduce either an exhaustive list or a nonexhaustive list.20 A nonexhaustive list
20 The Code is in good company. Shakespeare appears to use “consists of” both ways in a single exchange:
Sir Toby Belch: * * * Does not our life consist of the four elements?
Sir Andrew Aguecheek: Faith, so they say; but I think it rather consists of eating and drinking.
Sir Toby Belch: Thou’rt a scholar; let us therefore eat and drink.
(continued...) - 35 -
is the only option that doesn’t render section 280E ineffective and absurd. We
therefore read section 280E to deny business-expense deductions to any trade or
business that involves trafficking in controlled substances, even if that trade or
business also engages in other activities.
B. Purpose
We also note that Harborside has a subtler argument about the play between
literal meaning and statutory purpose. It reminds us that dispensaries that are legal
under state law didn’t exist in 1982 and Congress even today won’t let the DOJ
prosecute them as if they were street-corner drug dealers. See Consolidated
Appropriations Act, 2017 sec. 537; Consolidated Appropriations Act, 2016 sec.
542; Consolidated and Further Continuing Appropriations Act, 2015 sec. 538; see
also McIntosh, 833 F.3d at 1177. These arguments aren’t new, either--the Ninth
Circuit disposed of them in Olive, 792 F.3d at 1150-51, so we mostly reiterate its
reasoning here to acknowledge that Harborside has preserved it.
Although section 280E predates states’ legalization of medical marijuana,
“[t]hat Congress might not have imagined what some states would do in future
years has no bearing on our analysis. It is common for statutes to apply to new
20 (...continued) William Shakespeare, Twelfth Night act 2, sc. 3. The four elements are an exhaustive list, but eating and drinking aren’t all of life, even for Sir Andrew. - 36 -
situations. And here, application of the statute is clear.” Id. at 1150. The
restriction on how the DOJ uses funds is irrelevant here because “the government
is enforcing only a tax, which does not prevent people from using, distributing,
possessing, or cultivating marijuana in California. Enforcing these laws might
make it more costly to run a dispensary, but it does not change whether these
activities are authorized in the state.” Id. at 1150.
Finally, we note that several members of Congress asked the IRS to issue
guidance saying that medical-marijuana dispensaries aren’t subject to section
280E, and the IRS said it couldn’t do that unless Congress amended the Code or
the Controlled Substances Act. See IRS Information Letter 2011-0005. Members
of Congress have subsequently introduced several bills that would exempt state-
legal marijuana businesses from section 280E. Small Business Tax Equity Act of
2011, H.R. 1985, 112th Cong. (2011); Small Business Tax Equity Act of 2013,
H.R. 2240, 113th Cong. (2013); Small Business Tax Equity Act of 2015, H.R.
1855, 114th Cong. (2015); Small Business Tax Equity Act of 2015, S. 987, 114th
Cong. (2015); Small Business Tax Equity Act of 2017, H.R. 1810, 115th Cong.
(2017); Small Business Tax Equity Act of 2017, S. 777, 115th Cong. (2017);
Responsibly Addressing the Marijuana Policy Gap Act of 2017, H.R. 1824, 115th - 37 -
Cong. (2017); Responsibly Addressing the Marijuana Policy Gap Act of 2017, S.
780, 115th Cong. (2017). None has been enacted.
We hold that section 280E prevents Harborside from deducting its business
expenses.
IV. More Than One Trade or Business?
Harborside says that even if section 280E applies to its marijuana sales, it
can still deduct its expenses for any separate, nontrafficking trades or businesses.
That’s correct. See CHAMP, 128 T.C. at 184-85; see also Olive, 792 F.3d at
1149. We therefore need to determine which--if any--of Harborside’s activities
are separate trades or businesses.
An activity is a trade or business if the taxpayer does it continuously and
regularly with the intent of making a profit. See, e.g., Commissioner v.
Groetzinger, 480 U.S. 23, 35 (1987); United States v. Am. Bar Endowment, 477
U.S. 105, 110 n.1 (1986). A single taxpayer can have more than one trade or
business, CHAMP, 128 T.C. at 183, or multiple activities that nevertheless are
only a single trade or business, see, e.g., Davis v. Commissioner, 29 T.C. 878, 891
(1958). Even separate entities’ activities can be a single trade or business if
they’re part of a “unified business enterprise” with a single profit motive. Morton
v. United States, 98 Fed. Cl. 596, 600 (2011). - 38 -
Whether two activities are two trades or businesses or only one is a question
of fact. See, e.g., CHAMP, 128 T.C. at 183; Owens v. Commissioner, T.C. Memo.
2017-157, at *21. To answer it, we primarily consider the “degree of
organizational and economic interrelationship of various undertakings, the
business purpose which is (or might be) served by carrying on the various
undertakings separately or together * * *, and the similarity of the various
undertakings.” Olive, 139 T.C. at 41; sec. 1.183-1(d), Income Tax Regs.
We’ve considered this issue with other California medical-marijuana
dispensaries. In CHAMP, 128 T.C. at 175, 183, we found that the taxpayer had
two distinct trades or businesses--caregiving services and medical-marijuana
sales--even though its customers paid a single fee that entitled them to unlimited
access to the services and a fixed amount of marijuana. We noted there that seven
of the taxpayer’s employees distributed marijuana, eighteen employees provided
caregiving services, and no employees did both. Id. at 185. Moreover, dispensing
marijuana occurred in only 10% of one of the taxpayer’s three facilities. Id. at
176. We found the taxpayer’s primary purpose was to provide caregiving
services, and that those services were both “substantially different” from and
“stood on * * * [their] own, separate and apart” from dispensing marijuana. Id. at
183. - 39 -
In Olive, however, we held (and the Ninth Circuit agreed) that a taxpayer
who sold medical marijuana and provided complimentary services--including
movies, board games, yoga classes, massages, snacks, personal counseling, and
advice on how to best consume marijuana--had a single trade or business. Olive,
139 T.C. at 38-42; Olive, 792 F.3d at 1148-50. The taxpayer in Olive charged
only for marijuana, and set a price based on the amount and type of marijuana its
patients bought; the cost of the other services was bundled into that price. Olive,
139 T.C. at 42; 792 F.3d at 1149. The same employees who sold marijuana also
provided the services, and the taxpayer paid no additional wages, rent, or other
significant costs connected exclusively with those services. Olive, 139 T.C. at 41.
The taxpayer also had a single bookkeeper and accountant. Id. at 42. These facts
led us to find that the services were “incident to” the sale of marijuana, and we
noted that the two activities had a “close and inseparable organizational and
economic relationship.” Id. at 41. We held that they were “one and the same
business.” Id.
The most recent case where we had to figure out the number of a marijuana
dispensary’s trades or businesses is Canna Care, Inc. Like Harborside, the
taxpayer there sold medical marijuana and other items, including books, T-shirts,
and hats. Canna Care, Inc., at *4, *12. Unlike the taxpayer in Olive, the taxpayer - 40 -
in Canna Care, Inc. had at least a little bit of income from nonmarijuana sales. Id.
at *12. But we still found only a single trade or business--selling marijuana--and
“the sale of any other item was an activity incident to” those sales. Id. But our
analysis there was constrained: The parties had stipulated that the taxpayer “was
in the business of distributing medical marijuana” and the record didn’t enable us
to determine what percentage of the taxpayer’s income came from marijuana sales
and what percentage came from other sources. See id.; see also Alterman v.
Commissioner, T.C. Memo. 2018-83, at *27-*28 (refusing to allow business-
expense deductions where the taxpayers failed to identify specific payments,
provide record citations, or propose findings of fact sufficient for us to distinguish
expenses associated with the sale of marijuana from those associated with the sale
of nonmarijuana merchandise).
Harborside presented its case in greater detail. It argues that it had four
activities, each of which was a separate trade or business:
• sales of marijuana and products containing marijuana;
• sales of products with no marijuana;
• therapeutic services; and
• brand development.
We consider each. - 41 -
A. Selling Marijuana and Products Containing Marijuana
There’s no question that selling marijuana and products containing
marijuana was Harborside’s primary purpose. Sixty percent of the members
Harborside’s security checked in were there to buy marijuana in one form or
another. Marijuana and marijuana products took up around 75% of Harborside’s
sales floor. Harborside’s employees spent 80-90% of their time purchasing,
processing, and selling these products. And those sales generated at least 98.7%
of Harborside’s revenue during each of the years at issue. This was certainly a
trade or business--specifically, the trade or business of trafficking in a controlled
substance. See Olive, 139 T.C. at 38; CHAMP, 128 T.C. at 182-83.
B. Selling Products That Didn’t Contain Marijuana
Harborside’s sale of items that didn’t contain marijuana--such as branded
clothing, hemp bags, books about marijuana, and marijuana paraphernalia such as
rolling papers, pipes, and lighters--generated the remaining 0.5% of its revenue.
The same Harborside employees who bought, processed, and sold marijuana also
sold these items, but selling them took up only 5-10% of their time. The
nonmarijuana items occupied only 25% of the sales floor where Harborside sold
marijuana, and that sales floor was accessible only to patrons who had already
presented their credentials to security--which means that no one who couldn’t buy - 42 -
marijuana could buy these nonmarijuana items. And the record shows no separate
entity, management, books, or capital for the nonmarijuana sales. This leads us to
find that the sale of non-marijuana-containing products had a “close and
inseparable organizational and economic relationship” with, and was “incident to,”
Harborside’s primary business of selling marijuana. See Olive, 139 T.C. at 41; see
also Tobin v. Commissioner, T.C. Memo. 1999-328, 1999 WL 773964, at *5-*6
(farm and garden one activity because same employees, equipment, management,
and books). There’s also an obvious business purpose for selling items that
facilitate and encourage marijuana use alongside actual marijuana. We also find
that the sale of items that are about marijuana, are branded with Harborside’s logo,
or enable use of marijuana is not “substantially different” from the sale of
marijuana itself. See CHAMP, 128 T.C. at 183.
Harborside nevertheless argues that its sale of anything other than marijuana
is a separate trade or business. It cites an analogy the Ninth Circuit used in Olive,
792 F.3d at 1150, to explain why a store that charged for marijuana and gave away
incidental services had only a single trade or business. In that analogy, a
hypothetical bookstore that sold books and gave away coffee to attract customers
(“Bookstore A”) had only one trade or business, whereas a hypothetical bookstore - 43 -
that sold books and also sold coffee (“Bookstore B”) had two trades or businesses.
Id.
We think Harborside misses the analogy’s point: It shows that a service a
taxpayer doesn’t charge for, but which attracts customers, isn’t a separate trade or
business. It doesn’t mean that selling two things is necessarily two separate trades
or businesses. Bookstore B is there to provide contrast to Bookstore A, which is
what the court compared to the taxpayer in Olive. Id.
Finally, the analogy--though a good fit for Olive, which was selling
marijuana and giving away snacks and soft drinks--doesn’t suit Harborside. A
better analogy would be to a bookstore that derives 0.5% of its revenue from
selling stationery, bookmarks, and T-shirts with pictures of books on them
(“Bookstore C”). To be completely analogous to Harborside, Bookstore C would
sell these items using the same employees, sales floor, management, ledgers, and
business entity it used to sell books. That hypothetical bookstore would, we think,
be a single trade or business under the Ninth Circuit’s reasoning. And
Harborside’s sale of non-marijuana-containing items is, we find, not a separate
trade or business. - 44 -
C. Therapeutic Services
Recognizing that an activity needs a profit motive to be a separate trade or
business, Harborside argues that a portion of each marijuana sale was actually a
purchase of its free holistic services.21 This is what it told its patrons, too.
Harborside says this makes it like CHAMP. But in CHAMP, 128 T.C. at
175-76, members paid a set fee for unlimited access to extensive services and also
received a fixed amount of marijuana--the services’ price wasn’t “bundled” into
the amount paid for marijuana, to use Harborside’s terminology. And we found
that the services in CHAMP were the taxpayer’s primary purpose, took up most of
its employees’ time, and used almost all of its three facilities. Id. at 174-76, 183,
185.
Harborside is more like the dispensary in Olive, 792 F.3d at 1148, where
patrons paid according to the amount and type of marijuana they wanted and in
return gained access to incidental services. Harborside tries to distinguish itself by
pointing out that it offered many more services than the much smaller taxpayer in
Olive did.22 But the services were still incidental; Harborside’s security spent only
21 Harborside argues that “the price for these services was rolled into the price of the cannabis.” 22 In Olive, 792 F.3d at 1148, the taxpayer’s combined reported income and (continued...) - 45 -
5% of its time checking in people for the services, while spending 60% of its time
checking in people who were there to buy marijuana. And independent
contractors, rather than Harborside’s own employees, provided those services.
During the years at issue Harborside paid those contractors a total of only about
$680,000--less than 1% of its sales revenue from marijuana.
The relationship between Harborside’s marijuana business and holistic
services closely fits Olive’s “Bookstore A” analogy. See id. at 1150. Just as a
bookstore that gives away coffee is still only a bookstore, a marijuana dispensary
that gives away services is still only a marijuana dispensary. See id. The fact that
Harborside used a tiny bit of its marijuana-sales revenue to pay for those services
doesn’t change anything--after all, Bookstore A necessarily pays for its coffee
with book sales. And we also find that there were business reasons to offer these
services alongside marijuana sales: It justified premium pricing and helped
Harborside meet the community-benefit standards California law required. We
therefore find that Harborside’s holistic services were not a separate trade or
business.
22 (...continued) claimed expenses for each year we considered were under $500,000. In contrast, Harborside had $5 million-$25 million in total revenue during each of the years at issue. - 46 -
D. Branding
Harborside’s final argument on this subject is that its brand-development
activity was a separate trade or business. Because this did not generate any
revenue until after the years at issue, the Commissioner compares it to
preoperational expenditures that have to be capitalized instead of deducted.
Harborside insists it is a trade or business eligible for section 162 deductions
because from day 1 it performed them with an independent profit motive. To
show a profit motive without any revenue, Harborside says its branding activities
were part of a “unified business enterprise” with its activities that did make money
during the years at issue.
A separate entity purposely operating at a loss is still a trade or business
eligible for deductions if it and entities related to it together form a unified
business enterprise that itself has a profit motive. See Campbell v. Commissioner,
868 F.2d 833, 836-37 (6th Cir. 1989) (partnership leasing airplane to sister
corporation at loss had profit motive because common owners benefited), aff’g in
part, rev’g in part T.C. Memo. 1986-569; Kuhn v. Commissioner, T.C. Memo.
1992-460, 1992 WL 193604, at *5 (partnership’s below-market lease of land to
sister corporation had profit motive because corporation benefited); Morton, 98
Fed. Cl. at 602 (S corporation that owned airplane was part of unified business - 47 -
enterprise with shareholder’s other businesses and therefore had a profit motive).
In other words, the unified-business-enterprise doctrine Harborside relies on says
that separate but related entities can share a single profit motive; it doesn’t say that
a single entity’s unprofitable activities are a separate trade or business. Rather
than show that Harborside’s branding was separate from its marijuana sales, the
unified-business-enterprise doctrine instead suggests that it was part of a single
overall trade or business.
There’s also no actual evidence to suggest that Harborside’s brand
development was in any way a separate trade or business. As far as we can tell,
Harborside did its branding using the same entity, management, capital structure,
employees, and facilities as its marijuana sales. See Tobin, 1999 WL 773964, at
*5-*6. And rather than being “substantially different” from the underlying sale of
marijuana, Harborside’s brand development was necessarily entwined with it. See
CHAMP, 128 T.C. at 183. Harborside’s branding, therefore, had a “close and
inseparable organizational and economic relationship” with, and was “one and the
same business” as, its marijuana sales. See Olive, 139 T.C. at 41. It was not a
separate trade or business.
Harborside dedicated the lion’s share of its resources to selling marijuana
and marijuana products. Those sales accounted for over 99.5% of its revenue. Its - 48 -
other activities were neither economically separate nor substantially different. We
therefore hold that Harborside had a single trade or business--the sale of
marijuana. That’s trafficking in a controlled substance under federal law, so
Harborside cannot deduct any of its related expenses. See sec. 280E; see also
Olive, 139 T.C. at 38; CHAMP, 128 T.C. at 182-83.
V. Cost of Goods Sold
The fact that Harborside can’t deduct any of its business expenses doesn’t
mean it owes tax on its gross receipts. All taxpayers--even drug traffickers--pay
tax only on gross income, which is gross receipts minus the cost of goods sold
(COGS). See, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934);
CHAMP, 128 T.C. at 178 n.4; secs. 1.61-3(a), 1.162-1(a), Income Tax Regs.
Congress understood that when it enacted section 280E. See S. Rept. No. 97-494,
supra at 309, 1982 U.S.C.C.A.N. at 1050. We’ve understood it ourselves. See
Olive, 139 T.C. at 32-36.
But what is the distinction between a business-expense deduction and an
adjustment for COGS? Deductions are subtractions from gross income that
taxpayers make when they calculate their taxable income. Sec. 63(a). Deductions
are statutory, and Congress can grant or deny them as it chooses--the standard
refrain is that they’re a matter of Congress’s “legislative grace.” INDOPCO, Inc. - 49 -
v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co., 292 U.S. at 440;
Olive, 139 T.C. at 32. We’ve already seen an example of Congress’s withholding
that grace from those whose works it rejects--it grants most taxpayers a deduction
for ordinary and necessary business expenses in section 162, but then uses section
280E to deny those deductions to drug traffickers. See Canna Care, Inc., at *7.
COGS is the costs of acquiring inventory, through either purchase or
production. See, e.g., Reading v. Commissioner, 70 T.C. 730, 733 (1978) (COGS
is “expenditures necessary to acquire, construct or extract a physical product
which is to be sold”), aff’d, 614 F.2d 159 (8th Cir. 1980); secs. 1.61-3(a), 1.162-
1(a), Income Tax Regs. As we’ve said, all taxpayers, regardless of the business
they’re in, use COGS to offset their gross receipts when they calculate gross
income. See, e.g., Olive, 139 T.C. at 20 n.2.
The big difference between deductions and COGS adjustments is timing.
See INDOPCO, 503 U.S. at 83-84; Wasco Real Props. I, LLC v. Commissioner,
T.C. Memo. 2016-224, at *19. Taxpayers can usually claim at least part of a
deductible expense for the year they incur it. See, e.g., INDOPCO, 503 U.S. at 83-
84; Wasco Real Properties I, LLC, at *19. But when accounting for COGS they
have to capitalize an item’s cost in the year of acquisition or production and either
amortize it or wait until the year the item’s sold to make the corresponding - 50 -
adjustment to gross income.23 See, e.g., INDOPCO, 503 U.S. at 83-84; Wasco
Real Props. I, LLC, at *19.
A. How Should Harborside Account for its COGS?
The Code tells taxpayers what to include in COGS. See, e.g., secs. 263,
263A, 471. But there’s more than one set of rules, and the issue here is which set
applies to Harborside. The Commissioner thinks Harborside needs to follow the
rules under section 471, but Harborside insists it’s subject to the rules of section
263A. We consider each.
1. Section 471
Section 471 was in place when Congress enacted section 280E. It
empowers the Commissioner to write regulations that govern how taxpayers
account for inventories. See sec. 471. This the Commissioner did--with separate
regulations for resellers and producers. See secs. 1.471-3(b) and (c), 1.471-11,
Income Tax Regs.
23 A simple example illustrates the difference. If in year 1 a taxpayer incurs a deductible expense of $100, he can reduce his taxable income for year 1 by $100. If in year 1 he instead buys 100 units of inventory for $100 and manages to sell 10 of those units per year, he has to take a $10 COGS adjustment in year 1, a $10 adjustment in year 2, and so on, through year 10, when he runs out of inventory. In each case, the taxpayer reduces the amount of income he’s taxed on by a total of $100. The difference is that he recovers the entire deductible expense in year 1, but recovers his inventory cost as he sells the inventory, which in this example means he doesn’t get the full $100 back until year 10. - 51 -
The regulations tell resellers to use as their COGS the price they pay for
inventory plus any “transportation or other necessary charges incurred in acquiring
possession of the goods.” Sec. 1.471-3(b), Income Tax Regs. The regulations for
producers are more complex. Producers must include in COGS both the direct and
indirect costs of creating their inventory. See secs. 1.471-3(c), 1.471-11, Income
Tax Regs. The regulations tell producers to capitalize the “cost of raw materials,”
“expenditures for direct labor,” and “indirect production costs incident to and
necessary for the production of the particular article, including * * * an
appropriate portion of management expenses.” Sec. 1.471-3(c), Income Tax Regs.
Direct and indirect production costs are further explained in section 1.471-11(b),
In their current forms, section 471 and its regulations also direct taxpayers
to section 263A for additional rules.
2. Section 263A
Congress enacted section 263A in 1986. TRA sec. 803. That section
instructs both producers and resellers to include “indirect” inventory costs in their
COGS. Sec. 263A(a)(2)(B), (b); sec. 1.263A-1(a)(3), (c)(1), (e), Income Tax
Regs. It also broadens the definition of indirect costs for both types of taxpayers.
Compare sec. 1.263A-1(e)(3), Income Tax Regs., with sec. 1.471-11, Income Tax - 52 -
Regs. Congress thought this would treat taxpayers more fairly. S. Rept. No. 99-
313, at 140 (1986), 1986-3 C.B. (Vol. 3) 1, 140. It also thought this would do a
better job of matching COGS adjustments to the years in which taxpayers realized
the related income. Id.; see also Office of the Sec’y, Dep’t of the Treasury, 1 Tax
Reform for Fairness, Simplicity, and Economic Growth: Treasury Department
Report to the President 126-28 (1984).
These sections are also about timing. A business that could immediately
deduct indirect costs under section 471 now has to treat those costs as capital
expenditures and wait until it realizes related income to adjust for them. In a sense
Congress is taking away some current deductions but allowing them in later years,
renamed COGS. It is legislative grace deferred, but not denied.
Most business don’t like this. They’d rather have a deduction now than
increased COGS later. See, e.g., Frontier Custom Builders, Inc. v. Commissioner,
T.C. Memo. 2013-231, at *14 (homebuilder argued it was a seller, not a producer,
in attempt to avoid capitalization), aff’d, 626 F. App’x 89 (5th Cir. 2015). But
drug traffickers have a different attitude. Although section 280E prevents them
from deducting expenses, they are still entitled to COGS adjustments. Olive, 139
T.C. at 32-36. By renaming COGS what had been deductions, Congress made it
possible for traffickers to adjust for expenses that they couldn’t previously claim. - 53 -
They have to make those adjustments in the later year when the inventory is sold,
but later is better than never.
Except that maybe it’s still never. In 1988 Congress amended section
263A(a)(2), adding flush language that says: “Any cost which (but for this
subsection) could not be taken into account in computing taxable income for any
taxable year shall not be treated as a cost described in this paragraph.” TAMRA
sec. 1008(b)(1). The regulations show that “cost” here means expenses that would
otherwise be deductible. See sec. 1.263A-1(c)(2), Income Tax Regs. In their
explanation of how section 263A(a)(2)’s flush language works, the regulations
point out that if a business meal is entirely attributable to the acquisition or
production of inventory, the taxpayer capitalizes only 80% of it because section
274(n), at that time, limited business meal deductions to 80% of their “cost”
(which the section itself calls an “expense”, see sec. 274(n)); the taxpayer doesn’t
get to capitalize the whole meal and escape the 80% limitation on the deduction,
sec. 1.263A-1(c)(2)(i), Income Tax Regs. So 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. - 54 -
3. Harborside’s Argument
Can Congress get away with this? Harborside argues that limiting its COGS
to “only the actual cost used to purchase inventory” violates the Sixteenth
Amendment. Its theory is that section 263A represents the most accurate tax-
accounting method for calculating COGS and that not letting marijuana
dispensaries use it forces them to pay tax on more than their gross income. In
other words, Harborside thinks section 263A somehow defines COGS for
constitutional purposes.
That’s wrong. The Sixteenth Amendment’s meaning didn’t change when
Congress enacted section 263A. See U.S. Const. art. V (providing only method
for changing constitution). Section 471 wasn’t found unconstitutional during the
many decades when it was the only means of calculating COGS, and it wouldn’t
be unconstitutional now if Congress repealed section 263A. The Constitution
does limit Congress to taxing only gross income, and courts have consistently
held--including in cases Harborside cites--that gross income is gross receipts
minus direct costs. See Reading, 70 T.C. at 733 (COGS are direct investment in
item sold); Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707, 715 (1956) (gross
income on sales is income for Sixteenth Amendment); Anderson Oldsmobile, Inc.
v. Hofferbert, 102 F. Supp. 902, 905 (D. Md. 1952) (IRS can tax only amount - 55 -
realized on sale minus basis), aff’d, 197 F.2d 504 (4th Cir. 1952). Harborside, like
all taxpayers, can still adjust for its direct costs--or, to use its terminology, “the
actual cost used to purchase inventory.” It therefore pays tax only on the amount
it realizes on sales, which is what the Constitution requires.
Harborside compares itself to the taxpayer in Anderson Oldsmobile, but that
case doesn’t help it. There the taxpayer paid more for its inventory than since-
repealed federal price controls allowed, and the Commissioner tried to limit the
taxpayer’s COGS to the highest legal price. Id. at 903. The court held that
because Congress can tax only gross income, the taxpayer was entitled to a COGS
adjustment for the actual amount it paid for its inventory even though that amount
was illegally high. Id. at 903, 905, 909.
As Harborside correctly points out, Anderson Oldsmobile says that statutes
can’t let the Commissioner tax more than gross income. Id. at 905. But that’s not
what’s happening here. Unlike Anderson Oldsmobile, where the Commissioner
wanted to use a statute to deny the taxpayer a COGS adjustment for part of its
direct cost of purchasing inventory, these cases find the Commissioner saying only
that Harborside can’t use section 263A to capitalize indirect costs that it wouldn’t
otherwise be able to deduct. Harborside still gets to do exactly what the taxpayer - 56 -
in Anderson Oldsmobile did: calculate its gross income by subtracting the direct
cost of its inventory from its gross receipts. See id. at 905.
What Anderson Oldsmobile really holds is that taxpayers can adjust for
COGS whether or not their direct costs are legal. See id. at 903; see also
Pittsburgh Milk Co., 26 T.C. at 717 (taxpayer who sold milk below legal price
used actual price when calculating income). This tells us what we already know:
Harborside would get COGS adjustments for its direct inventory costs no matter
what--even if it was trafficking cocaine or any other controlled substance not legal
under California law. The only things Harborside doesn’t get are indirect
inventory costs granted as deductions and then deferred under section 263A.
The section 263A capitalization rules don’t apply to drug traffickers.
Unlike most businesses, drug traffickers can’t capitalize indirect expenses beyond
what’s listed in the section 471 regulations. Section 263A expressly prohibits
capitalizing expenses that wouldn’t otherwise be deductible, and drug traffickers
don’t get deductions. Because federal law labels Harborside a drug trafficker, it
must calculate its COGS according to section 471.
B. Is Harborside a Producer or a Reseller?
Because the section 471 regulations have different rules for resellers and
producers, how Harborside calculates its COGS depends on which type of - 57 -
taxpayer it is. Harborside was without question a reseller of the marijuana edibles
and non-marijuana-containing products it bought from third parties and sold at its
facility. But the situation is more complex for the marijuana bud it sold.
Harborside insists it produced this marijuana and can include in its COGS the
indirect inventory costs that section 1.471-3(c), Income Tax Regs., describes. The
Commissioner says Harborside is a reseller and, under section 1.471-3(b), Income
Tax Regs., it can include only its inventory price and transportation costs.
1. What Does “Produce” Mean?
To sort this out we first need to know what “produce” means. The
Commissioner, citing a Court of Claims case, says that under section 471
“production” means “manufacturing”. See Heaven Hill Distilleries, Inc. v. United
States, 476 F.2d 1327, 1335 (Ct. Cl. 1973). He then cites a line of cases saying
that “manufacturing” requires a change to the essential character of the
merchandise. Marcor, Inc. v. Commissioner, 89 T.C. 181, 193 (1987); see also
Anheuser-Busch Brewing Ass’n v. United States, 207 U.S. 556, 562 (1908); In re
I. Rheinstrom & Sons Co., 207 F. 119 (E.D. Ky. 1913), aff’d sub nom. Cent. Tr.
Co. v. George Lueders & Co., 221 F. 829 (6th Cir. 1915); People ex rel. New
England Dressed Meat & Wool Co. v. Roberts, 155 N.Y. 408, 412 (1898); People
v. Knickerbocker Ice Co., 1 N.E. 669 (N.Y. 1885). His argument, then, is that - 58 -
“production” means “change”. Look at the dates of most of these cases, though--
they predate the Sixteenth Amendment.
Harborside at least points us to something more recent, the Ninth Circuit
case, Suzy’s Zoo v. Commissioner, 273 F.3d 875 (9th Cir. 2001), aff’g 114 T.C. 1
(2000). That case, however, isn’t about section 471. It’s about section
263A(g)(1)’s definition of “produce”--which says that term “includes construct,
build, install, manufacture, develop, or improve”--and section 1.263A-2(a)(1)(i),
Income Tax Regs., which says that “produce includes the following: construct,
build, install, manufacture, develop, improve, create, raise, or grow.” Suzy’s Zoo,
273 F.3d at 878 (emphasis added).
Although Suzy’s Zoo is about section 263A, it’s useful for construing
section 471’s regulations which, like section 263A’s regulations, provide different
methods of accounting for inventory that’s “purchased” or “produced” but don’t
define those terms. See sec. 1.471-3(b) and (c), Income Tax Regs. We think
“produce” should mean the same thing in section 471 as it does in section 263A.
We also think we should follow the Ninth Circuit’s reasoning in a case appealable
to that court. See Golsen, 54 T.C. at 757.
In Suzy’s Zoo, the taxpayer, a greeting-card company, designed images and
sent them to a contract printer who did color separations, made proofs, and printed - 59 -
them using its own materials. A trucking company then picked up the prints and
took them to a finisher. The finisher cut and folded the prints into greeting cards
and returned them to the taxpayer. The printer and the finisher each bore the risk
of loss while they had the materials. Suzy’s Zoo, 273 F.3d at 877.
We held--and the Ninth Circuit affirmed--that the taxpayer was a “producer”
because it retained title to the items throughout the contract-production process.
Id. at 877, 880. Citing regulations under section 263A, the court said: “The only
requirement for being a ‘producer’ * * * is that the taxpayer be ‘considered an
owner of the property produced,’” that “ownership is ‘based on all of the facts and
circumstances,’” and that “[a] taxpayer may be considered an owner of property
produced, even though the taxpayer does not have legal title to the property.” Id.
at 880 (citing section 1.263A-2(a)(1)(ii)(A), Income Tax Regs.). A taxpayer can
be a “producer”, moreover, even if it uses contract manufacturers to do the actual
production. Id. at 878 (citing section 263A(g)(2)). The Ninth Circuit explained
that achieving section 263A’s purpose of treating all taxpayers fairly required a
broad construction of “produce”. Id. at 879; see also Von-Lusk v. Commissioner,
104 T.C. 207, 215 (1995); S. Rept. No. 99-313, supra at 140, 1986-3 C.B. (Vol. 3)
at 140. We’ve said this before ourselves, not coincidentally in a case holding that - 60 -
“production” for section 263A doesn’t require a physical change. See Von-Lusk,
104 T.C. at 217.
“Produce” is therefore broader than “manufacture”. That’s also evident
from the Code and regulations. We saw that already in section 263A(g)(1) and
section 1.263A-2(a)(1)(i), Income Tax Regs. See supra pp. 58-59. The section
471 regulations also show that “production” and “manufacturing” are distinct, if
related, concepts. Section 1.471-11, Income Tax Regs., discusses “production”
costs, but refers in several places to costs “incident to and necessary for
production or manufacturing,” a construction implying that the two terms are not
identical, even if they are closely related and receive identical tax treatment.24 For
purposes of section 471, production turns on ownership--ownership as determined
by facts and circumstances, not formal title.
2. Did Harborside Own What Its Growers Grew?
In finding that Suzy’s Zoo was a producer, the Ninth Circuit emphasized the
“degree of control * * * [the taxpayer] exercise[d] over the manufacturing
24 The heading of section 1.471-11, Income Tax Regs., is “Inventories of Manufacturers,” but this doesn’t change our analysis of its text. Statutory titles and headings are useful when interpreting ambiguous words or phrases, but “they cannot undo or limit that which the text makes plain.” Bhd. of R.R. Trainmen v. Baltimore & Ohio R.R. Co., 331 U.S. 519, 528-29 (1947); see also Dixon v. Commissioner, 132 T.C. 55, 81 (2009). - 61 -
process.” Suzy’s Zoo, 273 F.3d at 880. Harborside says it also exercised a high
degree of control over the growers it purchased marijuana from. It points out that
it bought marijuana only from its members, and even then only if the members
used Harborside’s clones (which they either bought or received for free), took
Harborside’s growing class, followed Harborside’s best practices, and met
Harborside’s quality-control standards.
But there was more to Suzy’s Zoo. There the taxpayer acquired ownership
when it first designed the characters because that was the most important step and
the one that required the most skill and expertise. Suzy’s Zoo, 114 T.C. at 8.
Suzy’s Zoo’s contractors couldn’t sell, copy, or use those characters without
breaching Suzy’s Zoo’s license. Id. Suzy’s Zoo retained the “exclusive right to
sell the finished product,” id. at 9, and it accepted all the finished products it
ordered, see Suzy’s Zoo, 273 F.3d at 877.
Harborside, unlike Suzy’s Zoo, see id.; Suzy’s Zoo, 114 T.C. at 8-10, didn’t
create the clones, maintain tight control over them, order specific quantities,
prevent sales to third parties, or take possession of everything produced.
Harborside bought clones from nurseries and either sold them to growers with no
strings attached or gave clones to growers expecting that they’d sell bud back to
Harborside. Nothing prevented either type of grower from selling to another - 62 -
collective, and DeAngelo thought it would be futile to try to use the courts to stop
them.25 Harborside had complete discretion over whether to purchase what bud
growers brought in, paid growers only if it purchased their bud, and at times
rejected the “vast majority” of its growers’ bud. And Harborside thought growers
could do whatever they wanted with the rejected bud.
This was not the type of contract-manufacturing arrangement we saw in
Suzy’s Zoo, 273 F.3d at 877, where a designer hired others to make its products
but owned those products at all stages of their creation. Harborside merely sold or
gave members clones that it had purchased from nurseries and bought back bud if
and when it wanted. In between these two steps it had no ownership interest in the
marijuana plants. Harborside is therefore a reseller for purposes of section 471
and must adjust for its COGS according to section 1.471-3(b), Income Tax Regs.26
This leaves only the issue of whether Harborside owes accuracy-related
penalties under section 6662(a). We will address this issue in a separate opinion.
25 DeAngelo said he never sued anyone for breach of contract because “the possibility o[f] prevailing on contract disputes in something that involves a controlled substance is slim and would be expensive.” 26 Harborside did have a “processing room.” See supra p. 8. But the “processing” that went on there--reinspection, packaging, and labeling--fall within the category of “purchasing, handling, and storage” that resellers do without losing their character as resellers. See sec. 1.263A-3(c), Income Tax Regs.
Related
Cite This Page — Counsel Stack
151 T.C. No. 11, Counsel Stack Legal Research, https://law.counselstack.com/opinion/patients-mutual-assistance-collective-corporation-dba-harborside-health-tax-2018.