US Tax Court Strikes Blow To California Cannabis Dispensary

Harborside Health Center, a marijuana dispensary in Oakland CA, challenged its ability to deduct business expenses not directly related to cannabis sales. This week, the US Tax Court ruled against them and other dispensaries, continuing to muddy the waters and blur the lines between state and federal cannabis business treatment. Here’s what this ruling means for California marijuana business tax implications moving forward.

Interpreting 26 U.S. Code Section 280E

The crux of Harborside’s legal challenge revolved around Section 280E of the tax code. That section states the following:

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.

A brief look at this language reveals several key problems. First, there’s the fact that California has legalized recreational marijuana usage, despite the plant’s continued federal status as a Schedule I controlled substance. That creates an incredible amount of cognitive, or legal, dissonance as the courts must hold two conflicting ideas simultaneously. If marijuana is a legitimate consumer good, it stands to follow that businesses selling that product can make the usual expense deductions in connection with the operating requirements of their business. On the other hand, if — as Section 280E asserts — marijuana is federally illegal, there can be no credit or deductions made in connection with the dispensary whatsoever.

Here’s where Harborside’s legal challenge comes in: because Harborside offers a multitude of products and services other than straight sales of cannabis, they claimed that they should be able to make tax deductions connected to those non-cannabis expenses. They argued in Tax Court that the phrase “consists of” in Section 280E implies that the entire enterprise centers around sale of the controlled substance. As Harborside offered alternative therapy and several products (such as hemp-constructed bags etc) that are not controlled, they felt it fair and within the intent of the law to deduct accordingly.

Tax Court Denies Harborside’s Challenge

Unfortunately for Harborside Health Center and California dispensaries across the entire state, the US Tax Court did not agree with their interpretation of Section 280E, and ruled to deny the ability to make any deductions or claim any pertinent credits.

In the Tax Court’s view, even these side services and products were “close and inseparable” to Harborside’s main revenue stream: cannabis. This is a gigantic blow to California marijuana businesses seeking to understand how they are expected to operate from a tax compliance standpoint, further underscoring the need for tax attorney guidance for anyone operating a dispensary.

The Tax Court’s ruling in this matter had one other major distinction that will potentially ramp up the oncoming clash between dispensaries and the federal government. Critically, the Court ruled that Harborside was not a “producer” of marijuana, but rather a “reseller.” This seemingly minor distinction actually has significant implications in terms of cost of goods sold — a major determinant in the final taxable dollar amount each year.

One thing is for certain: we haven’t seen the last of these types of challenges as marijuana continues to be legal in California while federally illegal. For dispensary owners attempting to stay tax-compliant, they’ll need to keep abreast of these changes as they occur.

ABAJIAN LAW’S TAKE: This was overly ambitious of the dispensary’s owners to take this matter to Tax Court, as Section 280E pretty clearly disallows expenses. The Court’s decision reaffirms what we believe to be the stated intent of the law as currently written.