Tax Court Confirms No Deductions for State-Legal Cannabis Business, Part I: Harborside on the Front Lines Again

Here we examine the operations of Harborside, a state-legal California nonprofit medical marijuana dispensary, and its recent tax court challenge.

Few industries have experienced greater legal and regulatory challenges than the U.S. cannabis industry. In this blog series, we are going to focus on a specific medical marijuana dispensary in Oakland, CA that has been in the forefront of the federal legal battles faced by state-legal cannabis businesses.

About Harborside

Steve DeAngelo opened the Patients Mutual Assistance Collective Corporation, better known as the Harborside Health Center (“Harborside”), 10 years after California legalized the medical use of cannabis through passage of the California Compassionate Use Act of 1996.

The Harborside medical marijuana dispensary operated without legal hassles from 2006 through 2012. Then it became embroiled in a bitter, 4-year-long legal dispute that threatened to close it down. That dispute included a failed attempt by the Department of Justice to seize the property on which Harborside operates, and another failed attempt of Harborside’s landlord to evict her tenant.

Harborside’s commercial real estate issues were followed by IRS troubles. The dispensary received Notices of Deficiency that denied its claimed deductions and costs of goods sold from 2007 through 2012, and which asserted tens of millions of dollars in taxes and accuracy-related penalties.

Harborside’s Operations

Harborside operates as a California nonprofit medical dispensary, with excess income returned to patients in the form of free patient services and charitable donations. To the IRS, however, it is “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.”

This is how Justice Holmes commenced his opinion in the recent Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner of Internal Revenue decision (published November 29, 2018). That opinion described Harborside’s operations and background at great length, classifying its activities fall into four categories which are important to know in order to fully understand the tax case:

  1. Sourcing and Processing. An estimated 90-95% of Harborside employee time is spent managing the purchase, storage, testing and processing of marijuana-related products. This includes the purchase and sale of clones (plant cuttings used to cultivate marijuana), marijuana flowers (the part of the plant that people smoke), and marijuana-containing products (including “edibles, beverages, edibles, beverages, extracts, concentrates, oils, topicals, and tinctures”).
    A limited amount of time is spent on the purchase and sale of Harborside’s non-marijuana containing products, which includes “shirts, hats, and pins; nonbranded gear such as socks and hemp bags; and a variety of other products including books, dabbing equipment, rolling papers, and lighters.”
  2. Sales and pricing. To prevent its product from leaking into the black market, Harborside requires all new patients to present a photo ID and written recommendation from a California-licensed physician, sign a collective cultivation agreement, and agree to abide by Harborside’s rules and regulations. Pricing is purposefully set above the black-market rate to prevent resale.
  3. Community outreach. As a California nonprofit organization, Harborside is not permitted to pay dividends or sell equity. California Health & Safety Code Section 11362.765 prohibits the cultivation or distribution of cannabis for profits, so Harborside uses its excess revenue for the benefit of its patients or the community. The marijuana dispensary provides its patients with the following therapeutic services at no additional cost: Hypnotherapy, reiki, naturopathy, chiropractic, acupuncture, yoga, qigong, Alexander technique, and tai chi. It also offers grow classes, support groups, and addiction treatment counseling. Providers are all independent contractors paid directly by Harborside.
  4. Administrative functions. Other Harborside employees work in the areas of security, finance, human resources, and management.

No deductions allowed

In Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner of Internal Revenue, the Tax Court disallowed a tax deduction on all of Harborside’s expenses per 26 U.S. Code § 280E – including its non-marijuana related expenditures – although many dispensaries are permitted to take deductions for activities unrelated to cannabis.

In our next few posts in this series, we will discuss the court’s reasoning and how the manner in which a marijuana dispensary operates is a significant factor in the tax treatment of its non-marijuana related income.

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