A cannabis business may deduct business expenses for non-marijuana-related activities only if certain conditions are met.
In our recent posts on the Harborside vs. IRS case, we explained how the Oakland medical marijuana dispensary was unable to bar the case against it on the grounds that the matter had already been adjudicated, and convince the Tax Court that the language of 26 U.S. Code § 280E barring deductions for marijuana businesses does not apply to it because its activities do not merely “consist of” trafficking in a controlled substance.
In this post, we review the third argument made by Harborside, that it should at least be permitted to deduct business expenses for its non-marijuana-related activities.
Defining “separate trade or business”
Harborside correctly pointed out that a number of other marijuana businesses have been permitted to deduct non-cannabis-related business expenses. The court agreed that expenses for any separate, nontrafficking trades or businesses may be deducted by a marijuana dispensary, and set out to determine if any of Harborside’s activities qualified.
The court’s task here was to determine whether the Harborside medical marijuana dispensary’s operations involved more than one trade or business. That determination, it stated, is a question of fact in which the business’ purpose, the similarity of the activities, and the interrelationship of the activities must be considered. Here are summaries of the main cases it referenced, and why the deduction was allowed or disallowed in each of those cases:
- Deductions for non-cannabis-related activities were allowed in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP). In that case, the dispensary operated two distinct businesses – caregiving services and marijuana sales – even though its customers paid a single fee for both. Since the two businesses did not share any common employees, and marijuana sales took place in only one of the taxpayer’s facilities (and comprised only 10% of that business), the court determined that caregiving was the taxpayer’s main activity and that it stood “separate and apart” from the marijuana sales. Therefore, the taxpayer was permitted to deduct expenses allocated to the caregiving business (but not to the marijuana-sales business).
- In Olive v. Commissioner, a taxpayer that sold medical marijuana and, like Harborside, also provided free services, was deemed a single trade or business and was not permitted to deduct any of its operating expenses. The court noted that the taxpayer in that case charged only for the marijuana, had no significant costs connected exclusively with the non-marijuana services, and that the employees who sold the marijuana were the same employees that provided the services. The court concluded that the services provided were merely “incident to” the sale of marijuana, that the two activities had a “close and inseparable organizational and economic relationship,” and that the taxpayer was engaging in activities that were, in essence, “one and the same business.”
- The taxpayer in Canna Care, Inc. v. Commissioner was also engaged in a single trade or business and was not permitted to deduct expenses for the sale of its nonmarijuana items (books and socks) because those activities were “incident to its business of distributing medical marijuana.”
Harborside argued that it had four activities, each of which was a separate trade or business: (1) sales of marijuana and products containing marijuana; (2) sales of products with no marijuana; (3) therapeutic services; and (4) brand development. The court, however, determined that Harborside’s main purpose is to sell marijuana. Following is a breakdown of its analysis:
The sales floor. Marijuana and marijuana products comprised 75% of Harborside’s products offered for sale. Despite the fact that 25% of the sales floor was reserved for non-marijuana products, marijuana sales generated at least 98.7% of the dispensary’s revenue.
Employee activities. Like Olive, the same employees who bought, proceeded, and sold the marijuana also sold the non-marijuana items. 80-90% of Harborside employee time was spent on the marijuana products.
Customers. The Harborside sales floor (including the area containing the non-marijuana items) was only accessible to customers who arrived with their medical marijuana credentials. 60% of Harborside’s members came to the dispensary to buy some form of marijuana.
Management. There were no separate entities or books for Harborside’s nonmarijuana sales, and the management was the same. Even the non-marijuana products were about marijuana, enabled the use of marijuana, and/or were branded with the Harborside logo. This indicates that, as in Canna Care, the sale of non-marijuana products was inseparable from and merely “incident to” the Harborside’s primary business – marijuana sales.
Profit Motive and Payment Structure. The act of selling two products or types of products does not mean that each is a separate trade or business. Neither is a free service considered a separate trade or business, even if it attracts customers. Harborside argued that like CHAMP, a portion of each of its marijuana sales was in fact a purchase of the free holistic services it provided. The court disagreed, noting that while Harborside sold marijuana and offered holistic services for free, the “global fee” changed by the taxpayer in CHAMP was for a fixed amount of marijuana and the balance was for its services (which comprised the majority of its space and employee time). The court concluded that the Harborside Health Center’s operations were more similar to those in Olive, in which the taxpayer also provided free services and where deductions were denied. This is besides the fact that the value of Harborside’s free services totaled merely 1% of Harborside’s marijuana revenue, and were in any event needed in order for Harborside to meet the State of California’s community-benefit requirements.
Branding. Despite Harborside’s contention that its branding activities constituted a separate trade or business, the court failed to find any evidence of that – on the contrary, everything about the dispensary’s operations, from its marijuana sales, to its structure, employees, and facilities utilized, indicated that Haborside’s branding work was “necessarily entwined” with its brand development.
What are you really doing?
If nearly everything you’re doing is selling marijuana, you are unlikely to succeed in an argument that you operate a separate non-marijuana trade or business without ample evidence to the contrary. In Harborside vs. IRS, a significant part of the Tax Court’s opinion was dedicated to distinguishing between Harborside’s operations and that of other marijuana dispensaries. Other marijuana businesses should prepare for the same kind of scrutiny.
During the tax years at issue, Harborside’s marijuana sales accounted for nearly all of its revenue. Its other activities, including the sale of non-marijuana products and holistic services, were not managed separately. It is therefore not surprising that the Tax Court concluded that Harborside operated a single trade or businesses. And since that business was selling marijuana, a controlled substance prohibited under federal law, the court denied Harborside all of its business deductions per 26 U.S. Code § 280E.
In our next post, we will discuss what Harborside was permitted to include in its cost of goods sold (COGS).