Tax Court Confirms No Deductions for State-Legal Cannabis Business, Part VI: A Win for Harborside – No Accuracy-Related Penalties for Marijuana Business Acting in Good Faith

Tax Court waives accuracy-related penalties for Harborside Health Center, holding that it acted reasonably and in good faith when taking its tax position.

After numerous defeats, Oakland’s Harborside medical marijuana dispensary finally obtained a tax court win – a victory that will have wide-ranging benefits for the marijuana industry.

In our previous posts in this blog series, we explained how Harborside failed to convince the court that:

  1. its tax case should be banned on the basis of res judicata (see Part II)
  2. 26 U.S. Code § 280E should not apply to it because its activities do not solely “consist of” dealing in a controlled substance (see Part III),
  3. it should still be able to deduct business expenses relating to its non-marijuana-related activities (see Part IV), and
  4. its Cost of Goods Sold (COGS) should include that indirect costs permitted under 26 U.S. Code § 263 (see Part V)

The Tax Court concluded the Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner of Internal Revenue case by stating that the issue of accuracy-related penalties would be addressed in a separate opinion, an opinion which was recently released to the delight of Harborside and the entire marijuana industry.

The accuracy-related penalty

26 U.S. Code § 6662 imposes a 20% penalty on a tax underpayment that is attributable to a taxpayer’s “substantial understatement” of their income tax obligation, or for their negligence or disregard of rules or regulations. A “substantial understatement” is a tax underpayment that exceeds the lesser of (1) $10 million, or (2) the greater of 10% of the tax owed or $10,000.

The accuracy-related penalty may be waived if the court finds that the taxpayer acted reasonably and in good faith when taking its tax position.

A marijuana business’ good-faith efforts

The Tax Court waived Harborside’s substantial accuracy-related penalties, concluding that because the marijuana dispensary had filed all of its tax returns in a timely manner, maintained accurate financial records, substantiated all its claimed deductions and cost of goods sold (COGS), and made good-faith efforts to comply with the law, that the penalties were not warranted. The court also agreed with Harborside that:

  1. During the tax years at issue in the case, the only legal guidance was the CHAMP case;
  2. The IRS has yet to publish regulations for Section 280E; and
  3. The IRS provided no guidance on capitalization of inventory costs for marijuana businesses prior to the year 2015.

The court was particularly impressed with arguments made by Steve DeAngelo, Harborside’s co-founder and Chairman, that he made good-faith efforts to comply with the law despite the lack of clear legal authority to guide him and others in the medical marijuana industry.

Next steps for Harborside

Steve DeAngelo has expressed his pleasure with Harborside’s success in sparing marijuana businesses from unjust accuracy-related penalties. He still intends to appeal the court’s decision regarding business deductions, insisting that the IRS should treat cannabis businesses as it does all others. We’ll see whether or not DeAngelo succeeds, or whether we will just need to wait until Congress reforms Section 280E.

In our final post in this series, we will summarize the lessons learned from the Harborside vs. IRS case.