Tax Court Confirms No Deductions for State-Legal Cannabis Businesses, Part II: Harborside vs. IRS

In recent Tax Court case, Harborside Medical Center of Oakland, California, is unsuccessful in claiming that res judicata bars the IRS from pursuing a tax claim against it.

Following the passage of the California Compassionate Use Act of 1996 and subsequent laws permitting the collective or cooperative cultivation of marijuana, marijuana dispensaries began to pop up all over the state. However, under federal law these dispensaries remained illegal and business tax deductions are disallowed under 26 U.S. Code § 280E.

Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner of Internal Revenue (Harborside vs. IRS) is the latest in a series of legal and operational challenges that the Harborside medical marijuana dispensary co-founder Steve DeAngelo has faced since 2012. The case was Harborside’s challenge to an IRS assessment of tens of millions of dollars in deficiencies and accuracy-related penalties after most of its claimed deductions and costs of goods sold were denied for tax years 2007 through 2012.

This case provides taxpayers and their counsel with some invaluable guidance on how the Tax Court is interpreting the tax code for state-legal, federally-illegal cannabusinesses.

Compliance does not provide guaranteed protection from government intervention

The Tax Court acknowledged that when Steve DeAngelo opened the Harborside Heath Center in order to provide medical marijuana to patients in Oakland, California, he took great pains to ensure that his new, state-legal enterprise was in compliance with California and local laws. DeAngelo obtained the proper permits, organized as a California nonprofit, and established quality control procedures over Harborside’s product to ensure that it is medicine-grade.

In addition, Harborside’s operations are managed as a “closed-loop” system in accordance with California law – all of its employees are patients, the marijuana is provided only by patients, and the product is sold exclusively to patients. Harborside’s cannabis is priced high so that it provides no advantage to those who may be looking to divert it to the illegal market. Finally, Harborside is a “C” Corporation for federal tax purposes and it timely files a Form 1120, U.S. Corporation Income Tax Return every year.

The tax court also acknowledged that the millions of dollars in taxes and accuracy-related penalties will be difficult for Harborside to pay, since despite its high earnings, all excess Harborside income has been utilized for community outreach (therapeutic services, grow classes, support groups, and addiction treatment counseling).

If the government abandons one claim against you, that doesn’t mean that it can’t bring another

Before the Harborside’s tax troubles began, the Department of Justice (DOJ) attempted to seize the property on which it operates through a civil forfeiture action on the grounds that the medical marijuana dispensary had violated federal drug laws. After a lengthy legal battle, the DOJ dropped its case. When the tax case later commenced, Harborside attempted to have the IRS action barred on the grounds that the claim had already been adjudicated. This is called res judicata.

Res judicata may bar a lawsuit if the identical claim was already tried by a court, by the same parties, and there has already been a final judgment on the merits. In this case, Harborside tried to argue that the IRS could not argue that it was trafficking in a controlled substance (and therefore apply Section 280E) because the matter had already been addressed in the earlier civil forfeiture claim.

The tax court noted that res judicata generally does apply to tax cases. However, it pointed out that although the two cases share many of the same facts, the government could not have brought the action against Harborside for its tax deficiencies as part of the previous civil forfeiture case (they “are not… different paths to the same goal”). It therefore ruled that res judicata does not bar the IRS deficiency action here.

In our next post, we will continue our examination of the Harborside v. IRS case with a discussion of how the Tax Court determined what it means for a business to “consist of” trafficking through an in-depth analysis of the phrase in common usage, statutes, case law, and Shakespeare.