Last Friday, the U.S. Tax Court ruled against California-based cannabis dispensary company Harborside, which had hoped to end the 280E tax code stranglehold over the marijuana industry's profit margins. The two and half year battle ended when the court upheld the tax code.
"We regret that Harborside was unsuccessful in its attempt to persuade the U.S. Tax Court that the plain meaning of Internal Revenue Code Sec. 280E does not apply to state-licensed cannabis dispensaries," said Harborside CEO Andrew Berman. "We feel this is a setback for the entire cannabis industry, which is simply seeking the same tax treatment by the IRS that every other industry is subjected to."
Section 280E, which prevents state-legal marijuana companies from deducting otherwise ordinary business expenses from their total income, is one of the biggest obstacles cannabis entrepreneurs run up against. While most companies in the U.S. pay a standard corporate tax rate of 35%, cannabis businesses, thanks to 280E, often face effective tax burdens of 70% or more.
The judge still has to address the penalties phase in a second opinion. Jordan Zoot, the CEO of cannabis accounting firm ABIZinaBOX estimated that Harborside's tax deficiency with penalties and interest could approach $20 million. He wrote, "The years before the Tax Court in the case decided November 29 were 2007-2012. Harborside appears to have at least doubled its revenue in the six succeeding years. Harborside may have a substantially larger federal income tax liability for the six succeeding years -- 2013-2018."
FLRish is the company that manages Harborside, and it had announced in August that it was entering into a binding letter agreement with Lineage Grow Company Ltd. (CSE:BUDD) for a reverse takeover in a deal valued at C$200 million. Lineage will acquire all of the outstanding shares of Harborside in exchange for newly issued shares of Lineage. The move will help Harborside expand within the state and across the U.S.
Berman said "Harborside remains in a very strong financial position as it undergoes its transition from a non-profit to a for-profit entity and subsequent listing on the Canadian Securities Exchange. At this point in time, we do not expect the Court ruling to have any effect on the timing of our listing. FLRish management anticipated the Court outcome and has been proactive in considering it in financial projections and planning."
Zoot also noted that the judge pointed out that Harborside used an inefficient tax income operating structure and methodology for its dispensary operations -- an opinion that could affect other California cannabis companies that have used this same approach. The opinion by the judge surely had many companies racing to their accountants to make sure their organizations are set up in the most tax-efficient structure.
Federal Legislation
California companies have been trying to remedy the 280E situation because it seems legislation on a national level hasn't made any progress. Just last week, legislation sponsored by Colorado lawmaker Jared Polis that would have alleviated the 280E burden was blocked from going to a vote. Outgoing Texas Representative Pete Sessions, who lost in the midterm elections, prevented the amendment from going to a vote by refusing to classify it as "in order." The incoming Rules Committee chairman Rep. James McGovern said he would allow the cannabis amendment to be considered once he is in charge. In the meantime, Sessions is continuing to block any cannabis legislation from going to a vote.
A free cannabis legislation tracker is available here on the Green Market Report to follow the progress of cannabis legislation.
The History of 280E
The heart of Section 280E centers around how Federal tax law deals with businesses that are associated with "trafficking" substances that are listed in Schedule I or Schedule II of the Controlled Substance Act. Since cannabis remains listed as a Schedule I substance at the federal level, the Internal Revenue Service applies Section 280E to most state-legal marijuana companies, preventing them from deducting normal business expenses from their total income.
The measure was originally passed in response to a 1982 U.S. Tax Court case in which a cocaine dealer successfully defended tax deductions relating to his illegal drug business. Congress enacted 280E to prevent other drug dealers from following suit and trying to deduct business expenses relating to their illegal activities.
Although it stems from the case of someone who was operating clearly outside the bounds of all state and federal laws, the IRS has since decided that Section 280E also applies to licensed, regulated marijuana businesses acting in full compliance with state cannabis laws and federal guidelines. If cannabis was rescheduled to a lower classification, it's possible that the issue would be resolved.
Most businesses in the United States are only required to pay taxes on their taxable income, which is calculated by subtracting business expenses from total income. But cannabis businesses can only deduct the cost of goods sold on their taxes -- that is, the direct costs of the materials used in creating goods along with the direct labor costs used to produce those goods.
The businesses cannot deduct operating expenses like payroll, rent, electricity, and advertising, or the high costs of obtaining a state marijuana license. Together, these non-deductible costs account for a substantial portion of the total costs associated with running a business.
Next Steps
"280E continues to negatively impact the growth of the legal cannabis industry, the jobs that it has created, and state/local tax revenue that have come as a result," said Harborside co-founder Steve DeAngelo. "Harborside therefore remains committed to pursuing the elimination of this impediment and will continue its efforts through the courts and Congress."
Harborside said it plans to appeal to the United States Court of Appeals for the Ninth Circuit. The company said it was the practice of the Ninth Circuit to encourage parties to negotiate and come to an agreement prior to oral arguments. So, it sounds like Harborside is hoping to reach a settlement of sorts.
