The Tax Court held that a medical marijuana dispensary was required to calculate its cost of goods sold (COGS) using the rules of Sec. 471 rather than Sec. 263A because Sec. 263A does not allow the capitalization of any cost that otherwise would not be deductible. The court also held that under Sec. 471, the taxpayer was a reseller, not a producer, of marijuana buds because it did not own them during the entire production process, and thus its COGS was the purchase price of the marijuana and any freight charges to acquire it.
Facts: In 2006, Patients Mutual Assistance Collective Corp., doing business as Harborside Health Center, began operations as a medical marijuana dispensary. From 2007 to 2012, virtually all of its revenue each year came from marijuana-related sales consisting of the sale of clones (cuttings from a cannabis plant that can be transplanted to grow more plants), marijuana buds, and products containing marijuana. During that same period less than 1% of its revenue came from products that did not contain marijuana. About 55% to 60% of its employees' time was spent buying and processing marijuana. When filing its corporate tax return for tax years 2007 to 2012, Harborside deducted its ordinary business expenses and included indirect inventory costs in its COGS. The IRS audited those returns, disallowed most of Harborside's deductions, reduced its COGS, and assessed tens of millions of dollars in deficiencies and accuracy-related penalties. Harborside petitioned the Tax Court for relief.
Issues: Sec. 280E disallows a deduction for any expense of a trade or business that consists of trafficking in controlled substances such as medical marijuana. When determining gross income, drug traffickers are allowed to subtract COGS. Under Regs. Sec. 1.471-3(b), inventory cost for resellers is the amount paid for inventory plus other costs necessary to acquire the inventory, such as freight charges. For producers, inventory cost is raw material cost, direct labor cost, and indirect production costs (Regs. Sec. 1.471-11). Sec. 263A requires producers and resellers to include in inventory cost indirect service costs such as purchasing, handling, security, warehousing, and cost accounting costs; however, any otherwise nondeductible cost cannot be added to inventory cost.
Harborside argued that if it were denied the use of Sec. 263A and if its COGS included only the purchase price of the marijuana, it would pay tax on more than its gross income, a violation of the 16th Amendment. It also argued that if it had to compute COGS under Sec. 471, it should be considered a producer of marijuana buds, allowing it to include indirect inventory costs in its COGS. Furthermore, Harborside argued, it should be allowed to deduct its ordinary business expenses because "consists of" trafficking in controlled substances in Sec. 280E implies an exhaustive list, meaning that the provision applies only to businesses that exclusively traffic in controlled substances.
Holding: The Tax Court held that the Sec. 263A rules do not apply to drug traffickers because that provision "expressly prohibits capitalizing expenses that wouldn't otherwise be deductible"; therefore, Harborside, as a drug trafficker, must calculate its COGS using the rules of Sec. 471. The court then held that, for purposes of Sec. 471, Harborside was not a producer of the marijuana buds that it sold because it did not own them during the entire production process. According to the court, ownership requires the taxpayer to maintain a high degree of control over the goods during the entire production process, and the taxpayer did not meet this standard because it either sold or gave marijuana seeds or clones to its members with no strings attached and then later bought buds from the members only if and when it wanted to do so. The court also found that based on dictionaries, the Code, and case law, the term "consists of" can introduce an exhaustive or nonexhaustive list, but interpreting it in this context as introducing a nonexhaustive list "is the only option that doesn't render [Sec.] 280E ineffective and absurd." Therefore, the court held it referred to a nonexhaustive list, and, therefore, Sec. 280E applies to any trade or business that is involved in trafficking controlled substances, even if it has other activities.
- Patients Mutual Assistance Collective Corp., 151 T.C. No. 11 (2018)
— By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.