Harborside & Nor Cal Opinions. Dispensaries, Don’t Despair. There Are Solutions

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AUTHOR:  aBIZinaBOX Inc. CPAs – Jordan S. Zoot, CPA

The recent Tax Court decision in Northern California Small Business Assistants Inc. v. Commissioner [“Nor Cal”][1] made what is perhaps the most damning statements[2] yet regarding the application of IRC Sec. 280E to cannabis dispensaries. The Court stated:


“Our precedent is unambiguous. Congress, rather than this Court, is the proper body to redress petitioner’s grievances. We are constrained by the law, and Congress has not carved out an exception in IRC Sec.280E for businesses that operate lawfully under State law.

Until then, petitioner is not entitled to deduct expenses incurred in the operation of its drug-related business.”

In reaching our holding, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit.”


The Court in Nor Cal followed the Tax Court precedential analysis by Judge Mark V. Holmes in his opinion in the first Harborside case[3].

The first Harborside case rejected the manner in which the two dispensaries determined Cost of Goods Sold (“COGS”).  Judge Holmes agreed with the Chief Counsel Memorandum[4] that IRC Sec. 471 should be used by a cannabis dispensary to determine COGS.  The opinion in Harborside rejected the use of IRC Sec. 263A and approved the use of IRC Sec. 471 in the determination of COGS[5].

The situation becomes particularly grim for California dispensaries beginning after 2017.  California’s Bureau of Cannabis Control adopted regulations beginning in 2018 that require Retailers to purchase cannabis that has been tested, packaged, and labeled by a Distributor[6].  The adoption of these regulations renders virtually all adjustments to COGS by a dispensary improper[7].


A California cannabis dispensary can mitigate against a significant portion of the adverse impact of the Harborside and Nor Cal opinions. These opinions create an opportunity for a cannabis dispensary to exclude from gross revenue a substantial portion of the money collected from cannabis consumers. Through the adoption of proper record-keeping systems and procedures, a dispensary can treat all of the money it collects for taxes that are not included in COGS as taxes imposed on consumers, or as reimbursements for taxes paid or payable by the dispensary, that must be remitted to various governmental agencies.


A dispensary will collect state level Cannabis Excise Tax [“CET”], California Sales Tax, and it may collect any of a variety of municipal and county sales taxes, excise taxes, and gross receipts taxes[8]. These funds are money that a dispensary is obligated to remit to various governmental agencies.


As a consequence of the Harborside and Nor Cal opinions, it is critical for a dispensary to not allow these funds [“Reimbursable Taxes”] to be included in gross revenue. If Reimbursable Taxes are properly identified and consistently segregated using an escrow account[9] [“Reimbursable Tax Escrow”], all taxing agencies should recognize these taxes are properly excluded from gross revenue.


The taxes included in the money a dispensary will collect from retail customers can be classified into five categories as follows:


(1) income taxes which will be paid by the dispensary out of income;

(2) CCT which will be paid to a distributor by the dispensary as part of COGS;

(3) local taxes on cannabis that may be comparable to the preceding classification (2) or comparable to either of the two classifications (4) and (5) that follow;

(4) CET which is an excise tax that a dispensary is required to collect from a cannabis consumer that has some aspects of being money held in trust by virtue of the requirement that collections of CET in excess of the amounts actually paid by a dispensary to distributors are owed to California under the language of the statute; and

(5) Sales Tax collections which are more specifically money that constitute a trust fund in the hands of the retail seller that is collected as an agent for California and for which there is personal liability for a failure to remit.


We believe that the taxes identified in (1) and (2) above cannot be excluded from gross revenue. However, the taxes identified in (3), (4), and (5) may be excluded from gross revenue by a dispensary if:


  • Each of the taxes is separately stated and identified on sales receipts that the dispensary provides to its retail customers; and
  • The dispensary creates and maintains separate Reimbursable Tax Escrow trust account as well as complete and accurate records of each type of tax collected, deposited into the account, and remitted from the account, and performs a reconciliation for the trust account and the various Reimbursable Taxes each time the dispensary prepares a tax return and remits tax to a governmental agency.


While this issue is not entirely free from doubt, a dispensary that carefully maintains and utilizes a separate trust account, and minimizes transfers into and out of such an account, has a high probability the segregation of these funds as well as the exclusion of these funds from gross revenue will be respected.


Sources / Footnotes

[1] 153 TC 4 (2019)

[2] The taxpayer also argued in this case that IRC Sec. 280E solely applies to IRC. Sec. 162 deductions.  The taxpayer argued that the text of IRC Sec. 280E “tracks” the language of IRC Sec. 162 which allows a deduction for all ordinary and necessary business expenses.  The taxpayer argued the use of the same language indicated the prohibition of IRC Sec.  280E should solely apply to IRC Sec. 162 deductions. Judge Goeke points out the taxpayer’s argument ignored the first line of IRC Sec.  280E which states, “No deduction or credit shall be allowed . . . .” (Emphasis added.)  The Court states the language of this section is clear and unequivocal.

Judge Goeke also points to a broader statutory scheme as support for the conclusion IRC Sec. 280E means what it says – no deductions under any section shall be allowed for businesses that traffic in a controlled substance.  As the Court points out, IRC Sec. 261 which is found in part IX of subchapter B of Chapter 1 of the Code, provides that “no deduction shall, in any case, be allowed in respect of the items specified in this part.”  IRC Sec. 280E is found in part IX[9]

[3] 151 TC 11(2018)

[4] CCM 201504011

[5] The tax year 2015 is significant for two reasons. The Tax Court’s decision in Olive v. Commissioner, 139 TC 19, 36-42 (2012) aff’d 792 f.3d 1146 [CA-9, 2015] was the first reviewed decision that discussed the phrase “consists of” in IRC Sec. 280E.  Olive was not affirmed by the 9th Circuit until 2015.  Chief Counsel Memorandum 201504011 was issued in 2015. This Memorandum provided the first guidance from the IRS relating to IRC Sec. 280E.  The IRS has never promulgated regulations relating to IRC Sec. 280E. A taxpayer that fails to utilize IRC Sec. 471 post-2015 is almost certainly subject to the “substantial understatement” penalty contained in IRC Secs. 6662, and potentially the civil fraud penalty in IRC Sec. 6663.

[6] See § 5412. Prohibition on Packaging and Labeling by a Retailer.

  • A licensed retailer shall not accept, possess, or sell cannabis goods that are not packaged as they will be sold at final sale, in compliance with this division.
  • A licensed retailer shall not package or label cannabis goods.
  • Notwithstanding subsection (b) of this section, a licensed retailer may place a barcode or similar sticker on the packaging of cannabis goods to be used in inventory tracking. A barcode or similar sticker placed on the packaging of a cannabis goods shall not obscure any labels required by the Act or this division.

Authority: Section 26013, Business and Professions Code. Reference: Section 26120, Business and Professions Code. and

  • 5303. Packaging, Labeling, and Rolling.
  • A licensed distributor may package, re-package, label, and re-label cannabis, including pre- rolls, for retail sale. All packages of cannabis, including pre-rolls, shall comply with the following:
  • Until January 1, 2020, all packages shall meet the following requirements:
  • The package shall protect the cannabis, including pre-rolls, from contamination and shall not expose the cannabis or pre-rolls to any harmful substance.
  • The package shall be tamper-evident.
  • If the package of cannabis or pre-rolls contains more than one serving, then the packaging shall be resealable.
  • The package shall not imitate any package used for goods that are typically marketed to children.
  • Beginning January 1, 2020, all packages shall meet the requirements of subsection (a)(1) of this section and shall also meet the following requirements:
  • The package shall be child-resistant until the package is first opened. For purposes of this division, the following packages are considered child-resistant:
  • Any package that has been certified as child-resistant under the requirements of the Poison Prevention Packaging Act of 1970 Regulations (16 C.F.R. §1700.15(b)(1)) (Rev. July 1995), which is hereby incorporated by reference.
  • Plastic packaging that is at least 4 mils thick and heat-sealed without an easy-open tab, dimple, corner, or flap.
  • The package shall be labeled with the statement “This package is not child-resistant after opening.”
  • Notwithstanding subsections (a)(1)-(a)(2) of this section, immature plants and seeds shall not be required to be packaged in child-resistant, tamper-evident, and resealable packaging.
  • A licensed distributor shall not process cannabis but may roll pre-rolls that consist exclusively of any combination of flower, shake, leaf, or kief. Pre-rolls shall be rolled prior to regulatory compliance testing.
  • Licensed distributors may label and re-label a package containing manufactured cannabis goods with the amount of cannabinoids and terpenoids based on regulatory compliance testing results.

Authority: Section 26013, Business and Professions Code. Reference: Sections 26013 and 26120, Business and Professions Code.

[7] The common practice for California dispensaries prior to the Harborside decision was to purchase flower in bulk, and then process and package, label, and possibly test the flower in-house.  With proper substantiation, the opinion in Harborside permits a dispensary to utilize IRC Sec. 471 to increase COGS for both the direct and indirect costs properly allocable to the handling, processing, packaging, and security for the conversion of bulk purchases of cannabis inventory into a retail product.

The Harborside opinion approves the use of IRC Sec. 471.  California’s regulation of its cannabis industry, however, now prohibits a dispensary from processing products for retail sale.  A California dispensary must acquire cannabis products from a distributor in a consumer-ready form.  Commercial cannabis products must be acquired by a California dispensary fully packaged and labeled.  As a consequence of regulatory requirements, effective January 1, 2019, a California dispensary is effectively subject to income tax on Gross Income (Gross Revenue less Cost of Goods Sold [“COGS”] )  for federal income tax purposes.

[8] A similar set of principles applies to the portion of employment taxes which are withheld from employee paychecks and treated as “trust funds”. A discussion of employment taxes is beyond the scope of this article.

[9] An escrow account is an account where funds are held in trust for a particular purpose, for example a segregation of funds that were collected for a taxing agency. In formalized escrow arrangements third-party acting as a fiduciary will hold funds in a segregated trust account. Funds are subject to disbursement in accordance with the contractual arrangements for the escrow.


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