The Stage is Set

On December 3, 2019, Taxpayer timely[i] filed a notice of appeal from a decision of the U.S. Tax Court that had been entered approximately two months earlier.[ii]

Source JD Supra: https://www.jdsupra.com/legalnews/taxation-of-a-medical-marijuana-65114/

Because Taxpayer is a corporation, the Tax Court’s decision will be reviewed by the Court of Appeals for the Ninth Circuit, which is the circuit in which Taxpayer’s principal place of business is located.[iii] It is also the largest of the thirteen Courts of Appeals – thus, it is one of the most influential.[iv]

In accordance with the Code,[v] the Ninth Circuit will review de novo[vi] the legal rulings set forth in the Tax Court’s opinion.

With that, the stage is set for another episode of “Cannabis v. the Code.”

You all know our first contestant, the Commissioner of Internal Revenue, who hails from Washington, D.C.[vii]

Before introducing our second contestant – specifically, the appellant Taxpayer – let’s review the contest rules.[viii]

The Code

Under Federal law, cannabis is a “Schedule I” controlled substance; thus, the manufacture, distribution, dispensation, or possession of marijuana – even medical marijuana recommended by a physician – is prohibited as a matter of Federal law.[ix]

Deductions

The Code allows a business to deduct, for purposes of determining its taxable income, all of “the ordinary and necessary expenses paid or incurred during the taxable year in carrying on” such business,[x] subject to certain exceptions.[xi]

One of these exceptions resides in Section 280E of the Code, which provides that:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Marijuana is a Schedule I controlled substance, and dispensing it is “trafficking” within the meaning of Section 280E.

Therefore, the Code prohibits a taxpayer that is engaged in the business of “trafficking” in marijuana from deducting their related expenses.

Cost of Goods Sold

However, the fact that a taxpayer engaged in the business of trafficking in controlled substances cannot deduct its business expenses does not mean the taxpayer owes tax on the gross receipts generated by the business.

All taxpayers – including “drug traffickers” – pay tax only on their gross income, which is equal to the excess of their gross receipts over their cost of goods sold (“COGS”).

But what is the distinction between a business expense deduction and an adjustment for COGS? Deductions are subtractions from gross income that taxpayers make when they calculate their taxable income.[xii] They are “statutory”; in other words:

Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.[xiii]

COGS is the costs of acquiring inventory, through either purchase or production.[xiv] All taxpayers, regardless of their business, use COGS to offset their gross receipts when they calculate gross income.

Deduction v. COGS?

The main difference between deductions and COGS is one of timing; specifically, when does the taxpayer who incurs the cost in question benefit from the resulting reduction in their taxable income?

In general, a taxpayer can claim a deductible expense (and thereby reduce their taxable income) for the year in which they incur it. However, when accounting for COGS, the taxpayer has to capitalize the cost for the item in the year of acquisition or production of the item; then the taxpayer generally waits until the year in which the item is sold to make the corresponding adjustment (i.e., reduction) to their gross income.

Recognizing that a taxpayer may be tempted to include an otherwise non-deductible expense in their COGS, the Code provides that “Any cost which [(but for the capitalization and COGS rules)] could not be taken into account in computing taxable income for any taxable year shall not be treated as” an adjustment to COGS.[xv] In this context, “cost” means expenses that would otherwise be deductible;[xvi] thus, the taxpayer cannot circumvent the prohibition against claiming a deduction for an expense – for example, under Section 280E of the Code – by including the expense in their COGS.[xvii]

The Golden State

During the years at issue, California law provided an exemption from California laws penalizing the possession and cultivation of marijuana for patients and their primary caregivers when the possession or cultivation was for the patient’s personal medical purposes and was recommended or approved by a physician.[xviii]

Also during those years, California allowed the collective or cooperative cultivation of marijuana for medicinal purposes.[xix]

These laws led to the formation of the first marijuana dispensaries – which brings us to our next contestant.

Taxpayer’s “Business”[xx]

Taxpayer hails from California, where they operate a medical marijuana dispensary out of a space that has a reception area, healing room, purchasing office, processing room, clone room, and multipurpose room.[xxi] The facility also has a large sales floor, offices, and storage areas.

In order to operate a dispensary in compliance with California law, Taxpayer was organized and run as a not-for-profit.[xxii] It also operated under a “closed-loop” system, meaning that mean that all of its marijuana had to be provided by its patients, sold exclusively to its patients, handled only by its employees, and not diverted into the illegal market.

Taxpayer sold a wide variety of products, comprised of four main groups: clones,[xxiii] marijuana flowers, marijuana-containing products, and non-marijuana-containing products.

Taxpayer bought clones from clone nurseries, cared for them while they were in its store, repackaged them, and then sold them to its patients. It stored the clones in a clone room and sold them at a counter dedicated to clone sales. Taxpayer had at least four employees who spent their time entirely in the purchase and sale of clones.[xxiv]

Taxpayer purchased all of its marijuana flowers[xxv] from its patient-growers. Some of these growers promised to sell what they cultivated back to Taxpayer, and Taxpayer gave them either seeds or clones to get started. Other growers, however, bought seeds and clones from Taxpayer.

Once a grower had cultivated, harvested, and otherwise prepared their marijuana buds, they would bring them to Taxpayer to sell. Taxpayer had a purchasing office to inspect and test the incoming marijuana. It would accept marijuana that satisfied its criteria and rejected the rest.

If Taxpayer agreed to purchase the marijuana, it would store the marijuana in a vault, and send a sample out for testing by a third-party laboratory. If all went well, the marijuana would go to a processing room where it underwent further preparation before being weighed, packaged, and labeled. Taxpayer’s staff would put it on display on the sales floor, or put it back in the vault until needed. At least three employees were dedicated to acquiring inventory, at least four devoted to managing inventory, and still others whose sole job was to process the marijuana and ready it for resale.

Taxpayer’s marijuana-containing products included edibles, beverages, extracts, concentrates, oils, etc. (purchased from other collectives), which it tested, repackaged, relabeled, and then sold to its own patients. Taxpayer estimated that about 55% to 60% of its employees’ total time was spent on buying and processing marijuana (both the buds and marijuana-containing products), and another 25% to 30% selling it.

Taxpayer also sold non-marijuana-containing products.[xxvi] Taxpayer purchased these items from outside vendors, stored them, and resold them to patients. A little less than 25% of the sales floor was used to display and sell these items, and around 5% to 10% of Taxpayer’s employees’ time was dedicated to buying and selling these entirely legal products.

In order to prevent its marijuana from leaking into the black market, no one could enter Taxpayer’s sales floor without going through a rigorous identification process that included the presentation of a photo ID and a written recommendation from a physician licensed to practice in California. A patient also had to sign a collective cultivation agreement giving other patients the right to cultivate marijuana on their behalf, and agree to abide by Taxpayer’s rules. Taxpayer also sold its marijuana at a premium above the black-market rate to discourage its patients from reselling it.

Taxpayer’s “Problem”

Taxpayer realized significant profits. Although Taxpayer was taxable as a C-corporation for federal tax purposes, as a non-profit-profit corporation it was prohibited by California law from paying dividends; rather, it was required to use any “excess revenue” for the benefit of its patients or the community.

To this end, Taxpayer provided its patients with a wide variety of services at no additional cost.[xxvii] It continually informed its patients that Taxpayer would use part of the purchase price of the marijuana to pay for patient services and community outreach; however, patients were not required to buy marijuana to use the services.

All of the services were coordinated by Taxpayer’s “holistic-services” director[xxviii] and took place on Taxpayer’s premises. Taxpayer paid the persons who provided these service, all of whom were independent contractors.

Taxpayer had other employees in support roles. The security department, for example, spent most of its time checking in both patients and vendors and then escorting vendors into the back of the building to meet with a purchasing manager. The security group spent 60% of its time checking in patients who came to buy marijuana, another 5% checking in people on site to receive a service, and the rest in assisting vendors. Taxpayer also had an administrative group, which included employees in its finance, human resources, and facilities departments, as well as its executives.

Tax Returns and Audit

As a C-corporation, Taxpayer filed annual Forms 1120, U.S. Corporation Income Tax Return. The IRS selected Taxpayer’s 2007, 2008, and 2009 income tax returns for audit. Eventually, the IRS issued notices of deficiency for Taxpayer’s 2007 through 2012 taxable years. The notices denied most of Taxpayer’s claimed business deductions and COGS.

The IRS’s primary reason for its adjustments was that “[n]o deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on a trade or business that consists of trafficking in controlled substances.”

Taxpayer petitioned the U.S. Tax Court for relief. As we shall see, no such relief was forthcoming, which is why Taxpayer filed the above-described notice of appeal, presumably in the hope that the Ninth Circuit will be more receptive to its arguments.

The Tax Court Provides Some Context

The Court began by explaining the applicable California law and describing its conflict with Federal law.

The CCUA, the Court explained, did not decriminalize marijuana in California. Instead, it created an affirmative defense to charges of possessing or cultivating marijuana for persons who did so for personal, physician-approved use. Primary caregivers of such persons could also raise the defense. In 2003, the Court continued, California extended the CCUA’s affirmative defense to charges of transporting marijuana for patients and primary caregivers who “associate within the State of California in order collectively or cooperatively to cultivate marijuana for medical purposes.”[xxix] The MMPA also instructed California’s attorney general to develop guidelines to “ensure the security and non-diversion of marijuana grown for medical use.” Those guidelines stated that medical-marijuana cooperatives should be formally organized, not operate for profit, maintain business licenses and permits, verify each member’s status as a patient, execute an agreement with each member regarding the use and distribution of marijuana, keep records of distribution, and neither buy marijuana from nor distribute marijuana to nonmembers.

The Tax Court then described how the conflict between Federal and California law went to the Supreme Court in 2005, when two California medical-marijuana users tried to enjoin the U.S. from enforcing the Federal marijuana law against them.[xxx] The Supreme Court upheld the Federal prohibition on marijuana sale and possession with respect to medical-marijuana users.

According to the Tax Court, Congress then further complicated the situation by enacting a series of appropriations riders[xxxi] that prevented the Department of Justice (“DOJ”) from using any funds “to prevent * * * [States that permit medical-marijuana use] from implementing their own laws that authorize the use, distribution, possession, or cultivation of medical marijuana.”[xxxii] When interpreting such a rider, the Ninth Circuit stated that DOJ prosecutions of individuals who complied with state medical-marijuana laws interfered with the implementation of such laws and were therefore impermissible.[xxxiii] Thus, even though medical marijuana is illegal under Federal law, it appears that the Federal law may not be enforced by the DOJ in those states that permit the medical use of marijuana.[xxxiv]

That being said, Congress did not limit the reach of the Code.[xxxv] Thus, Section 280E prevents any trade or business that “consists of trafficking in controlled substances” from deducting any business expenses, while Section 263A(a)(2) prevents taxpayers from capitalizing – and later recovering – costs that were otherwise nondeductible.

The Court then described its first major medical-marijuana dispensary case,[xxxvi] in which it found that the taxpayer operated two trades or businesses: one that provided caregiving services, and one that sold marijuana. After requiring the taxpayer in that case to allocate its expenses between its two businesses according to the number of its employees and the portion of its facilities devoted to each, the Court allowed the taxpayer to deduct the expenses properly allocated to its caregiving business, but not those allocated to its marijuana-sales business.

By contrast, the Court stated that in its next medical-marijuana case[xxxvii] it held that a dispensary that derived all its revenue from marijuana sales, but that also provided free activities and services to its patrons, was a single trade or business. Because that single trade or business was selling marijuana, the Court held that Section 280E precluded the deduction of any of the taxpayer’s operating expenses, but did not prevent the taxpayer from adjusting for costs of goods sold.[xxxviii]

Similarly, in a later case,[xxxix] the Court found that the taxpayer – which stipulated that it was “in the business of distributing medical marijuana” – was engaged in a single trade or business because its sale of non-marijuana items, such as books, “was an activity incident to its business of distributing medical marijuana.” Thus, Section 280E prohibited the deduction of any of its business expenses.

Taxpayer’s Deductions

Taxpayer presented a number of arguments in support of its right to claim deductions for the expenses reported on its tax returns.[xl] Two of these, in particular, presented some interesting issues.

More Than One Trade or Business?

Taxpayer argued – and the Court agreed – that even if Section 280E applied to its marijuana sales, it could still deduct its expenses for any separate, non-trafficking trades or businesses. The Court, therefore, needed to determine which, if any, of Taxpayer’s activities were separate trades or businesses.

According to the Court, an activity is a trade or business if the taxpayer does it continuously and regularly with the intent of making a profit.[xli] A single taxpayer can have more than one trade or business, or multiple activities that nevertheless are only a single trade or business. The Court noted that even the activities of separate entities can constitute of a single trade or business if they are part of a “unified business enterprise” with a single profit motive.[xlii]

Whether two activities are two trades or businesses or only one is a question of fact. The Court stated that, to answer the question, it had to consider the “degree of organizational and economic interrelationship of various undertakings, the business purpose which is (or might be) served by carrying on the various undertakings separately or together * * *, and the similarity of the various undertakings.”

Recalling one of its earlier decisions,[xliii] the Court described how that taxpayer had two distinct trades or businesses – caregiving services and medical-marijuana sales – even though its customers paid a single fee that entitled them to unlimited access to the services and a fixed amount of marijuana. The Court noted there that seven of the taxpayer’s employees distributed marijuana, eighteen employees provided caregiving services, and no employees did both – there were two distinct workforces. Moreover, dispensing marijuana occurred in only 10% of one of the taxpayer’s three facilities. Thus, the Court found the taxpayer’s primary purpose was to provide caregiving services, and that those services were both “substantially different” from and “stood on * * * [their] own, separate and apart” from dispensing marijuana.

In a later decision,[xliv] however, the Court held that a taxpayer who sold medical marijuana and provided complimentary services[xlv] had a single trade or business. That taxpayer charged only for marijuana, and set a price based on the amount of marijuana its patients bought; the cost of the other services was bundled into that price. The same employees who sold marijuana also provided the services, and the taxpayer paid no additional wages, rent, or other significant costs connected exclusively with those services. The taxpayer also had a single bookkeeper and accountant for both “lines of business.” On these facts, the Court held that the services were “incident to” the sale of marijuana, and that the two activities had a “close and inseparable organizational and economic relationship.” They were “one and the same business.”

Taxpayer’s Reasoning

Taxpayer asserted that it had several activities, each of which was a separate trade or business:

  • Sales of marijuana and products containing marijuana;
  • Sales of products with no marijuana; and
  • Therapeutic services.[xlvi]

The Court considered, and dismissed, Taxpayer’s position.

For starters, the Court stated there was no question that selling marijuana and products containing marijuana was Taxpayer’s primary purpose. Sixty percent of the individuals that Taxpayer’s security checked in to their facility were there to buy marijuana in one form or another. Marijuana and marijuana products took up around 75% of Taxpayer’s sales floor. Its employees spent 80-90% of their time purchasing, processing, and selling these products, and those sales generated almost all of Taxpayer’s revenue during each of the years at issue.

Thus, the Court concluded, Taxpayer was in the trade or business of trafficking in a controlled substance.

Taxpayer’s sale of items that didn’t contain marijuana[xlvii] generated the remaining 0.5% of its revenue. The same Taxpayer employees who bought, processed, and sold marijuana also sold these items, but selling them took up only 5-10% of their time. The non-marijuana items occupied only 25% of the sales floor where Taxpayer sold marijuana, and that sales floor was accessible only to patrons who had already presented their credentials to security – which meant that no one who couldn’t buy marijuana could buy these non-marijuana items. What’s more, the record showed no separate entity, management, books, or capital for the non-marijuana sales.

This led the Court to find that the sale of non-marijuana-containing products had a “close and inseparable organizational and economic relationship” with, and was “incident to,” Taxpayer’s primary business of selling marijuana. There was also an obvious business purpose, the Court added, for selling items that facilitated and encouraged marijuana use alongside actual marijuana. It also found that the sale of items that were about marijuana, were branded with Taxpayer’s logo, or enabled the use of marijuana was not “substantially different” from the sale of marijuana itself.

The Court turned next to Taxpayer’s argument that a portion of each marijuana sale was actually a purchase of its “free” holistic services. The Court distinguished the Taxpayer’s situation from one in which members paid a set fee for unlimited access to extensive services and also received a fixed amount of marijuana, noting that in the latter case the purchase of services was paramount. The Taxpayer’s “price” for services, in contrast, was included in the amount paid for marijuana; patrons paid according to the amount and type of marijuana they wanted and, in return, gained access to incidental services. As the Court put it, a marijuana dispensary that gives away services is still only a marijuana dispensary. The fact that Taxpayer used some of its marijuana-sales revenue to pay for those services did not change that fact. Moreover, there were business reasons, the Court continued, to offer these services alongside marijuana sales: it justified premium pricing and helped Taxpayer meet the community-benefit standards required under California law. Thus, the Court found that Taxpayer’s services were not a separate trade or business.

In sum, the Court found that Taxpayer “dedicated the lion’s share of its resources to selling marijuana and marijuana products.” Those sales accounted for almost all of its revenue; its other activities were neither economically separate nor substantially different. Therefore, the Court held that Taxpayer had a single trade or business: the sale of marijuana. Because that constituted “trafficking in a controlled substance” under federal law, Taxpayer could not deduct any of its related expenses.

Taxpayer’s COGS

Having rejected Taxpayer’s arguments in support of its right to deduct the expenses it incurred in carrying on its trade or business, the Court turned its attention to Taxpayer’s arguments regarding the computation of its COGS.

The Court explained that the Code informs taxpayers of what items to include in COGS. The issue in this case, however, was that two statutory provisions were invoked, with the IRS and Taxpayer disagreeing as to which was applicable.

One provision authorized the IRS to write regulations to govern how taxpayers account for inventories (the “inventory rules”).[xlviii] Pursuant to the regulations promulgated thereunder, “resellers” are directed to use as their COGS the price they paid for inventory plus any “transportation or other necessary charges incurred in acquiring possession of the goods.”[xlix] “Producers,” however, are directed to include in COGS both the direct and indirect costs of creating their inventory.[l]

A second provision (the “capitalization rules”) directs both producers and resellers to include indirect inventory costs in their COGS.[li]

Before delving further into the two COGS provisions, the Court explained how they affect the timing of a taxpayer’s realization of any tax benefit attributable to the expenses incurred by the taxpayer. For example, a business that may otherwise immediately deduct indirect costs would, instead, have to capitalize those costs in accordance with these provisions and then wait until it realizes the related income before adjusting for the expenses. In other words, the benefit of the deduction would be deferred.

Most businesses, the Court asserted, would prefer to have an immediate deduction rather than an increased COGS later. “But drug traffickers,” the Court continued, “have a different attitude.”

Although section 280E prevents them from deducting expenses, they are still entitled to COGS adjustments. By renaming COGS what had been deductions, Congress made it possible for traffickers to adjust for expenses that they couldn’t previously claim. They have to make those adjustments in the later year when the inventory is sold, but later is better than never.

Reflecting this point, Taxpayer argued that the IRS was denying it the ability to add its indirect expenses to its COGS under the capitalization rules.

In response, the Court explained that Taxpayer could not use these rules to capitalize indirect costs that it would not otherwise be able to deduct on a current basis. That’s because the capitalization rules expressly prohibit capitalizing expenses that would not otherwise be deductible.[lii] Drug traffickers, the Court stated, could not deduct any business expenses[liii] and, so, they could not use the capitalization rules to include indirect expenses in their COGS.

Aside from that, the Court observed, because Taxpayer was a reseller, it was still allowed to calculate its gross income by subtracting, as part of its COGS – under the inventory rules – the direct cost of its inventory (inventory price and transportation costs) from its gross receipts, whether or not such direct costs were legal.

Taxpayer, however, insisted that it was a producer of the marijuana bud that it sold and, therefore, could include in its COGS the indirect inventory costs described in the inventory rules.[liv]

The Court rejected this argument, observing that Taxpayer did not create the clones, maintain control over them, or take possession of everything produced. Rather, Taxpayer bought clones from nurseries and either sold them to growers with no strings attached or gave clones to growers expecting that they’d sell bud back to Taxpayer. Nothing prevented either type of grower from selling to another collective. Taxpayer had complete discretion over whether to purchase whatever the bud growers brought in, paid growers only if it purchased their bud, and at times rejected its growers’ bud.

In other words, Taxpayer was a reseller, not a producer; thus, it could not include its indirect costs in its COGS under the inventory rules.

Game over?

The Ninth

It remains to be seen when Taxpayer’s appeal from the Tax Court’s decision will be heard by the Ninth Circuit.[lv]

However, based upon the facts of Taxpayer’s case, and based upon some of the Ninth Circuit’s earlier decisions in this area,[lvi] query whether Taxpayer can reasonably expect a positive outcome?

Notwithstanding Taxpayer’s situation, the Tax Court’s decision does provide some useful guidance for those businesses that operate – or that are thinking about operating – in states that have legalized the medical use of marijuana.

In particular, the importance of separating the sale of marijuana and marijuana products from the sale of services and other products looms large. Perhaps these varied lines should be housed in different business entities, maintain separate books and accounts, and employ separate workforces? To the extent they “share” any service providers, the separate entities should agree upon a reasonable allocation of the costs therefor. Of course, each entity should charge separately for its own particular products and/or services – the two should not be bundled together. As far as locations are concerned, the two separate lines of business should be physically separated and easily distinguishable from each other.

With the implementation of the foregoing guidelines, it may be possible to maximize the deductions that are reasonably attributable to the non-marijuana activities.

As for the COGS, it is clear that Congress sought to limit the expenses that “drug traffickers” – resellers, such as Taxpayer – could include in their COGS to their direct expenses only, pursuant to the inventory rules, which do not distinguish between legal and illegal expenses. They are not permitted to use the capitalization rules to also add their indirect illegal expenses to COGS.

Any modification to this limitation will likely have to wait for a change in the Federal treatment of marijuana as an illegal controlled substance.

In any case, stay tuned for the sequel to Taxpayer’s drama, which will be played at the Ninth Circuit.


[i] In general, a taxpayer seeking appellate review of a decision of the Tax Court must file a notice of appeal with the clerk of the Tax Court within 90 days after the Court’s decision is entered. IRC Sec. 7483.

See also Rule 13 of the Federal Rules of Appellate Procedure.

[ii] Patients Mutual Assistance Collective Corporation v. Comm’r, 151 T.C. No. 11 (11/29/18) (which consolidated Docket Nos. 14776-14, 30851-12, 29212-11); entered October 17, 2019.

Note that the date on which the opinion (November 2018) was issued is not the same as the date on which the Tax Court’s decision was entered (October 2019). The opinion, written by a Tax Court Judge, explains the conclusions reached after the trial. After the opinion is issued, a decision will be entered that is consistent with the Judge’s opinion. IRC Sec. 7459.

In general, where the Tax Court has ruled in favor of the IRS, the decision sets forth the amount of the resulting deficiency.

[iii] IRC Sec. 7482(b)(1)(B).

[iv] Its decisions cover approximately one-fifth of the country’s population, residing in Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. (Its jurisdiction also covers certain Territories; e.g., Guam.)

At least until recently, the Ninth Circuit has been viewed as one of the most “liberal” of courts – Pres. Trump’s appointments have changed that.

[v] IRC Sec. 7482(a) provides that the U.S. Courts of Appeals have exclusive jurisdiction to review the decisions of the Tax Court, and directs that they do so in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury.

[vi] See, e.g., Scheidelman v. Comm’r, 755 F.3d 148 (2d Cir. 2014). This is a higher level of scrutiny than simply determining whether the lower court’s decision was clearly erroneous in light of the evidence.

[vii] IRC Sec. 7803.

[viii] In case you’re wondering, the recreational use of cannabis has not been legalized in the State of New York. Guess I’m still giddy over the Titans’ win against the Pats.

[ix] See Controlled Substances Act, P.L. 91-513, sec. 202.

[x] IRC Sec. 162(a).

[xi] IRC Sec. 161.

[xii] IRC Sec. 63(a).

[xiii] New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

[xiv] Reg. Sec. 1.61-3(a), Sec. 1.162-1(a).

[xv] IRC Sec. 263A(a)(2).

[xvi] Reg. Sec. 1.263A-1(c)(2).

[xvii] See Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647.

[xviii] See the California Compassionate Use Act of 1996 (“CCUA”). California was the first state to legalize the medical use of cannabis. Fast forward to 2016, California approved a ballot measure to legalize the recreational use of cannabis.

[xix] More on this below.

[xx] You’ll appreciate all of these details later.

[xxi] You’re expanding your vocabulary, aren’t you?

[xxii] In case you’re wondering, the IRS has determined that a marijuana dispensary generally cannot qualify as a tax-exempt organization under IRC Sec. 501(c)(3) because it is engaged in what federal law regards as a criminal enterprise and, thus, is not operated exclusively for charitable purposes.

Some might say it’s the worst of two worlds: a taxable not-for-profit.

[xxiii] Cuttings from a female cannabis plant that can be transplanted and used to cultivate marijuana. Yes, you heard me.

[xxiv] You’ll never think of “the clone wars” in the same way again.

[xxv] It’s not the leaves of the marijuana plant, but its flowers (or buds) that people can smoke.

I know what some of you may be thinking but, to quote Austin Powers, “That’s not my bag, baby!”

[xxvi] These included branded gear such as shirts, hats, and pins; non-branded gear such as socks and hemp bags; and a variety of other products including books, dabbing equipment, rolling papers, and lighters.

[xxvii] These services included one-on-one therapeutic sessions for hypnotherapy, acupuncture, and chiropractic consultations, as well as group sessions for yoga and tai chi. Taxpayer also offered grow classes, support groups, addiction treatment counseling, and a “sliding scale program” that gave discounts to patients with financial difficulties.

[xxviii] My firm has one of those – not.

[xxix] The Medical Marijuana Program Act (“MMPA”).

[xxx] See Gonzales v. Raich, 545 U.S. 1 (2005).

[xxxi] Basically, a provision added to a spending bill that denies funding for a specified action by an executive agency.

[xxxii] Consolidated Appropriations Act, 2019, P.L. 116-6, sec. 537; Consolidated Appropriations Act, 2018, P.L. 115-141, sec. 538; Consolidated Appropriations Act, 2017, P.L. 115-31, sec. 537; Consolidated Appropriations Act, 2016, P.L. 114-113, sec. 542; Consolidated and Further Continuing Appropriations Act, 2015, P.L. 113-235, sec. 538.

[xxxiii] United States v. McIntosh, 833 F.3d 1163 (9th Cir. 2016).

[xxxiv] This state of affairs continues today.

[xxxv] “The power to tax involves the power to destroy.” Chief Justice John Marshall, in McCulloch v. Maryland (1819).

[xxxvi] Californians Helping to Alleviate Med. Problems, Inc. v. Comm’r (CHAMP), 128 T.C. 173, 181 (2007).

[xxxvii] Olive v. Comm’r, 139 T.C. 19 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015).

[xxxviii] The years at issue predated the amendment, in 1988, of IRC Sec. 263A.

[xxxix] Canna Care, Inc. v. Comm’r, T.C. Memo 2015-206, aff’d, 694 F. App’x 570 (9th Cir. 2017).

[xl] One of these – that Taxpayer’s business did not “consist of” trafficking in a controlled substance under Section 280E – occupied an inordinate amount of the Court’s time and will not be considered here. The Court examined what it means for a business to “consist of” trafficking, and concluded that Taxpayer’s trade or business included trafficking in controlled substances, “even if that trade or business also engages in other activities.”

[xli] This is the standard definition.

[xlii] Witness the discussions of what constitutes a “trade or business” for purposes of Sec. 199A of the Code. For our purposes, think of the “crack and pack” strategies that so many endorsed before regulations were proposed to thwart the artificial division of what was, in substance, a single trade or business.

[xliii] CHAMP, supra note xxxvi.

[xliv] Olive, supra note xxxvii.

[xlv] Including movies, yoga classes, massages, personal counseling, and advice on how to best consume marijuana.

[xlvi] Taxpayer’s final argument was that its brand-development activity was a separate trade or business, insisting that it was performed with an independent profit motive. In order to support a profit motive without any revenue, Taxpayer claimed that its branding activities were part of a “unified business enterprise” with its money-making activities during the years at issue.

A separate entity purposely operating at a loss, the Court stated, was still a trade or business eligible for deductions if it and the entities related to it together formed a unified business enterprise that itself had a profit motive. In other words, the unified-business-enterprise doctrine Taxpayer relied on said that separate but related entities could share a single profit motive. Rather than show that Taxpayer’s branding was separate from its marijuana sales, the unified-business-enterprise doctrine instead suggested that it was part of a single overall trade or business.

As the Court stated, “Rather than being “substantially different” from the underlying sale of marijuana, Taxpayer’s brand development was necessarily entwined with it.” It was not a separate trade or business.

[xlvii] Such as branded clothing, hemp bags, books about marijuana, and marijuana paraphernalia such as rolling papers, pipes, and lighters.

[xlviii] IRC Sec. 471.

[xlix] Reg. Sec. 1.471-3(b).

[l] Reg. Sec. 1.471-3(c); Reg. Sec. 1.471-11. The regulations direct producers to capitalize the “cost of raw materials,” “expenditures for direct labor,” and “indirect production costs incident to and necessary for the production of the particular article, including * * * an appropriate portion of management expenses.”

[li] IRC Sec. 263A(a)(2)(B) and Sec. 263A(b); Reg. Sec. 1.263A-1(a)(3), (c)(1), (e).

[lii] IRC Sec. 263A(a), last sentence.

[liii] IRC Sec. 280E.

[liv] Recall that the inventory rules apply differently for resellers than for producers, with the latter being allowed to include both their direct and indirect costs.

It was clear that Taxpayer was a reseller of the marijuana edibles and non-marijuana-containing products it bought from third parties and sold at its facility – thus, it could not include the indirect costs thereof in its COGS.

[lv] It has been assigned Case Number 19-73078.

[lvi] See, e.g., Olive, supra note xxxvii.

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