Ninth Circuit Upholds Denial of Cannabis Dispensary's Claimed Exclusions

(Parker Tax Publishing May 2021)

The Ninth Circuit affirmed a Tax Court decision rejecting a retail cannabis dispensary's claimed exclusions for various expenditures, which the dispensary incurred in purchasing and processing marijuana, and held that the dispensary's inventory costs had to be determined under Reg. Sec. 1.471-3(b). The court found that the taxpayer improperly treated the expenditures, including certain employee compensation and the costs of laboratory testing, which were not deductible due to Code Sec. 280E, as excludable costs of goods sold. Patients Mutual Assistance Collective Corporation v. Comm'r, 2021 PTC 119 (9th Cir. 2021).

Background

Patients Mutual Assistance Collective Corporation, doing business as Harborside Health Center (Harborside), operates one of the largest retail cannabis dispensaries in the United States. For tax years 2007 through 2012, Harborside was a not-for-profit corporation and medicinal cannabis collective operating under California laws governing medical marijuana operations. Consistent with California law, Harborside sold products only to individuals who possessed a physician's written recommendation for medical marijuana. Prospective members also had to sign a cultivation agreement permitting other Harborside members to grow marijuana on their behalf as part of the Harborside collective.

Harborside sold several categories of products, including "buds," or cannabis flowers. Harborside purchased buds from its patients-growers and did not grow any itself. Would-be sellers brought buds to Harborside's purchasing office, where a Harborside employee would inspect and test the buds for quality. If the buds were acceptable, the employee negotiated a purchase price. Once Harborside purchased the buds, it stored them in a secure vault and sent a sample for third-party laboratory testing. If the results were satisfactory, employees would reinspect, trim, weigh, package, and label the buds in preparation for resale.

On its returns for the years at issue, Harborside claimed tens of millions of dollars in business expense deductions and exclusions from income. According to Harborside, some of its expenditures were excluded from income as part of its inventory cost under general tax accounting rules.

The IRS disallowed nearly all of the exclusions and deductions and issued Harborside notices of deficiency showing over $29 million in tax deficiencies for years 2007 through 2012. Harborside challenged the deficiencies in the Tax Court but, in Patients Mutual Assistance Collective Corporation v. Comm'r, 151 T.C. 176 (2018), the Tax Court sided with the IRS and disallowed most of Harborside's claimed exclusions and all of its claimed deductions. Harborside appealed to the Ninth Circuit.

Under Code Sec. 280E, deductions that would otherwise be allowable as ordinary and necessary business expenses under Code Sec. 162(a) are disallowed for taxpayers who engage in trafficking in controlled substances like marijuana. Code Sec. 471(a) provides that, if a taxpayer is required to maintain an inventory, inventory must be taken on the basis prescribed by the IRS as conforming to the best accounting practice in the trade or business and as most clearly reflecting income. Reg. Sec. 1.471-2(c) generally requires inventory be valued using one of two methods: cost, or cost or market, whichever is lower. A taxpayer electing to use the cost method must apply the definition of "cost" contained in Reg. Sec. 1.471-3. For taxpayers that are resellers, Reg. Sec. 1.471-3(b) defines and limits the types of outlays associated with purchased merchandise that a taxpayer can treat as inventory costs. It provides that the term "cost" includes only the invoice price, less certain discounts, as well as transportation or other necessary charges incurred in acquiring possession of the goods.

Observation: A higher inventory valuation is important in the cannabis industry since inventory costs are deductible as costs of goods sold, whereas other expenses run afoul of Code Sec. 280E and thus are not deductible.

Harborside argued on appeal that various expenditures it incurred in the course of purchasing and processing the marijuana it resold were in fact excludable costs that were part of its inventory cost under the general tax accounting rules of Code Sec. 471. These expenditures included employee compensation relating to the negotiation of bud purchases and the cost of laboratory testing. Harborside did not dispute that, as a merchandising business, it was required to maintain an inventory under Code Sec. 471, and conceded that it elected to use the cost method to account for its inventory. However, Harborside argued that Reg. Sec. 1.471-3(b) did not apply. Harborside asserted that it satisfied the "best accounting practice" and "clear reflection of income" rules in Code Sec. 471 when it included the disputed exclusions within its inventory cost. Harborside also argued that because the IRS did not frame its challenge to Harborside's inventory method in terms of a failure to clearly reflect income, it lacked the authority to compel Harborside to change its accounting method. Harborside contended that under Max Sobel Wholesale Liquors v. Comm'r, 630 F.2d 670 (9th Cir. 1980), the definition of "cost" in Reg. Sec. 1.471-3(b) could not be grounds for disallowing Harborside's cost computation because it was a permissible determination of cost of goods sold. Finally, Harborside argued that Reg. Sec. 1.471-3(d) exempted it from the requirements of Reg. Sec. 1.471-3(b) and permitted it to include its purchasing and processing costs in its inventory cost. Reg. Sec. 1.471-3(d) provides that, in any industry in which the usual rules for computing the cost of production are in applicable, costs may be approximated upon such basis as may be reasonable and in conformity with established trade practice in the particular industry.

Analysis

The Ninth Circuit held that the Tax Court did not err in concluding that Harborside's inventory cost for each of the years at issue was determined by Reg. Sec. 1.471-3(b). The court found that Code Sec. 471(a) mandates that inventories are determined as prescribed by the IRS and that, under this authority, the IRS issued regulations the validity of which Harborside did not challenge. Thus, the court said that Harborside's compliance with Code Sec. 471(a) could not be assessed without consideration of the implementing regulations, in this case Reg. Sec. 1.471-3(b). The court also rejected Harborside's contention that the IRS lacked authority to compel Harborside to change its accounting methods. The court found that, while the IRS cannot force a taxpayer to use a particular accounting method, it does have the power to assert deficiencies where a taxpayer's method of accounting does not conform to the applicable regulations, and the court said that was all the IRS sought to do in this case.

The court also found that Harborside misread the Max Sobel decision, which held that a statute limiting deductions did not give the IRS the authority to deny exclusions for cost of goods sold. The court said that the IRS was not purporting to invoke Code Sec. 280E as a basis to deny Harborside exclusions and that Max Sobel does not address the issue in this case, namely, which expenditures are includible in cost of goods sold in the first place.

Finally, the court rejected Harborside's argument that it was exempted from Reg. Sec. 1.471-3(b) under Reg. Sec. 1.471-3(d). The court explained that Reg. Sec. 1.471-3(d) applies only to industries, including farmers, miners, and retail merchants that use the retail method to approximate costs, in which the usual rules for computation of cost of product are inapplicable. The court found that Harborside failed to show that marijuana retail is an industry in which the usual rules for computation of cost of production are inapplicable. The court noted that each of the types of taxpayers to which Reg. Sec. 1.471-3(d) applies faces some difficulty in using the standard methods and, in the court's view, Harborside presented no cogent argument for why a marijuana dispensary cannot compute its cost of production under the usual rules that apply to a retailer. It seemed to the court that Harborside's only argument was that, because its expenditures would be disallowed under Code Sec. 280E, it instead should be allowed to include such costs as inventory costs under Reg. Sec. 1.471-3(d) rather than Reg. Sec. 1.471-3(b). But the court said that Harborside did not ground this entitlement to different treatment in any statutory or regulatory authority.

Observation: Harborside also argued that (1) Code Sec. 280E is unconstitutional as a direct tax rather than a tax on income, and (2) the Tax Court erred in its application of Reg Sec. 1.471-3(b) by failing to allow at least some of its claimed exclusions (such as employee salaries relating to negotiating marijuana purchases) as necessary charges incurred in acquiring possession of the goods. However, since Harborside did not raise these arguments before the Tax Court, the Ninth Circuit did not address them.

For a discussion of the denial of deductions by Code Sec. 280E, see Parker Tax ¶96,512. For a discussion of inventories, see Parker Tax ¶242,310.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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