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What Cannabis Businesses Can Learn from the Harborside Inc. Case vs. the IRS

Posted by Jack Wilson on May 5, 2021 7:28:40 AM

In late April, a U.S. appeals court rejected an attempt to end Section 280E of the IRS tax code by California-based cannabis company Harborside Inc.

The results of this case are yet another incident of the IRS halting the cannabis industry’s prerogative to modify, reduce, or eliminate this federal tax provision.

Section 280E has been difficult for the cannabis industry to navigate and has proven an obstacle for cannabis companies ––– one that has cost their industry millions in additional taxes and penalties.

Today, we are going to take a look at the history of the case, the justification for the ruling, and what the cannabis industry and cannabis businesses can take away from this recent ruling.

Overview: Harborside Inc. vs. the IRS

Harborside is one recent example in a much longer list of high-profile 280E-related cases in which the IRS conducted a large-scale audit of a cannabis business.

If you have not been following the story of Harborside Inc. in the news, see below for a brief breakdown of some of the highlights from the case:

  • The case involved Harborside’s corporate income tax liabilities for tax years 2007-2012.
  • The IRS disallowed nearly all of the company's deductions and exclusions on these returns, issuing an initial tax bill of $29 million.
  • Harborside appealed to the IRS, at which point the agency agreed that overpayments used for purchasing goods could be excluded.
  • Even with exclusions, this resulted in $11 million owed in back taxes and penalties.

Harbor inc. case - paperwork

Harborside and their legal counsel had a two-pronged strategy in approaching their case:

  1. Try to eliminate 280E in the argument that it is unconstitutional; and
  2. To seek more favorable rulings on additional business expenses.

Although they were unsuccessful in eliminating or modifying 280E, they were able to substantially reduce their tax obligation to the IRS.

Harborside Inc.: Business and Operations

Harborside (a subsidiary of San Jose Wellness) is a vertically integrated cannabis business, that is based in the San Francisco Bay Area. The company was founded in 2006.

In fact, the organization was awarded one of the first six medical cannabis licenses in the United States. Since then, Harborside has grown into one of the largest and most reputable cannabis retailers in the world.

Harbor inc. case - San Francisco Bay Area

They currently have retail locations in San Jose, Oakland, Desert Hot Springs, and San Leandro, as well as nearly 50-acres of farmland in Monterey County, servicing a client base of over 250,000 registered customers.

Cannabis Industry: Other 280E Cases and 280E Case Results

The case of Harborside inc. is one of many in a growing list of cases that address the nature and use of 280E.

Other recent examples include:

Section 280E is particularly stringent when applied to the regulation of cannabis dispensaries. 

This provision has been exercised by the IRS in a way that dispensaries are limited to only deduct the wholesale purchase price at which the dispensary bought cannabis from the grower. 

See our resources below to learn more about 280E: 

More Details on Harborside Inc. and its Approach to 280E

The Harborside case came to a conclusion this past February of 2021, in which the US Appeals court denied Harborside's lobby to end 280E.

The Tax Court also determined that Harborside cannot claim tax deductions for depreciation or charitable contributions under Section 280E of the IRS code.

Attorney James Mann (of Greenspoon Marder LLP and representation for Harborside Inc.) filed an appeal with the U.S. Court of Appeals for the 9th Circuit in San Francisco on behalf of Harborside on May 26, 2020.

The 9th Circuit Court of Appeals upheld the US Tax Court decision that cannabis dispensary Harborside will owe back taxes for taking business deductions and exclusions, in connection with the sale of a federally illegal substance.

Harbor inc. case - ruling

Mann maintains that banning deductions for such costs as acquiring raw cannabis is unconstitutional, due to the fact this is a tax placed on the gross income of the business instead of the net.

The 16th Amendment does lay out that it is legal to have an income tax. However, Mann’s argument for his client rested on the fact that this enforcement of section 280E results in a tax that’s not on income, but instead on business expenses (cost of goods sold). As Mann stated, this is what makes it "unconstitutional."

Mann's appeal also centered around the fact that the Internal Revenue Service does not afford state-legal cannabis companies the same deductions and exclusions for COGS (Cost of Goods Sold) as mainstream companies.

“The IRS and the Tax Court have been taking a very restrictive view of what COGS means for cannabis businesses. “The argument is that Harborside should be able to calculate its COGS the exact same way as Whole Foods.” - Harborside Attorney James Mann

What Can Cannabis Companies Learn From Harborside vs. the IRS?

For over a decade, the Internal Revenue Service has been conducting large-scale initiatives to audit the cannabis businesses and enforce 280E. 

Cannabis business owners, partners, investors, and entrepreneurs should use the information in this case as a learning experience.

Keep in mind that this is just one example of many, illustrating how critical it for cannabis companies to:

  • Be diligent about their taxes, bookkeeping, and finances;
  • And operate within the law and the tax code.

Unfortunately, not all accounting firms are familiar with navigating 280E and working with cannabis businesses.

Working with CPAs that specialize in working with cannabis businesses is critical for both risk mitigation and the long-term financial success of growers, cultivators, manufacturers, dispensaries, and cannabis retail businesses.

Partnering with cannabis CPAs and financial experts who work in the industry are the best defenses for staying compliant with 280E and protecting your business in the event of an audit.

Specialized Tax Preparation and Planning for Cannabis Companies

If you need guidance or assistance with tax planning, tax preparation, audit and assurance services, outsourcing CFO services, or accounting due diligence ––– don’t hesitate to get help before it’s too late. 

Contact our cannabis CPAs and financial advisors at GreenGrowthCPAs.com or call us today at 800-674-9050.

Topics: News, Compliance, Accounting

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