We recently discussed the impact of the Harborside opinion on cannabis tax planning, a tax court decision that disturbed, but didn’t really surprise, those of us who regularly work on the application of tax rules in the cannabis industry. The industry faces a secondary assault following the U.S. Tax Court’s opinion in Alternative Health Care Advocates. The opinion in Alternative raises new — more surprising and more disturbing — concerns regarding common cannabis tax planning strategies and focuses on the use of management companies.
The facts in Alternative include the following persons:
- Alternative Health Care Advocates (Alternative), a California nonprofit mutual benefit corporation classified as a C corporation for U.S. tax purposes.
- Wellness Management Group, Inc. (Wellness), a California corporation classified as an S corporation for U.S. tax purposes.
- Duncan (D), 80-percent owner of Wellness and President of Alternative.
- Richard Kearns (K), 10-percent owner of Wellness and Secretary of Alternative.
- Kwit (E), 5-percent owner of Wellness and patient-member/consultant of Alternative.
- Rozmarin (R), 5-percent owner of Wellness and manager of Alternative.
- The individual mutual benefit members of Alternative.
Alternative operated a medical marijuana dispensary. Wellness handled daily operations for Alternative, which included hiring employees and paying expenses (advertising, wages, and rent). Alternative and Wellness maintained separate offices (but shared a mailing address) and maintained separate books and records on a shared computer.
Alternative obtained cannabis from its patient-members. It would prepare and process this cannabis for sale to its patient-members, which included trimming, drying, breaking down cannabis into gram or eighth-of-an-ounce increments, and maintaining clones. Additionally, Alternative obtained edibles, tinctures, oils, concentrates and topicals from its members in a condition ready for resale. The opinion notes that Alternative hired “processors” “through Wellness.”
Interestingly, both Alternative and Wellness maintained bank accounts with Bank of America and Chase Bank. Alternative operated within a “closed-loop” system. The closed-loop system required Alternative to limit both purchases and sales to patient-members. As such, Alternative purchased items from patient-members and sold cannabis items to them. Wellness paid Alternative’s other expenses, including advertising, wages and rent. Alternative reimbursed Wellness for these items. However, at times, Alternative directly paid for such items.
For the years in question, Alternative filed C corporation returns (Form 1120) and Wellness filed S corporation returns (Form 1120-S) while reporting the distributable share of Wellness income or loss to each Wellness shareholder on a schedule K-1. Both Wellness and Alternative reported gross income and other deductions. Additionally, Alternative reduced its gross receipts by its cost of goods sold. The tax returns filed by Alternative and Wellness did not reflect any disallowed expenses under IRC section 280E, and the IRS challenged each taxpayer’s respective position.
It should not surprise any of our readers that Alternative, a California medical marijuana dispensary, was disallowed expenses other than cost of goods sold under section 280E. What may be surprising is that the Tax Court extended the application of section 280E to Wellness, an S corporation acting as a “management” company for the dispensary.
The opinion cites the Tax Court’s earlier opinion in Olive and a tax code provision related to criminal activities related to USPS stamps to define “trafficking.” Olive held that dispensing medical marijuana constitutes trafficking for purposes of section 280E. Section 7208 defines trafficking — for purposes of prohibited stamp transactions — as buying, selling, offering for sale or giving away. The opinion also cites the Controlled Substances Act, noting that it prohibits importing, manufacturing, distributing and possessing controlled substances.
The analysis is limited to the following quote:
[T]he only difference between what Alternative did and what Wellness did (since Alternative only acted through Wellness) is that Alternative had title to the marijuana and Wellness did not. Wellness employees were directly involved in the provision of medical marijuana to the patient-members of Alternative’s dispensary. While Wellness and Alternative were legally separate, Wellness employees were engaged in the purchase and sale of marijuana (albeit on behalf of Alternative); that was Wellness’ primary business. We do not read the term “trafficking” to require Wellness to have had title to the marijuana its employees were purchasing and selling. Neither that section nor the nontax statute on trafficking limits application to sales on one’s own behalf rather than on behalf of another. Without clear authority, we will not read such a limitation into these provisions.
The analysis is troubling for several reasons. First, it ignores any contractual relationship between Alternative and Wellness. Second, it ignores any principal and agent relationship between Alternative and the employees provided by Wellness to Alternative. Third, a reasonable and logical expansion of the analysis suggests that dispensary employees are subject to section 280E. Fourth, the holding violates the tax principle that ambiguity in revenue raising provisions — notably IRC section 280E — should be construed in the taxpayer’s favor rather than the government’s favor.
The collateral damage of Alternative is unclear, and may suggest that cannabis companies should carefully (re)consider the use of management companies. Query whether it makes sense to restructure some management companies as so-called employee leasing companies. In the employee leasing arrangement context, the employees should be under the direction and control of the licensed entity rather than the employer of record. While the holding involves entities “directly involved” with cannabis, it suggests that real estate leasing and intellectual property leasing structures may face similar attacks in the future. Cannabis companies should carefully consider the tax risks of any tax planning strategies and determine if the potential benefits outweigh the associated risks.