PATIENTS MUTUAL ASSISTANCE COLLECTIVE CORPORATION d.b.a. HARBORSIDE HEALTH CENTER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 29212-11, 30851-12, 14776-14.
UNITED STATES TAX COURT
Filed November 29, 2018.
151 T.C. No. 11
1 We consolidated the cases at docket numbers 29212-11, 30851-12, and 14776-14 for trial, briefing, and opinion.
Held, further,
Held, further, during the years at issue P was engaged in only one trade or business, which was trafficking in a controlled substance.
Held, further, P must adjust for COGS according to the
Henry G. Wykowski and Christopher A. Wood, for petitioner.
Nicholas J. Singer and Julie Ann Fields, for respondent.
HOLMES, Judge: Patients Mutual owns what may well be the largest marijuana dispensary in America. To the Commissioner that just makes it a giant drug trafficker, unentitled to the usual deductions that legitimate businesses can claim, unable even to capitalize its indirect costs into its inventory, and subject to penalties for taking contrary positions on its tax returns for the tax years ending July 31, 2007 through 2012. Patients Mutual wants to be treated like any other business because it follows California law, it does more than distribute marijuana, and the federal government already decided not tо pursue a civil-forfeiture action against it.
I. California Medical-Marijuana Law
Under federal law marijuana is a Schedule I controlled substance. See
Under California law, things are somewhat different. In 1996 California voters adopted Proposition 215--the California Compassionate Use Act of 1996 (CCUA)--to “ensure that seriously ill Californians have the right to obtain and use marijuana for medical purposes.” See
II. DeAngelo and Harborside
Steve DeAngelo saw these early dispensaries--which he described as being run by either well-meaning marijuana activists with no business experience or “thug operators“--and realized patients needed a better option. So in 2005 DeAngelo cofounded Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center (Harborside) to be the “gold standard” in medical-marijuana dispensaries. His goal was to create a place where marijuana could be distributed responsibly, that was focused on patient care, and that provided benefits to both patients and the community. Harborside opened its doors in October 2006 and has grown into a booming business with more than 100,000 patient visits per year. It also generated a gusher of revenue during the years at issue:
| Year | Nonmarijuana sales revenue | Marijuana sales revenue | Total revenue | Marijuana percentage |
|---|---|---|---|---|
| 2007 | $487 | $5,448,635 | $5,449,122 | 99.99 |
| 2008 | 3,990 | 10,916,914 | 10,920,904 | 99.96 |
| 2009 | 16,878 | 17,334,597 | 17,351,475 | 99.90 |
| 2010 | 42,492 | 22,047,372 | 22,089,864 | 99.81 |
| 2011 | 58,588 | 20,895,823 | 20,954,411 | 99.72 |
| 2012 | 320,651 | 25,199,997 | 25,520,648 | 98.74 |
| Total | 443,086 | 101,843,338 | 102,286,424 | 99.57 |
At all relevant times Harborside operated out of an approximately 7,500-square-foot space that had a reception area, healing room, purchasing office, processing room, clone room, and multipurpose room. The facility also had a large sales floor, offices, storage areas, restrooms, and a break room with a kitchen.
But operating a dispensary is no small task. DeAngelo had to make sure Harborside complied with California and local laws. This included getting proper permits, running as a nonprofit, and operating under a “closed-loop” system. Harborside interpreted the “closed-loop” requirement to mean that all of its marijuana must be provided by its patients; sold exclusively to its patients; handled only by its employees, all of whom were its patients; and not diverted into the illegal market. How Harborside achieved all of this is important, so we will start with how Harborside sourced and processed its inventory.
Harborside sold a wide variety of products, which we will divide into four main groups--clones, marijuana flowers, marijuana-containing products, and non-marijuana-containing products.
1. Clones
Clones are cuttings from a female cannabis plant that can be transplanted and used to cultivate marijuana. Harborside 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 clone counter--the portion of the floor space dedicated to clone sales. During the years at issue Harborside had at least four employees who spent their time entirely in the purchase and sale of clones.
2. Marijuana Flowers
The Court learned at trial that it‘s not the leaves of the marijuana plant, but its flowers--or buds--that people can smoke.3 Harborside purchased all of its marijuana flowers from its patient-growers. Some of these growers promised to sell what they cultivated back to Harborside, and Harborside gave them either
Once a grower had cultivated, harvested, trimmed, flushed, dried, and cured his marijuana buds, he would bring them to Harborside to sell. Harborside had a purchasing office to inspect and test the incoming marijuana. Harborside would reject marijuana if it wasn‘t properly cured, if it hadn‘t been sufficiently trimmed, if it had an incurable safety issue such as pathogenic mold, or if it didn‘t contain the right “cannabinoid profile.” If, for example, Harborside was in need of a strain of marijuana that was rich in CBD,4 it might reject a batch of marijuana that was rich in THC.5 There were times Harborside rejected the “vast majority” of the bud that growers brought in, and a grower whose marijuana was rejected got no compensation (though he was free to sell it to another collective if he could).
3. Marijuana-Containing Products
Harborside‘s marijuana-containing products included edibles, beverages, extracts, concentrates, oils, topicals, and tinctures--marijuana-infused alcohol, vinegar, or glycerin. Harborside bought these items from other collectives, tested them, repackaged them if they came in bulk or needed child-proof packaging, relabeled them, and then sold them to its own patients. Harborside‘s human-resources director credibly estimated that about 55% to 60% of its employees’
4. Non-Marijuana-Containing Products
Harborside also sold non-marijuana-containing products. These included branded gear such as shirts, hats, and pins; nonbranded gear such as socks and hemp bags; and a variety of other products including books, dabbing equipment,6 rolling papers, and lighters. Harborside bought these items from outside vendors, stored them, and resold them to patients. Depending on the volume on hand, Harborside stored the non-marijuana-containing products on the sales floor and in one or more of its various storage rooms. A little less than 25% of the sales floor was used to display and sell these items and around 5% to 10% of Harborside‘s employees’ time was dedicated to buying and selling these entirely legal products.
B. Sales and Pricing
Harborside took great care to avoid its marijuana‘s leaking into the black market. For example, no one could enter the sales floor without going through a “very rigorous identification process.” This process required new patients to
C. Community Outreach
With premium prices, however, come significant profits. Harborside is a C corporation for federal tax purposes,7 but to comply with California‘s nonprofit requirement,8 its bylaws prohibited it from paying dividends or selling еquity, and
The services included one-on-one therapeutic sessions for reiki, hypnotherapy, naturopathy, acupuncture, and chiropractic consultations as well as group sessions for yoga, qigong, the Alexander technique, and tai chi. Harborside also offered grow classes, support groups, addiction treatment counseling, and a “sliding scale program” that gave discounts to patients with financial difficulties. All of the services were coordinated by Harborside‘s holistic-services director and took place in either Harborside‘s healing room or its multipurpose room. Harborside footed the bill and paid the service providers--all of whom were independent contractors. The total amounts paid were:
| Year | Amount |
|---|---|
| 2007 | $30,290 |
| 2008 | 93,341 |
| 2009 | 119,884 |
| 2010 | 144,441 |
| 2011 | 141,926 |
| 2012 | 150,466 |
D. Administrative Functions
Harborside 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. Harborside‘s human-resources director estimated that 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. Harborside also had an administrative group, which included employees in its ombuds,9 finance, human resources, and facilities departments as well as its executives.
All seemed well until July 2012, when the federal government filed a civil-forfeiture action in the U.S. District Court for the Northern District of California. The lawsuit alleged that the property which Harborside rents and on which it operates its business was subject to forfeiture because it was used to commit the distribution, cultivation, and possession of marijuana in violation of
IV. Tax Returns and Audit
The forfeiture action wasn‘t Harborside‘s only run-in with the federal government--it also caught the attention of the IRS. Recall that Harborside is a C corporation for federal tax purposes with tax years ending July 31. It filed Forms 1120, U.S. Corporation Income Tax Return, for 2007 to 2012 and later amended its 2007, 2008, and 2009 returns. These returns were selected for audits that led to
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.”
Harborside filed timely petitions for all years at issue. Its principal place of business was in California at all relevant times, so absent a stipulation by the parties these cases are appealable to the Ninth Circuit. See
OPINION
I. Background
The CCUA did not decriminalize marijuana in California. See, e.g., People v. Harris, 52 Cal. Rptr. 3d 577, 582 (Ct. App. 2006) (marijuana remained a controlled substance under California law). It instead created an affirmative defense to charges of possessing or cultivating marijuana for persons who did so for personal, physician-approved use.
In 2003 California enacted the Medical Marijuana Program Act (MMPA), also known as Senate Bill 420 and now codified at
Federal law did not follow. The conflict between federal and state law went to the Supreme Court in 2005 when two California medical-marijuana users tried to enjoin the U.S. Attorney General and the Drug Enforcement Agency from enforcing federal marijuana law against them. See Gonzales v. Raich, 545 U.S. 1, 7 (2005). The Court upheld the federal prohibition on marijuana sale and possession with respect to medical-marijuana users, both under the Commerce Clause,
One might think the Supremacy Clause would have stifled the spread of state attempts at legalizing what remained illegal under federal law. But one would be wrong. And Congress complicated the situation by enacting a series of appropriations riders that prevent the Department of Justice (DOJ) from using any funds “to prevent * * * [States that рermit medical-marijuana use] from implementing their own laws that authorize the use, distribution, possession, or
But the IRS is part of the Department of the Treasury, and marijuana sellers must still contend with the Code. Here their major problem is section 280E, which prevents any trade or business that “consists of trafficking in controlled substances” from deducting any business expenses. Congress enacted this section in 1982 as a response to our decision in Edmondson v. Commissioner, T.C. Memo. 1981-623, where we allowed a cocaine dealer to deduct the ordinary and necessary expenses of his illicit trade. See S. Rept. No. 97-494, at 309 (1982), 1982
Given this state of the law it‘s perhaps not surprising that Harborside isn‘t the first marijuana dispensary to appear in our Court. In our first major medical-marijuana case, we found that the taxpayer operated two separate trades or businesses--one that provided caregiving services and one that sold marijuana. CHAMP, 128 T.C. at 183-84. We therefore required the taxpayer to allocate its expenses between its two businesses according to the number of its employees and the portion of its facilities devoted to each. Id. at 185. We allowed it to deduct the expenses that it properly allocated to its caregiving business, but not those allocated to its marijuana-sales business. Id. at 173-74.
While Harborside raises some of the same issues we addressed in these cases, it also presents some new ones. Here we are asked to decide
- whether res judicata precludes the Commissioner from arguing Harborside was engaged in trafficking in a controlled substance;
- whether Harborside‘s business “consists of” trafficking in a controlled substance under section 280E;
whether Harborside has more than one trade or business; - what Harborside may include in its cost of goods sold; and
- whether Harborside is liable for accuracy-related penalties.
We will take each in turn.
II. Res Judicata
Harborside first argues that res judicata is a complete defense to its tax woes. Its position is that these cases and the 2012 civil-forfeiture action are all based on the same claim--that Harborside was trafficking in a controlled substance. It argues that the U.S. attorney’s decision to dismiss the forfeiture action with prejudice means that as a matter of law Harborside was not a drug trafficker and cannot be subject to section 280E.
Res judicata--or claim preclusion--is an affirmative defense that bars suits on the same cause of action, and it does apply to tax litigation. See Russell v. Commissioner, 678 F.2d 782, 785-86 (9th Cir. 1982); Koprowski v. Commissioner, 138 T.C. 54, 59-60 (2012). The rule is easy to state:
[W]hen a court of competent jurisdiction has entered a final judgment on the merits of a cause of action, the parties to the suit and their privies are thereafter bound “not only as to every matter which was offered and received to sustain or dеfeat the claim or demand, but as to any other admissible matter which might have been offered for that purpose.”
Commissioner v. Sunnen, 333 U.S. 591, 597 (1948) (quoting Cromwell v. County of Sac, 94 U.S. 351, 352 (1876)).
To successfully assert a res judicata claim, Harborside would have to clear these hurdles:
- an identity of claims between the actions;
- privity between the parties in the actions; and
- a final judgment on the merits in the civil-forfeiture action.
See Tahoe-Sierra Pres. Council, Inc. v. Tahoe Reg’l Planning Agency, 322 F.3d 1064, 1077 (9th Cir. 2003).
We think Harborside smashes right into the first. For there to be an identity of claims, two cases must “arise out of the same transactional nucleus of facts.” Cent. Delta Water Agency v. United States, 306 F.3d 938, 952 (9th Cir. 2002) (quoting Fund for Animals v. Lujan, 962 F.2d 1391, 1398 (9th Cir. 1992)).14 This almost always means that res judicata applies only when the second claim could have been asserted in the previous action. See Tahoe-Sierra Pres. Council, 322 F.3d at 1078; Sawyer Tr. of May 1992 v. Commissioner, 133 T.C. 60, 77-78 (2009). Harborside’s cases here are about its tax deficiencies, and the parties agree that the government could not have brought such actions as part of the civil-forfeiture case in district court.
Harborside insists, however, this doesn’t matter and points to United States v. Liquidators of European Fed. Credit Bank, 630 F.3d 1139 (9th Cir. 2011). In Liquidators, the Ninth Circuit explained that in most cases the answer to the question of whether two cases share the “same transactional nucleus of facts” will be synonymous with the question of whether the contested claim in the second case could have been brought in the first. Id. at 1151. But it found an exception when it looked closely at forfeiture actions, and it held that res judicata barred a later criminal-forfeiture claim against the same property that had been the object of an earlier civil-forfeiture case. Id. at 1151-52. It reasoned that the two types of forfeiture actions always seek exactly the same result, arise from exactly the sаme facts, and offer the government two paths to reach the same goal. Id. at 1152 (which might have led one to think that the doctrine to apply was “election of remedy” rather than res judicata). But whether one looks at this puzzle as one of election of remedy or res judicata doesn’t matter here. The forfeiture action in district court sought just that--the forfeiture of the property leased by Harborside--whereas these cases seek to impose a civil tax liability. And while the two actions
III. Section 280E
The Code allows a business to deduct all of its “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
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 substancеs (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. [Emphasis added.]
Harborside argues that “consists of” means an exhaustive list--or in other words that section 280E applies only to businesses that exclusively or solely traffic in controlled substances and not to those that also engage in other activities. The Commissioner argues that a single trade or business can have several activities and that section 280E applies to an entire trade or business if any one of its activities is trafficking in a controlled substance. Both parties say their interpretations match other Code sections’ use of “consists of” and best fit section 280E’s purpose.
We’ve seen Harborside’s argument before. In Olive, 139 T.C. at 39, the taxpayer made a nearly identical argument, which we cursorily rejected.15 And, on appeal, the Ninth Circuit focused on the taxpayer’s misuse of CHAMP. See Olive, 792 F.3d at 1149-50. We could stop there with a nod to stare decisis, but the parties argue the question at great length and, given the importance of these cases
A. Statutory Interpretation
Harborside begins with an appeal to the “ordinаry, everyday usage” of the phrase. And we do agree that Harborside is right about the meaning of “consists of” in everyday use: For example, one says “The AFC East consists of the Bills, Patriots, Jets, and Dolphins,” and anyone fluent in English would understand that to mean that those are both all, and the only, teams in that division. Harborside also has some excellent secondary sources behind it on this point. See, e.g., Antonin Scalia & Bryan A. Garner, Reading Law: The Interpretation of Legal Texts 132 (2012) (contrasting “includes“, which sets off a nonexhaustive list, with “consists of” or “comprises“, each of which generally introduces an exhaustive list); Black’s Law Dictionary 279 (5th ed. 1979) (explaining that “consisting” “is not synonymous with ‘including‘” because “including“, when used in connection with a number of specified objects, always connotes incompleteness). This might seem as though it should be the end of our analysis--after all, “[t]he ordinary-meaning rule is the most fundamental semantic rule of interpretation.” Scalia & Garner, supra, at 69.
One might imagine--as a strictly theoretical matter--that a legislature might enact an absurdity, and our job as judges would be to enforce it. But the Commissioner reminds us that we shouldn’t do so if there is an effective-and-not-absurd meaning that is also permissible. We must both avoid “a sterile literalism
But can “consists of” ever introduce a nonexhaustive list?
1. Dictionaries
Harborside says “no“, and urges us to take a hint from the fourth edition of the American Heritage Dictionary. Harborside quotes a usage note in the entry for “include“. See American Heritage Dictionary 887 (4th ed. 2006). The note explains that “include” connotes, but does not necessarily mean, that a list immediately following it is incomplete. Id. It also suggests that authors introducing exhaustive lists use “comprise” or “consist of” instead. Id. It doesn’t say, however, that “consists of” necessarily introduces an exhaustive list. See id. And the dictionary’s definition of “consist” is “[t]o be made up of or composed,” “[t]o have a basis; reside or lie,” or “[t]o be compatible.” Id. at 392.
Harborside’s other dictionary citation is similarly ambiguous. An old edition of Black’s Law Dictionary defines “consisting” as “[b]eing composed or
Harborside even points us to an odd opinion that cites a precursor of the Oxford English Dictionary18 that says “‘[c]onsisting of’ can have the meaning of ‘to have its essential character in’ or ‘foundation in.‘” Madison Teachers, Inc. v. Madison Metro. Sch. Dist., 541 N.W.2d 786, 801 (Wis. Ct. App. 1995) (Sundby, J., concurring in part and dissenting in part) (citing IIC A New English Dictionary
2. The Code
But this is a tax case, and before we go too far afield in dictionaries or literature, we should draw back to other sections of the law we have to apply to these cases. See, e.g., United States v. Olympic Radio & Television, Inc., 349 U.S. 232, 236 (1955) (interpreting phrase consistently within Code chapter and saying courts should give Code “as great an internal symmetry and consistency as its words permit“). But see Util. Air Regulatory Grp. v. EPA, 573 U.S. ___, ___, 134 S. Ct. 2427, 2441 (2014) (“the presumption of consistent usage ‘readily yields’ to context” (quoting Environmental Defense v. Duke Energy Corp., 549 U.S. 561, 574 (2007))). What does the Code itself tell us about how to read “consists of“?
Harborside points out that in many Code sections Congress used the phrase “consists of” but then modified it--as it did in the electricity-related section above--to clarify that it doesn’t mean “is composed entirely оf.” See, e.g., sec. 581 (“a substantial part of the business of which consists of“); sec. 181(e)(2)(E) (added by the Consolidated Appropriations Act, 2016, sec. 169(c), 129 Stat. at 3067 (“includes or consists of“)). Harborside suggests that Congress could have similarly modified “consists of” in section 280E if it had intended to set off a
Unmodified uses of “consists of” do sometimes seem to introduce exhaustive lists. See, e.g., sec. 108(e)(4)(B) (“family of an individual consists of the individual’s spouse, the individual’s children, grandchildren, and parents, and any spouse of the individual’s children or grandchildren“). But in other places “consists of” would lead to an absurd result if it indicated an exhaustive list. The Commissioner points us to a glaring example: A “computer” eligible for accelerated depreciation “consists of a central processing unit containing extensive storage, logic, arithmetic, and control capabilities.” Sec. 168(i)(2)(B)(ii)(II) (emphasis added). Here, Harborside’s reading of “consists of” would mean that anything other than a central processing unit isn’t a computer. Surely something wouldn’t fаil to be a computer because it had a monitor, a keyboard, a mouse, or a power cord. See Dunford v. Commissioner, T.C. Memo. 2013-189, at *30-*31 (referring to a laptop as a “computer” when determining depreciation eligibility).
3. Caselaw
That leaves us with caselaw. Each party has precedent here, too. Harborside’s chief example is one from Wisconsin which held that a statute preventing “a collective bargaining unit consisting of school district professional employees” from arbitrating certain issues didn’t preclude arbitration by a unit that mainly had such employees but also had some other types of employees. Madison Teachers, Inc., 541 N.W.2d at 790-91, 793-94. That court said that a “decent respect for language makes it impossible to read ‘consisting of’ in the inclusive sense.” Id. at 794. But it also explained that none of the 482 occurrences of the phrase “consisting of” in Wisconsin’s statutes introduced nonexhaustive lists, and it pointed out that the Wisconsin legislature was careful to modify that phrase whenever it meant to use it inclusively. Id. Apparently Wisconsin’s code enjoys a consistency missing from the Internal Revenue Code, which as we’ve seen uses “consists of” multiple ways. It’s therefore hard for us--despite what we hope is our decent respect for language--to do as Harborside asks and interpret the phrase as mechanically as the Wisconsin Court of Appeals has.
Dictionaries, the Code, and caselaw all show that “consists of” can introduce either an exhaustive list or a nonexhaustive list.20 A nonexhaustive list
B. Purpose
We also note that Harborside has a subtler argument about the play between literal meaning and statutory purpose. It reminds us that dispensaries that are legal under state law didn’t exist in 1982 and Congress even today won’t let the DOJ рrosecute them as if they were street-corner drug dealers. See Consolidated Appropriations Act, 2017 sec. 537; Consolidated Appropriations Act, 2016 sec. 542; Consolidated and Further Continuing Appropriations Act, 2015 sec. 538; see also McIntosh, 833 F.3d at 1177. These arguments aren’t new, either--the Ninth Circuit disposed of them in Olive, 792 F.3d at 1150-51, so we mostly reiterate its reasoning here to acknowledge that Harborside has preserved it.
Although section 280E predates states’ legalization of medical marijuana, “[t]hat Congress might not have imagined what some states would do in future years has no bearing on our analysis. It is common for statutes to apply to new
Finally, we note that several members of Congress asked the IRS to issue guidance saying that medical-marijuana dispensaries aren’t subject to section 280E, and the IRS said it couldn’t do that unless Congress amended the Code or the Controlled Substances Act. See IRS Information Letter 2011-0005. Members of Congress have subsequently introduced several bills that would exempt state-legal marijuana businesses from section 280E. Small Business Tax Equity Act of 2011, H.R. 1985, 112th Cong. (2011); Small Business Tаx Equity Act of 2013, H.R. 2240, 113th Cong. (2013); Small Business Tax Equity Act of 2015, H.R. 1855, 114th Cong. (2015); Small Business Tax Equity Act of 2015, S. 987, 114th Cong. (2015); Small Business Tax Equity Act of 2017, H.R. 1810, 115th Cong. (2017); Small Business Tax Equity Act of 2017, S. 777, 115th Cong. (2017); Responsibly Addressing the Marijuana Policy Gap Act of 2017, H.R. 1824, 115th
We hold that section 280E prevents Harborside from deducting its business expenses.
IV. More Than One Trade or Business?
Harborside says that even if section 280E applies to its marijuana sales, it can still deduct its expenses for any separate, nontrafficking trades or businesses. That’s correct. See CHAMP, 128 T.C. at 184-85; see also Olive, 792 F.3d at 1149. We therefore need to determine which--if any--of Harborside’s activities are separate trades or businesses.
An activity is a trade or business if the taxpayer does it continuously and regularly with the intent of making a profit. See, e.g., Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); United States v. Am. Bar Endowment, 477 U.S. 105, 110 n.1 (1986). A single taxpayer can have more than one trade or business, CHAMP, 128 T.C. at 183, or multiple activities that nevertheless are only a single trade or business, see, e.g., Davis v. Commissioner, 29 T.C. 878, 891 (1958). Even separate entities’ activities can be a single trade or business if they’re part of a “unified business enterprise” with a single profit motive. Morton v. United States, 98 Fed. Cl. 596, 600 (2011).
We’ve considered this issue with other California medical-marijuana dispensaries. In CHAMP, 128 T.C. at 175, 183, we found that the 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. We noted there that seven of the taxpayer’s employees distributed marijuana, eighteen employees provided caregiving services, and no employees did both. Id. at 185. Moreover, dispensing marijuana occurred in only 10% of one of the taxpayer’s three facilities. Id. at 176. We 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. Id. at 183.
The most recent case where we had to figure out the number of a marijuana dispensary’s trades or businesses is Canna Care, Inc. Like Harborside, the taxpayer there sold medical marijuana and other items, including books, T-shirts, and hats. Canna Care, Inc., at *4, *12. Unlike the taxpayer in Olive, the taxpayer
Harborside presented its case in greater detail. It argues that it had four activities, each of which was a separate trade or business:
- sales of marijuana and products containing marijuana;
- sales of products with no marijuana;
- therapeutic services; and
- brand development.
We consider each.
There’s no question that selling marijuana and products containing marijuana was Harborside’s primary purpose. Sixty percent of the members Harborside’s security checked in were there to buy marijuana in one form or another. Marijuana and marijuana products took up around 75% of Harborside’s sales floor. Harborside’s employees spent 80-90% of their time purchasing, processing, and selling these products. And those sales generated at least 98.7% of Harborside’s revenue during each of the years at issue. This was certainly a trade or business--specifically, the trade or business of trafficking in a controlled substance. See Olive, 139 T.C. at 38; CHAMP, 128 T.C. at 182-83.
B. Selling Products That Didn’t Contain Marijuana
Harborside’s sale of items that didn’t contain marijuana--such as branded clothing, hemp bags, books about marijuana, and marijuana paraphernalia such as rolling papers, pipes, and lighters--generated the remaining 0.5% of its revenue. The same Harborside employees who bought, processed, and sold marijuana also sold these items, but selling them took up only 5-10% of their time. The nonmarijuana items occupied only 25% of the sales floor where Harborside sold marijuana, and that sales floor was accessible only to patrons who had already presented their credentials to security--which means that no one who couldn’t buy
Harborside nevertheless argues that its sale of anything other than marijuana is a separate trade or business. It cites an analogy the Ninth Circuit used in Olive, 792 F.3d at 1150, to explain why a store that charged for marijuana and gave away incidental services had only a single trade or business. In that analogy, a hypothetical bookstore that sold books and gave away coffee to attract customers (“Bookstore A”) had only one trаde or business, whereas a hypothetical bookstore
We think Harborside misses the analogy’s point: It shows that a service a taxpayer doesn’t charge for, but which attracts customers, isn’t a separate trade or business. It doesn’t mean that selling two things is necessarily two separate trades or businesses. Bookstore B is there to provide contrast to Bookstore A, which is what the court compared to the taxpayer in Olive. Id.
Finally, the analogy--though a good fit for Olive, which was selling marijuana and giving away snacks and soft drinks--doesn’t suit Harborside. A better analogy would be to a bookstore that derives 0.5% of its revenue from selling stationery, bookmarks, and T-shirts with pictures of books on them (“Bookstore C”). To be completely analogous to Harborside, Bookstore C would sell these items using the same employees, sales floor, management, ledgers, and business entity it used to sell books. That hypothetical bookstore would, we think, be a single trade or business under the Ninth Circuit’s reasoning. And Harborside’s sale of non-marijuana-containing items is, we find, not a separate trade or business.
Recognizing that an activity needs a profit motive to be a separate trade or business, Harborside argues that a portion of each marijuana sale was actually a purchase of its free holistic services.21 This is what it told its patrons, too.
Harborside says this makes it like CHAMP. But in CHAMP, 128 T.C. at 175-76, members paid a set fee for unlimited access to extensive services and also received a fixed amount of marijuana--the services’ price wasn’t “bundled” into the amount paid for marijuana, to use Harborside’s terminology. And we found that the services in CHAMP were the taxpayer’s primary purpose, took up most of its employees’ time, and used almost all of its three facilities. Id. at 174-76, 183, 185.
Harborside is more like the dispensary in Olive, 792 F.3d at 1148, where patrons paid according to the amount and type of marijuana they wanted and in return gained access to incidental services. Harborside tries to distinguish itself by pointing out that it offered many more services than the much smaller taxpayer in Olive did.22 But the services were still incidental; Harborside’s security spent only
The relationship between Harborside’s marijuana business and holistic services closely fits Olive’s “Bookstore A” analogy. See id. at 1150. Just as a bookstore that gives away coffee is still only a bookstore, a marijuana dispensary that gives away services is still only a marijuana dispensary. See id. The fact that Harborside used a tiny bit of its marijuana-sales revenue to pay for those services doesn’t change anything--after all, Bookstore A necessarily pays for its coffee with book sales. And we also find that there were business reasons to offer these services alongside marijuana sales: It justified premium pricing and helped Harborside meet the community-benefit standards California law required. We therefore find that Harborside’s holistic services were not a separate trade or business.
Harborside’s final argument on this subject is that its brand-development activity was a separate trade or business. Because this did not generate any revenue until after the years at issue, the Commissioner compares it to preoperational expenditures that have to be capitalized instead of deducted. Harborside insists it is a trade or business eligible for section 162 deductions because from day 1 it performed them with an independent profit motive. To show a profit motive without any revenue, Harborside says its branding activities were part of a “unified business enterprise” with its activities that did make money during the years at issue.
A separate entity purposely operating at a loss is still a trade or business eligible for deductions if it and entities related to it together form a unified business enterprise that itself has a profit motive. See Campbell v. Commissioner, 868 F.2d 833, 836-37 (6th Cir. 1989) (partnership leasing airplane to sister corporation at loss had profit motive because common owners benefited), aff’g in part, rev’g in part T.C. Memo. 1986-569; Kuhn v. Commissioner, T.C. Memo. 1992-460, 1992 WL 193604, at *5 (partnership’s below-market lease of land to sister corporation had profit motive because corporation benefited); Morton, 98 Fed. Cl. at 602 (S corporation that owned airplane was part of unified business
There’s also no actual evidence to suggest that Harborside’s brand development was in any way a separate trade or business. As far as we can tell, Harborside did its branding using the same entity, management, capital structure, employees, and facilities as its marijuana sales. See Tobin, 1999 WL 773964, at *5-*6. And rather than being “substantially different” from the underlying sale of marijuana, Harborside’s brand development was necessarily entwined with it. See CHAMP, 128 T.C. at 183. Harborside’s branding, therefore, had a “close and inseparable organizational and economic relationship” with, and was “one and the same business” as, its marijuana sales. See Olive, 139 T.C. at 41. It was not a separate trade or business.
Harborsidе dedicated the lion’s share of its resources to selling marijuana and marijuana products. Those sales accounted for over 99.5% of its revenue. Its
V. Cost of Goods Sold
The fact that Harborside can’t deduct any of its business expenses doesn’t mean it owes tax on its gross receipts. All taxpayers--even drug traffickers--pay tax only on gross income, which is gross receipts minus the cost of goods sold (COGS). See, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); CHAMP, 128 T.C. at 178 n.4;
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.
COGS is the costs of acquiring inventory, through either purchase or production. See, e.g., Reading v. Commissioner, 70 T.C. 730, 733 (1978) (COGS is “expenditures necessary to acquire, construct or extract a physical product which is to be sold”), aff’d, 614 F.2d 159 (8th Cir. 1980);
The big difference between deductions and COGS adjustments is timing. See INDOPCO, 503 U.S. at 83-84; Wasco Real Props. I, LLC v. Commissioner, T.C. Memo. 2016-224, at *19. Taxpayers can usually claim at least part of a deductible expense for the year they incur it. See, e.g., INDOPCO, 503 U.S. at 83-84; Wasco Real Properties I, LLC, at *19. But when accounting for COGS they have to capitalize an item’s cost in the year of acquisition or production and either amortize it or wait until the year the item’s sold to make the corresponding
A. How Should Harborside Account for its COGS?
The Code tells taxpayers what to include in COGS. See, e.g.,
1. Section 471
In their current forms,
2. Section 263A
Congress enacted
These sections are also about timing. A business that could immediately deduct indirect costs under
Most business don’t like this. They’d rather have a deduction now than increased COGS later. See, e.g., Frontier Custom Builders, Inc. v. Commissioner, T.C. Memo. 2013-231, at *14 (homebuilder argued it was a seller, not a producer, in attempt to avoid capitalization), aff’d, 626 F. App’x 89 (5th Cir. 2015). But drug traffickers have a different attitude. Although
Except that maybe it’s still never. In 1988 Congress amended
Can Congress get away with this? Harborside argues that limiting its COGS to “only the actual cost used to purchase inventory” violates the Sixteenth Amendment. Its theory is that
That’s wrong. The Sixteenth Amendment’s meaning didn’t change when Congress enacted
Harborside compares itself to the taxpayer in Anderson Oldsmobile, but that case doesn’t help it. There the taxpayer paid more for its inventory than since-repealed federal price controls allowed, and the Commissioner tried to limit the taxpayer’s COGS to the highest legal price. Id. at 903. The court held that because Congress can tax only gross income, the taxpayer was entitled to a COGS adjustment for the actual amount it paid for its inventory even though that amount was illegally high. Id. at 903, 905, 909.
As Harborside correctly points out, Anderson Oldsmobile says that statutes сan’t let the Commissioner tax more than gross income. Id. at 905. But that’s not what’s happening here. Unlike Anderson Oldsmobile, where the Commissioner wanted to use a statute to deny the taxpayer a COGS adjustment for part of its direct cost of purchasing inventory, these cases find the Commissioner saying only that Harborside can’t use
What Anderson Oldsmobile really holds is that taxpayers can adjust for COGS whether or not their direct costs are legal. See id. at 903; see also Pittsburgh Milk Co., 26 T.C. at 717 (taxpayer who sold milk below legal price used actual price when calculating income). This tells us what we already know: Harborside would get COGS adjustments for its direct inventory costs no matter what--even if it was trafficking cocaine or any other controlled substance not legal under California law. The only things Harborside doesn’t get are indirect inventory costs granted as deductions and then deferred under
The
B. Is Harborside a Producer or a Reseller?
Because the
1. What Does “Produce” Mean?
To sort this out we first need to know what “produce” means. The Commissioner, citing a Court of Claims case, says that under
Harborside at least points us to something more recent, the Ninth Circuit case, Suzy’s Zoo v. Commissioner, 273 F.3d 875 (9th Cir. 2001), aff’g 114 T.C. 1 (2000). That case, however, isn’t about
Although Suzy’s Zoo is about
In Suzy’s Zoo, the taxpayer, a greeting-card company, designed images and sent them to a contract printer who did color separations, made proofs, and printed
We held--and the Ninth Circuit affirmed--that the taxpayer was a “producer” because it retained title to the items throughout the contract-production process. Id. at 877, 880. Citing regulations under
“Produce” is therefore broader than “manufacture”. That’s also evident from the Code and regulations. We saw that already in
2. Did Harborside Own What Its Growers Grew?
In finding that Suzy’s Zoo was a producer, the Ninth Circuit emphasized the “degree of control * * * [the taxpayer] exercise[d] over the manufacturing
But there was more to Suzy’s Zoo. There the taxpayer acquired ownership when it first designed the characters because that was the most important step and the one that required the most skill and expertise. Suzy’s Zoo, 114 T.C. at 8. Suzy’s Zoo’s contractors couldn’t sell, copy, or use those characters without breaching Suzy’s Zoo’s license. Id. Suzy’s Zoo retained the “exclusive right to sell the finished product,” id. at 9, and it accepted all the finished products it ordered, see Suzy’s Zoo, 273 F.3d at 877.
Harborside, unlike Suzy’s Zoo, see id.; Suzy’s Zoo, 114 T.C. at 8-10, didn’t create the clones, maintain tight control over them, order specific quantities, prevent sales to third parties, or take possession of everything produced. Harborside 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 Harborside. Nothing prevented either type of grower from selling to another
This was not the type of contract-manufacturing arrangement we saw in Suzy’s Zoo, 273 F.3d at 877, where a designer hired others to make its products but owned those products at all stages of their creation. Harborside merely sold or gave members clones that it had purchased from nurseries and bought back bud if and when it wanted. In between these two steps it had no ownership interest in the marijuana plants. Harborside is therefore a reseller for purposes of
This leaves only the issue of whether Harborside owes accuracy-related penalties under
Notes
Sir Toby Belch: * * * Does not our life consist of the four elements?
Sir Andrew Aguecheek: Faith, so they say; but I think it rather consists of eating and drinking.
Sir Toby Belch: Thou’rt a scholar; let us therefore eat and drink.
(continued...) (...continued) William Shakespeare, Twelfth Night act 2, sc. 3. The four elements are an exhaustive list, but eating and drinking aren’t all of life, even for Sir Andrew.