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New Tax Court Opinion Highlights Tax Risks for Entities Functioning as Service Providers to Marijuana Businesses

by | Dec 27, 2018 | Tax Advice, IRS Audits and Appeals, IRS Audit, IRS Appeal, Tax Audit Help

On Thursday, December 20, 2018, the Tax Court released its opinion in Alternative Health Care Advocates et al v. Comm’r, 151 T.C. No. 13 (2018), a case involving the disallowance of deductions related to trafficking of marijuana mandated by Section 280E of the Internal Revenue Code. The Alternative Health Care Advocates opinion broke new ground by extending the scope of the deduction disallowance beyond the legal owner/seller of marijuana to an affiliated entity that participated in the marijuana sales.

With the legalization of medical marijuana in most states and the advent of legal recreational marijuana in a growing number, hundreds of businesses licensed by the states have sprung up to sell marijuana products. These enterprises operate much the same as other legit businesses: they buy product, rent store locations, pay employees, withhold employment taxes, etc. Unfortunately, most of the expenses that non-marijuana companies can deduct are not deductible by marijuana businesses. Section 280E of the Internal Revenue Code, a statute enacted at the height of the 1980s’ war on drugs, disallows business expenses incurred in the business of “trafficking in controlled substances.” (The one exception is the cost of the controlled substance itself, which is treated as “cost of goods sold,” rather than as a deduction.) The courts have upheld the disallowance, ruling that even state-licensed marijuana sales constitute the “trafficking in controlled substances.” Patients Mutual Assistance Collective Corp. v. Comm’r, 151 T.C. No 11 (2018); Olive v. Comm’r, 139 T.C. 19 (2012), aff’d 792 F.3d 1146 (9th Cir. 2015).

In what may be an effort to get around the consequences of the Section 280E deduction disallowance, some businesses have attempted to bifurcate their operations into multiple entities, with only one directly involved in the growing and providing of marijuana to patients. In Alternative Health Care Advocates, the entity that actually produced the marijuana (Alternative) was a California non-profit mutual benefit corporation, operated for the benefit of its customer-members. Alternative was taxed as a C corporation for federal tax purposes. The founders of Alternative also set up a second entity, Wellness, to provide management services to Alternative. Wellness elected to be taxed as an S corporation. Essentially, Wellness handled most aspects of Alternative’s business (hiring employees, paying expenses including advertising, wages and rent), except for the acquisition and sale of marijuana. Wellness took the position that it was not involved in trafficking (and thus all of its expenses were deductible), because it only provided services to Alternative and never actually owned or sold controlled substances.

Had this arrangement been respected for tax purposes, any disallowance of deductions because of Section 280E would have only impacted Alternative. As a C corporation, any additional tax liability imposed on Alternative might have only been collectible from the assets of that entity. The money paid by Alternative to Wellness would have been income to Wellness, but Wellness would have offsetting deductions for rent, wages, etc. The owners of Wellness would realize flow through profits on the difference between what Alternative paid it for providing management services, and the actual, lower cost to Wellness of providing such services to Alternative.

Unfortunately for the taxpayers, the Tax Court did not respect this arrangement, finding that Wellness, like Alternative, was engaged in “trafficking in controlled substances,” with respect to the services it provided to Alternative:

Petitioners argue that, as a management services company, Wellness did not itself engage in the purchase and sale of marijuana. But the only difference between what Alternative did and what Wellness did (since Alternative acted only 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.

We, therefore, hold that Wellness was engaged in the business of “trafficking in controlled substances” during the taxable years at issue.

Alternative Health Care Advocates et al v. Comm’r, 151 T.C. No 13, Slip Op. at 28-29 (2018). Thus, Wellness and its owners were subject to the Section 280E deduction disallowance.

To the extent that taxpayers and their advisors have put in place arrangements similar to the Alternative/Wellness structure in an effort to cabin potential Section 280E tax adjustments within the entity that grows or purchase marijuana and enjoy the economic benefits through an affiliated entity that provides management services or logistical support to the marijuana business for a fee, such arrangements may be challenged by the IRS on audit.

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