Tax Court Deals Another Blow to Cannabis Management Company Model

28 Dec Tax Court Deals Another Blow to Cannabis Management Company Model

On December 20^th, U.S. Tax Court issued its opinion in Alternative Health Care Advocates et al. v. Commissioner of Internal Revenue. The long opinion details various issues related to the specific case, but we will concentrate on one relatively small piece of it. How would the Tax Court treat income paid from a marijuana retailer to a management services company for that retailer?

In this case, Alternative Health Care Advocates provided medical marijuana to individuals in California under California law. Another company, Wellness Management Group, Inc., provided management services to Alternative Health Advocates. These services included hiring employees and managing HR for those employees, paying wages for those employees, paying advertising expenses, paying rent, etc. Wellness did not provide services of that nature or any nature to any other business entity. Wellness made money by collecting fees for its services from Alternative Health Care Advocates.

Under Section 280E of the Internal Revenue Code, businesses that are engaged in trafficking controlled substances cannot take regular business deductions, so they end up paying taxes on their gross receipts less their allowed cost of goods sold (COGS). If an expense doesn’t fit into the category of COGS, a company that is considered to be “trafficking” would have to pay taxes as if the expense hadn’t been incurred in the first place. This is how the effective tax rate for marijuana businesses can be outrageously high.

Marijuana businesses set up management companies for a few reasons. Tax avoidance under 280E can be one of them, but trying to set up a management company structure to avoid 280E-related tax problems can be complex and can backfire. Instead, most of the value of the management company model comes from the ability of the management company to get banking and enter into regular electronic transactions with third parties, including running payroll services.

But the model backfires if the management company is considered to be trafficking, because a management company introduces new transactions to the system involving the same pot of money. Imagine that a marijuana retail company generates $1 million and has $500,000 in 280E non-deductible expenses. That company standing alone would pay tax on the full $1 million. Now imagine that a management company is set up to handle the $500,000 in expenses and charges the marijuana company $500,000 to do so. The marijuana company now has $1 million in revenue and a non-deductible $500,000 bill to the management company and pays taxes on $1 million. The management company receives $500,000 from the marijuana company and pays salary and other expenses that also equal $500,000. If the management company is treated like any other business, the transaction is a wash and ends the same way as if there were no management company. If the management company is deemed to be “trafficking” however, then the marijuana business will find itself paying tax on both entities for the same revenue. The $500,000 paid to the management company ends up being taxed twice.

Unfortunately, the Tax Court decided that Wellness’s management activities were “trafficking” as much as Alternative Health Care Advocates’ activities were. In response to the taxpayers’ arguments that disallowing the 280E deductions for both businesses was inequitable, the Tax Court simply stated that the tax consequences were a direct result of the organizational structure the taxpayers put together.

Here are the takeaways for existing businesses, especially management companies. First, it’s worth noting that this case will likely be appealed, so keep an eye on that. Second, businesses have to plan their transactions involving management companies as if management company revenue is subject to 280E. Some management companies that offer broader services to a variety of different businesses may have some additional arguments that they are not engaged in “trafficking.” But if your management company is just a stand-in for your operating marijuana company, the Tax Court has indicated that it will approve of the IRS considering you to be trafficking as well. This case is one more reminder that Section 280E presents an ever-present obstacle to the ongoing health of marijuana businesses. Advocates must continue to concentrate their efforts to finally get Congress to repeal Section 280E.