Tax - Representation - Transactional

Cannabis Tax Advisors – Business Judgment

CannabisTax Advisors – Business Judgment – It should not have been necessary that we write this article.  We have known for a long time that the commercial cannabis industry was not well-served by the tax advice it was receiving.  We have from time to time commented on some egregious instances of inane advice.  The commentary relating to the three cases recently decided by the United States Tax Court, however, compels us to again take pen to hand.

The root problem seems to be that a substantial portion of the tax advisors involved with the cannabis industry lacks the breadth of business knowledge and experience that is a fundamental requirement in order to justifiably claim to be sufficiently skilled to advise cannabis business clients.  This is particularly true in connection with transactional matters.  Cannabis businesses are businesses even though the federal government insists such businesses are drug traffickers.  Cannabis businesses need advice from tax practitioners who skilled in providing tax advice to businesses.

The majority of the practitioners who are skilled in providing tax advice to businesses tend to be certified public accountants [“CPA’s”] with graduate degrees in taxation [an “MST”] or attorneys with an accounting education and an LLM in Taxation. Experience tells us a significant background in accounting and finance is a necessity. We note that more and more frequently tax issues arising in the cannabis industry will require a skilled attorney as well as a CPA with forensic knowledge who is employed by the attorney under Kovel protections[1].

Based on published information and solicitations, two groups of practitioners with different skill sets, specifically Enrolled Agents [“EA’s”] and criminal attorneys, appear to be the tax advisors for a majority of cannabis businesses.  While most members of both groups are talented in their own right, few have the accounting and finance education and experience to be skilled tax advisors to cannabis businesses.  The problem appears to have been exacerbated because criminal attorneys were “first on the scene” in the cannabis industry as a consequence of the evolution to a legal industry.

A similar circumstance brought many EA’s into the cannabis industry.  EAs tend to work solo or in small shops that lack the complexity and variety of business clients that one finds with a “Big 4” or national CPA firm. [This is not intended as a swipe, but rather an acknowledgment of the way tax practitioners acquire experience and expertise]. We constantly remind ourselves that cannabis is nothing more than an agricultural crop[3] that has “special status” at the present time, which will dissipate over time, particularly once the Federal government removes it from CSA Schedule I[4].

One of the unfortunate consequences of the Federal government’s approach to cannabis is that legal cannabis businesses are subjected to a draconian regimen of expense disallowance that is otherwise reserved for illegal trafficking in controlled substances[5].  There have been a substantial number of Tax Court cases involving IRC Sec. 280E.  Most of these cases involved dispensaries where a confluence of factors involving poorly maintained record and sloppy practices led to taxpayer receiving harsh rulings[6].  The Tax Court in Feinberg[7], refused to recognize a well-known cannabis industry tax practitioner as an expert under its version of the Daubert standard[8] of FRCP 702.

The Tax Court recently issued a very thorough analysis in a case involving Harborside Dispensary that was reviewed by the entire court[9].  We will leave the discussion of the Judge Holmes’ analysis to the myriad of other posts that have been written, some of which reach outrageously incorrect conclusions.  Judge Holmes provided Harborside with a small victory with respect to the application of IRC Sec. 6662 substantial understatement penalties in his TCM opinion based on his perception of the quality of recordkeeping and Harborside’s diligence in seeking to comply with the law[10].

The foregoing discussion brings us to the even more recent decision of the Tax Court in ALTERNATIVE HEALTH CARE ADVOCATES, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent, 151 T.C. No. 13.  This case involves the use of a management company by a cannabis business, which is a practice that appears to have evolved from the decision in Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP)[12]. The use of management companies has always been contentious due to the perception that somehow the standards were different due to the existence of IRC Sec. 280E[13].

The Tax Court’s decision in Alternative, which like Harborside was a reviewed opinion, seems to have caused a number of practitioners to “go off the deep end” and prognosticate that ANY use of a management company would attract fraud penalties.

Alternative was a costly defeat for Los Angeles dispensary owner Donald Duncan.  Mr. Duncan had attempted to circumvent 280E through the use of a management company to run his cannabis business. Judge Pugh determined both the dispensary and the management company – Wellness Management Group – were liable for the income tax and penalties.

Henry G. Wykowski, who represented Harborside in the two cases that preceded Alternative, as well as Alternative, made some surprising comments.  Mr. Wykowski said using a management company to run day-to-day medical marijuana operations was a “bad strategy.”

“They took a bad situation and made it worse, they doubled the pain, because now, both entities are subject to 280E,” he said.

The takeaway from Alternative’s situation?

“Anybody that’s now still doing that is on notice that they better change – and change fast,” Wykowski said.

Mr. Wykowski’s comments relating to both the Tax Court victories and defeats, like the comments of many others relating to these cases, belie a complete understanding of the three opinions.  The decision in Alternative increases the risk that use of a management company structure in connection with a cannabis business will attract attention and enhanced civil penalties.  In the eyes of some, the facts found by Judge Pugh could be a foundation criminal charges based on money laundering, structuring, and conspiracy.  There is, however, a counterbalance that appears to have been ignored.  There are good business reasons for the use of a management company structure.

Cannabis Tax Advisors – Business Judgment

Perhaps one of the most significant decisions in the history of income tax is Gregory v. Helvering[14]. The case is cited as part of the basis for two legal doctrines: the business purpose doctrine and the doctrine of substance over form. The business purpose doctrine is, if a transaction has no substantial business purpose other than the avoidance or reduction of Federal tax, the tax law may disregard the transaction. The doctrine of substance over form is that the economic substance of a transaction may determine the tax consequences even if the legal form of the transaction would support more favorable tax consequences.

In the litigation that arose from Mrs. Helvering’s utilization of transfers of stock between related corporations in order to minimize her tax liability, the Board of Tax Appeals ruled in favor of the taxpayer[15] .

On appeal, the Second Circuit reversed the Board of Tax Appeals, ruling in favor of the Commissioner. The Supreme Court of the United States also ruled in favor of the Commissioner. Although the letter of the law was arguably complied with, the appellate courts ruled the intention of the tax law was not to allow reorganizations merely for the purpose of tax avoidance. In the course of its judgment, the United States Supreme Court said the following.

“The legal right of a taxpayer to decrease the amount of what otherwise would be his [or her] taxes, or altogether avoid them, by means which the law permits, cannot be doubted. … But the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended. The reasoning of the court below [i.e., the reasoning of the Court of Appeals] in justification of a negative answer leaves little to be said.

Simply an operation having no business or corporate purpose-a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to the petitioner.

In these circumstances, the facts speak for themselves and are susceptible of but one interpretation. The entire undertaking though conducted according to the terms of [the statute], was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else”. … [T]he transaction upon its face lies outside the plain intent of the statute. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.”

Stated in absolutely clear terms, where a taxpayer selects a structure for its operations, where a legitimate business purpose exists, other than merely the avoidance of taxes, the Courts will defer to and respect a taxpayer’s business judgment. Hence the decision in Alternative disallowed the use of a management company based upon the facts in the case and disallowed the deductions for both entities. The Court did NOT rule that management company themselves we poisonous per se.

There are a number of unique challenges faced by the legal cannabis industry.  The lack of access to the banking system, being perhaps the most significant.  The use of a management company is certainly justified in order secure access to financial services.  Cannabis businesses need access to financial services in order to properly and accurately account for their activities.  Alternative’s misuse of a management company to conceal and evade led to a costly decision.  The use of a management company did not produce this costly result.

We intend to follow up this discussion with an expanded discussion of the types of activities that we believe would be considered to be of the type where there is a business purpose that justified the use of a management company and would more likely than not[16] prevail in a case involving the cannabis industry and an analysis of IRC Sec. 280E under the principles in Alternative.

Cannabis Tax Advisors – Business Judgment

[1] Kovel Accountants Cannabis Industry

[3] See California Cannabis Cultivation – Qualification as Farming which contains an extensive analysis of the byzantine path which leads us to the conclusion that the determination of the treatment of cannabis cultivation activity is determined under local law, through a line of judicature that relates to the “right to farm”.

The Federal Government has long taken a uniquely harsh position the treatment of expenditures associated with drug trafficking. In 1981, the Tax Court allowed an illegal business to recover the cost of the controlled substances (i.e., amphetamines; cocaine; marijuana) obtained on consignment and also to claim certain business deductions (a portion of the rent he paid on his apartment which was his sole place of business, the cost of a small scale, packaging expenses, telephone expenses, and automobile expenses). See Jeffrey Edmondson v. Commissioner, T.C. Memo. 1981-623.

In 1982, Congress enacted §280E, which reverses the holding in Edmondson as it relates to deductions other than the cost of the controlled substances. Under Explanation of Provision, the Senate Report reads as follows: All deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill. S. REP. NO. 97-494 (Vol. I), at 309 (1982). The Senate bill was adopted in conference. CONF. REP. NO. 97-760, at 598 (1982), 1982-2 C.B. 661.

IRC Sec. 280E provides

“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 substances (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.”

The drafters of the statute could never have contemplated the current situation where cannabis is legal for medical use in the majority of states, for recreational use in an increasing number of states, and remain illegal under the Federal statute.There was a period of relative calm after the issuance of the Cole Memorandum and the IRS Chief Counsel Memorandum [“CCM”][vi]. However, Attorney General Jeffrey Sessions rescinded the Cole Memorandum[vii] with the release of Dept. of Justice Press Release 18-8   in early 2018. The release provides:

“The Department of Justice today issued a memo on federal marijuana enforcement policy announcing a return to the rule of law and the rescission of previous guidance documents. Since the passage of the Controlled Substances Act (CSA) in 1970, Congress has generally prohibited the cultivation, distribution, and possession of marijuana.

In the memorandum, Attorney General Jeff Sessions directs all U.S. Attorneys to enforce the laws enacted by Congress and to follow well-established principles when pursuing prosecutions related to marijuana activities. This return to the rule of law is also a return of trust and local control to federal prosecutors who know where and how to deploy Justice Department resources most effectively to reduce violent crime, stem the tide of the drug crisis, and dismantle criminal gangs.

“It is the mission of the Department of Justice to enforce the laws of the United States, and the previous issuance of guidance undermines the rule of law and the ability of our local, state, tribal, and federal law enforcement partners to carry out this mission,” said Attorney General Jeff Sessions. “Therefore, today’s memo on federal marijuana enforcement simply directs all U.S. Attorneys to use previously established prosecutorial principles that provide them all the necessary tools to disrupt criminal organizations, tackle the growing drug crisis, and thwart violent crime across our country.”

[4] 21 CFR §1308.11 Schedule I.

[5] A detailed analysis of IRC Sec. 280E can be found in Analysis IRC Sec. 280E.

[6] See Alterman TC Memo 2018-83 Alternative View,  and Prof. Bryan Camp’s  Lesson From the Tax Court – Into The Weeds on COGS

[7] Neil Feinberg et ux., et al. v. Commissioner, (2017 Memo 2017-211) 

[8] See Cannabis CPA Becomes A Cannibal

[9] See  151 T.C. No. 11,   Harborside – Further Reflections

[10] See Harborside Redux, Harborside Beats Penalties,  Tax Court Reverses Itself a Year After a Fully Reviewed Opinion Acknowledging a “Graev” Mistake, and Graev 147 T.C. No 16 (2016)

[12] 128 T.C. 173, (2002 )

[13] We have explored the use of management companies in the cannabis industry in Management Services – Trade/Business deduction under IRC Sec. 162 are supported by the holding in Lender Management LLC, T.C. Memo. 2017-246,and Cannabis Management – Soothsayers . See also Marijuana Corporate Structures that Break the Rules, Cannalawblog.com, Robert McVay, June 3, 2015

[14] 293 U. S. 465 (1935)

Evelyn Gregory was the owner of all the shares of a company called United Mortgage Company (“United”). United Mortgage in turn owned 1,000 shares of stock of a company called Monitor Securities Corporation (“Monitor”). On September 18, 1928, she created Averill Corp and, three days after, transferred the 1000 shares in Monitor to Averill. On September 24, she dissolved Averill and distributed the 1000 shares in Monitor to herself, and on the same day sold the shares for $133,333.33. She claimed there was a cost of $57,325.45, and she should be taxed on a capital net gain on $76,007.88.

On her 1928 federal income tax return, Gregory treated the transaction as a tax free corporate reorganization[14]. under the . The Commissioner of Internal Revenue, Guy T. Helvering, argued in economic substance there was no business reorganization, that Gregory owned all three corporations and was simply following a legal form to make it appear like a reorganization so she could dispose of the Monitor shares without paying substantial income tax. Accordingly, she understated her liability by $10,000.

[15] See Gregory v. Helvering, 27 B.T.A. 223 (1932).

[16] “More likely than not” is the standard of proof required under IRS Sec. 6662 to overcome the test for application of the substantial understatement penalty. See Regs. Sec. 1.6662-4(d)(3)(ii) and Regs. Sec. 1.6664-4(f)(2)(B). For a further discussion of the benchmarks to meet standards of proof see Tax Authority – Hierarchy