I finished Part 2 of this series emphasizing section 280E’s principle force. Section 280E does not universally bar illegal commercial enterprises from deducting necessary and ordinary business expenses. Rather, section 280E only applies to businesses trafficking in substances banned under the Controlled Substances Act. The key takeaway from this distinction is that taxpayers can engage in another business and not be subject to section 280E with respect to that business. Thus, state-sanctioned cannabis businesses can improve their tax situation by conducting other activities, like counseling or caregiving, within the same entity if they can demonstrate that these activities constitute separate businesses.
Case law and treasury regulations underscore the well-established principle that a taxpayer can have more than one trade or business. The tax court in Californians Helping to Alleviate Medical Problems v. Commissioner (“CHAMP”) addressed this issue holding that the taxpayer’s caregiving services business and its cannabis business were separate business activities because the taxpayer “was regularly and extensively involved in the provision of caregiving services, and those services are substantially different from the [taxpayer’s] provision of medical marijuana.”
The cannabis dispensary in CHAMP “operated exclusively for charitable, educational and scientific purposes,” and its income was a bit less than its expenses. The director was experienced in health services and operated the dispensary with caregiving as the primary feature; dispensing cannabis, with instruction on how to best consume it, was a secondary feature. The majority of the employees, 18 out of 25, worked exclusively in the caregiving portion of the business. Slightly less than half of its members, suffered from AIDS and paid a single membership fee “for the right to receive caregiving services and medical marijuana from” the taxpayer. The CHAMP court allocated expenses between the marijuana business, which was subject to section 280E, and the caregiving business, agreeing with the taxpayer regarding how the expenses should be allocated.
The tax court’s holding in CHAMP notwithstanding, the IRS is empowered to second guess a cannabis enterprise’s characterization of its business. The IRS will challenge a taxpayer’s characterization of its business “when it appears that his [or her] characterization is artificial and cannot be reasonably supported under the facts and circumstances of the case.” The Tax Court has applied nine factors to determine whether a taxpayer’s characterization of two or more activities is unreasonable or artificial: (1) whether the taxpayer conducts the activities at the same location; (2) whether the taxpayer undertook the activities to find sources of revenue from his or her land; (3) whether the taxpayer formed the undertakings as separate activities; (4) whether one activity benefited from the other; (5) whether the taxpayer used one activity to advertise the other; (6) the degree to which the activities shared management; (7) the degree to which one individual managed the assets of both activities; (8) whether the taxpayer used the same accountant for the activities; and (9) the degree to which the activities shared books and records.
A recent Tax Court ruling provides cannabis enterprises with a cautionary example of what not to do. In Olive v. Commissioner, the IRS successfully contested the taxpayer’s characterization of his California medical cannabis dispensary as both a dispensary and a separate caregiving center as in CHAMP. The dispensary, The Vapor Room Herbal Center (“Vapor Room”), primarily sold medical cannabis and provided ancillary services.
The taxpayer at issue operated The Vapor Room as a sole-proprietor out of a 1250-square-foot room. He established the Vapor Room so his patrons, some of whom suffered from cancer or HIV/AIDS, “could socialize and purchase and consume medical marijuana there.” He “designed the Vapor Room with a comfortable lounge-like, community center atmosphere, placing couches, chairs and tables throughout the premises. He placed vaporizers, games, books, and art supplies on the premises for patrons to use at their desire.” The Vapor Room provided yoga classes, chess and other board games and movies, chair massages with a therapist, and complimentary snacks and beverages. The taxpayer did not charge patrons a fee to frequent the Vapor Room. The Vapor Room’s sole revenue source was its sale of medical cannabis.
In his purported reliance on CHAMP, the taxpayer asserted the Vapor Room trafficked in cannabis only when patrons purchased cannabis, while the rest of the Vapor Room’s business consisted of caregiving services. The court rejected this argument , stating:
Petitioner essentially reads our Opinion in CHAMP to hold that a medical marijuana dispensary that allows its customers to consume medical marijuana on its premises with similarly situated individuals is a caregiver if the dispensary also provides the customers with incidental activities, consultation or advice. Such a reading is wrong. A business that dispenses marijuana does not necessarily consist simply of the act of dispensing marijuana, just as a business that sells other goods does not necessarily consist simply of the passing of those goods.
Applying the nine factors stated above, the court held that the Vapor Room consisted of one business:
The facts here persuade us that the Vapor Room’s dispensing of medical marijuana and its providing of services and activities share a close and inseparable organizational and economic relationship. They are one and the same business. Petitioner [the owner of the Vapor Room] formed and operated the Vapor Room to sell medical marijuana to the patrons and to advise them on what he considered to be the best marijuana to consume and the best way to consume it. Petitioner provided the additional services and activities incident to, and as part of, the Vapor Room’s dispensing of medical marijuana. and the Vapor Room’s employees were already in the room helping the patrons receive and consume medical marijuana and the entire site of the Vapor Room was used for that purpose. The record does not establish that the Vapor Room paid any additional wages or rent to provide the incidental services and activities. Nor does the record establish that the Vapor Room made any other significant payment to provide the incidental activities or services. Petitioner also oversaw all aspects of the Vapor Room’s operation and the Vapor Room had a single bookkeeper and a single independent accountant for its business. These facts further support our conclusion that the Vapor Room had only one trade or business.
Cannabis entrepreneurs should beware that the tax court decided CHAMP before its decision itemizing the nine factors stated above. The record in CHAMP seemingly suggests that applying three of the factors compels the same outcome as Olive — same location, director, and accountant. On the other hand, the tax court did not provide that any one of the nine factors or what combination thereof determines the outcome. Prudent business people can manage this risk by structuring their state-sanctioned cannabis enterprises to comport with the nine factors.
Whether a cannabis business with one or more additional businesses is more analogous to CHAMP versus Olive likely turns on the nature and extent of the separate activities. For instance, if a cannabis business sells cannabis and smoking pipes, the taxpayer will likely face an uphill climb to prove that these two sectors of the business did not aid each other’s cash flows. Section 280E would deny this taxpayer all expense deductions even if it would not otherwise apply to an independent smoking pipe retailer. Businesses with more substantial separation, like significant separate costs and sales revenue are more likely to prevail. Such businesses should determine what expenses are allocable to the non-cannabis activities and deduct them.
 See Californians Helping to Alleviate Med. Problems v. Comm’r, 128 T.C. 173, 182 (2007) (hereinafter “CHAMP”).
 See Edward J. Roche, Jr., Federal Income Taxation of Medical Marijuana Businesses, 66 Tax Law. 429, 469 (2013).
 See Alverson v. Comm’r, 25 B.T.A. 482, 488 (1937); Treas. Reg. § 1.183(d)(1).
 See CHAMP, 128 T.C. at 183.
 See id. at 174, 176-77.
 See id. at 174-75.
 See id. at 175-76.
 See id. at 174-75.
 See id. at 185.
 See Treas. Reg. § 1.183-1(d)(1).
 See Trupp v. Comm’r, 103 T.C.M. (CCH) 1594, 2012 WL 1232085, *8 (2012).
 I have carefully attempted to withhold my personal opinion from these blogs to not detract from their informative purpose. I cannot resist here. The Olive case is a flagrant example of failing to plan for income taxation as a cannabis enterprise generally, failing to keep records for appropriate COGS adjustments, and having to react to these failings as a result.
 See Olive v. Comm’r, 139 T.C. 19, 37 (2012).
 See id. at 19.
 See id. at 21.
 See id.
 See id. at 21-22.
 See id. at 23.
 See id. at 22.
 See id.
 See id. at 39.
 See id. at 40.
 See id. at 41-42.
 See CHAMP, 128 T.C. at 175-85.
 See Trupp, 2012 WL at *8.
 See Roche, supra note 2, at 472.
 See id.
 See id.
Mike Parnes is an associate attorney representing private and public sector clients in various legal disputes. Mr. Parnes’s experience ranges from contract, real property, labor and employment, and fiduciary duty disputes to state and local tax and entity formation matters.
Before joining Barth Daly LLP, Mr. Parnes worked on the Professional Services team of a large tax technology company advising multistate businesses on various sales and use tax issues. During law school, Mr. Parnes clerked for a national firm’s state and local tax controversy practice, served as an extern for the State Board of Equalization’s Franchise Income Tax Appeals Division, and worked for two Sacramento civil litigation firms in his first and second summers.
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