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IRC § 280E: Defining "Trafficking" 

IRC § 280E applies to deductions and credits for amounts “paid or incurred” in carrying on a "trade or business" of “trafficking” or where there are activities that comprise a trade or business of trafficking. IRC § 7701(a)(25) states that “paid or incurred” shall be construed according to the taxpayer’s method of accounting in computing taxable income. However, expenses included in cost of goods sold (“COGS”) reduce taxable income and operates outside the reach of IRC § 280E. Generally speaking, IRC § 280E is less damaging to cultivators than retailers, because cultivators can attribute more business expenses to COGS.

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IRC § 280E does not specifically reference the definition of “trafficking” of controlled substances under the tax code. ​However, various federal statute and prior tax court cases have provided insight into how "trafficking" has been interpreted and defined for U.S. tax purposes when applying IRC § 280E. See below for summarized statute references as noted by the interpreting tax courts. 

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Federal Statues Defining "Trafficking"

• In the Controlled Substances Act, “[t]he term ‘dispense’ means to deliver a controlled substance to an ultimate user”. See 21 U.S.C. § 802(10); 21 U.S.C. § 841(a)(1) (prohibiting the manufacture, distribution, dispensation, or possession of marijuana).

• 26 U.S.C. § 7208, which criminalizes certain offenses relating to stamps, is the only section in the Internal Revenue Code that explicitly defines the term “trafficking”. § 7208(4)(B) defines “trafficking” as “[k]nowingly or willfully buy[ing], sell[ing], offer[ing] for sale, or giv[ing] away washed or restored stamp[s] to any person for use”.

• Congressional findings and declarations on controlled substances, see 21 U.S.C. § 801(2), describe it as “[t]he illegal importation, manufacture, distribution, and possession and improper use of controlled substances”.

• Federal statute criminalizing trafficking in counterfeit goods or services provides that “the term ‘traffic’ means to transport, transfer, or otherwise dispose of, to another, for purposes of commercial advantage or private financial gain, or to make, import, export, obtain control of, or possess, with intent to so transport, transfer, or otherwise dispose of”. See 18 U.S.C. § 2320(f)(5) (2012).

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Tax Court Cases Defining "Trafficking"

• In CHAMP, the tax court defined “trafficking” as the act of engaging in a commercial activity is "to buy and sell regularly." The court held the petitioner's supplying of medical marijuana to its care-giving services members is within that definition in that the taxpayer regularly bought and sold the marijuana, such that sales occurred when the taxpayer distributed the medical marijuana to its members in exchange for part of their membership fees. See CHAMP, 128 T.C. at 182.

• In Olive, the tax court held that “dispensing medical marijuana pursuant to California law was ‘trafficking’ within the meaning of IRC § 280E.” See Olive v. Commissioner, 139 T.C. at 38.  In Olive, the tax court also explicitly rejected the argument that because the taxpayers' activities did not "consist solely of" trafficking in medical marijuana with respect to the “consists of” language in IRC § 280E, the IRC § 280E limitation should not apply.

• In Alternative, the tax court reaffirmed IRC § 280E applies to medical marijuana dispensaries even though they are operating in compliance with the laws of their jurisdictions. See Alternative Health Care Advocates et al v. Comm’r, 151 T.C. No. 13 (2018), citing Patients Mutual Assistance Collective Corp. v. Commissioner (Patients Mutual), 151 T.C. (Nov. 29, 2018); Olive v. Commissioner, 139 T.C. at 38; CHAMP, 128 T.C. at 182-183; Canna Care, Inc. v. Commissioner, T.C. Memo. 2015-206.

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Whether a taxpayer's activities consist of "trafficking" for IRC § 280E purposes, the next important tax issue to be evaluated regarding U.S. tax implications within the cannabis industry concerns whether a "separate trade or business" exists which may not face IRC § 280E restrictions. Below outlines some recent and noteworthy cases on how U.S. tax courts have evaluated different taxpayer business structures attempting to bypass IRC § 280E.

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IRC § 280E: Defining "Separate Trade or Business" Recent Court Cases

Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173, (2007), U.S. Tax Court

In CHAMP, the court held deductions for non-cannabis-related activities were allowed. In CHAMP, the dispensary operated two distinct businesses: (1) care-giving services (cancer patient support) and (2) marijuana sales, even though its customers paid a single fee for both. Because the two businesses did not share any common employees, and marijuana sales took place in only one of the taxpayer’s facilities (and comprised only 10% of that business), the court determined that care-giving was the taxpayer’s main activity and that it stood “separate and apart” from the marijuana sales. Therefore, the taxpayer was permitted to deduct expenses allocated to the care-giving business (but not to the marijuana-sales business).

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• Separate Trade or Business:

  • An activity is a trade or business if the taxpayer does it continuously and regularly with the intent of making a profit.

  • A single taxpayer can have more than one trade or business, or multiple activities that nevertheless are only a single trade or business. See CHAMP, 128 T.C. at 183, see also Davis v. Commissioner, 29 T.C. 878, 891 (1958).

  • However separate entities’ activities can be a single trade or business if they’re part of a “unified business enterprise” with a single profit motive. See Morton v. United States, 98 Fed. Cl. 596, 600 (2011).

  • The CHAMP court determined that it was reasonable to find that the caregiving services were a separate business because they were so regular and extensive that the business “stood on its own” apart from the sale of marijuana.

    • In CHAMP, the court clarified that the caregiving services would not need to necessarily charge a separate fee in order to be generating a profit, since in CHAMP the dispensary charged a membership fee that covered both the medical marijuana and the caregiving services

    • Second, the caregiving services would not only need to be a “trade or business,” but also separate from the medical marijuana sales.

    • Under CHAMP, “whether an activity is a trade or business separate from another trade or business is a question of fact that depends on . . . the degree of economic interrelationship between the two undertakings.”

    • CHAMP cited Collins v. Commissioner, 47. 34 T.C. 592 (1960) which found that the existence of separate records and employees was probative of whether the taxpayer had two separate businesses. In Collins, separate accounting books were considered evidence in favor of the existence of two separate businesses, 50. Collins, 34 T.C. at 597–98. and CHAMP relied on the separately employed personnel and segregated use of the facility for the expense allocation. 51. CHAMP, 128 T.C. at 185.

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Olive v. C.I.R., 139 T.C. 19, 42 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015), U.S. Circuit Court of Appeals (9th Circuit)

In Olive, a taxpayer that sold medical marijuana and also provided free services, was deemed a single trade or business and was not permitted to deduct any of its operating expenses. The court noted that the taxpayer in that case charged only for the marijuana, had no significant costs connected exclusively with the non-marijuana services, and that the employees who sold the marijuana were the same employees that provided the services. The court concluded that the services provided were merely “incident to” the sale of marijuana, that the two activities had a “close and inseparable organizational and economic relationship,” and that the taxpayer was engaging in activities that were, in essence, “one and the same business.”

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• Separate Trade or Business:

  • ​In Olive, the Ninth Circuit Court of Appeals established definition of “trade or business” as something that is “entered into with the dominant hope and intent of realizing a profit.”

  • In Olive, the court held that a taxpayer who sold medical marijuana and provided complimentary services including movies, board games, yoga classes, massages, snacks, personal counseling, and advice on how to best consume marijuana, had a single trade or business.

    • The taxpayer in Olive charged only for marijuana, and set a price based on the amount and type of marijuana its patients purchased. However, the cost of the other services was bundled into that price.

    • The same employees who sold marijuana also provided the services, and the taxpayer paid no additional wages, rent, or other significant costs connected exclusively with those services.

    • The taxpayer also had a single bookkeeper and accountant.  

  • These facts led the court to find that the services were “incident to” the sale of marijuana, and that the two activities had a “close and inseparable organizational and economic relationship.” As such, the court held that they were “one and the same business.” Because selling medical marijuana was the only source of revenue, and it provided all its other services free of charge, the court concluded that its only trade or business was selling medical cannabis.

  • Olive cited to the U.S. Tax Court’s holding in CHAMP that a taxpayer can have two trades or businesses with only one of those two businesses subject to IRC § 280E if the non-trafficking portion of the business is a substantial source of revenue. The Ninth Circuit did not disagree with the CHAMP ruling, but it concluded that because Olive’s only “business” was selling medical marijuana because its other services were free of charge. Therefore all of the relevant activities “consisted of” trafficking in controlled substances and the deductions must be disallowed.

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Beck-v-C.I.R., T.C. Memo 2015-149 (2015), U.S. Tax Court

Here, the taxpayer operated two medical marijuana dispensaries where he sold marijuana and edibles. Customers were also permitted to medicate onsite. The taxpayer and his employees also instructed customers on the effects of marijuana and the proper use of smoking devices free of charge.

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• Separate Trade or Business:

  • The taxpayer also provided no evidence that the dispensaries sold any non-marijuana-related items. The sole purpose of the taxpayer's dispensaries was to provide customers with medical marijuana and instruct those customers on how to use it. Unlike in CHAMP, the taxpayer provided no evidence that he had any business activity unrelated to the sale or distribution of marijuana. Further, the taxpayer did not established which, if any, expenses were for any alleged services offered and which expenses related to the sale of marijuana.

  • In Beck, the tax court held that a marijuana business that only sold marijuana products, could not deduct any of the ordinary and necessary business expenses related to the marijuana business pursuant to IRC § 162(a). Deductions were limited to “cost of goods sold” per IRC § 280E.

  • In Beck , however, the court's decision discussed the CHAMP decision and upheld its holding that a business may have two or more businesses and that the ordinary and necessary business expenses relating to the non-marijuana businesses were deductible.

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Patients Mutual Assistance Collective Corp. (d.b.a. Harborside Health Center) v. Commissioner, 151 T.C. 11 (2018), U.S. Tax Court

In Harborside, the taxpayer argued that it had four activities, each of which was a separate trade or business: (1) sales of marijuana and products containing marijuana; (2) sales of products with no marijuana; (3) therapeutic services; and (4) brand development. The court, however, determined that taxpayer's main purpose is to sell marijuana. Below is a summary breakdown of the tax court analysis concluding the other activities were “incident to” the sale of marijuana:

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• High Majority of the Sales Floor & Revenue Comprised of Marijuana Products.

  • Marijuana and marijuana products comprised 75% of taxpayer products offered for sale. Despite the fact that 25% of the sales floor was reserved for non-marijuana products, marijuana sales generated at least 98.7% of the dispensary’s revenue.

• High Majority of Employee Activities Associated with Marijuana Products

  • Like Olive, the same taxpayer employees who bought, proceeded, and sold the marijuana also sold the non-marijuana items. 80-90% of taxpayer employee time was spent on the marijuana products.

• Only Medical Marijuana Credential Holding Customers Provided Access to Sales Floor.

  • The taxpayer sales floor (including the area containing the non-marijuana items) was only accessible to customers who arrived with their medical marijuana credentials reviewed by security. 60% of taxpayer’s members came to the dispensary to buy some form of marijuana.

• Non-Segregated Management of Marijuana v. Non-Marijuana Activities.

  • Taxpayer did not maintain separate entities or books for its non-marijuana sales, and the management was the same for both types of activities. Even the non-marijuana products were about marijuana, enabled the use of marijuana, and/or were branded with the taxpayer logo. This indicates that, as in Canna Care (see below), the sale of non-marijuana products was inseparable from and merely “incident to” the taxpayer's primary business of marijuana sales.

• Profit Motive and Payment Structure Significantly Position Toward Marijuana Products

  • The act of selling two products or types of products does not conclude that each is a separate trade or business. Neither is a free service considered a separate trade or business, even if it attracts customers.

  • Taxpayer argued that like CHAMP, a portion of each of its marijuana sales was in fact a purchase of the free holistic services it provided. The court disagreed, noting that while taxpayer sold marijuana and offered holistic services for free, the “global fee” changed by the taxpayer in CHAMP was for a fixed amount of marijuana and the balance was for its services (which marijuana product activities comprised the majority of its floor space and employee time).

  • The court concluded that the taxpayer's Health Center’s operations were more similar to those in Olive, in which the taxpayer also provided free services and where deductions were denied. This is besides the fact that the value of taxpayer’s free services totaled merely 1% of Harborside’s marijuana revenue, and were in any event needed in order for the taxpayer to meet the State of California’s "community benefit requirements" (nonprofit requirements) to use any excess revenue for the benefit of its patients or the community. California laws decriminalizing medical marijuana specifically stated that they did not “authorize any individual or group to cultivate or distribute cannabis for profit.” See Cal. Health & Safety Code sec. 11362.765(a). 

• Brand Development Services Entwined with Marijuana Sales Activities

  • The taxpayer argued that its branding activities constituted a separate trade or business. However, the court failed to find any evidence of supporting this claim. Instead, the court held everything about the dispensary’s operations, from its marijuana sales, to its structure, employees, and facilities utilized, indicated that the taxpayer’s branding work was “necessarily entwined” and it performed its branding using the same entity, management, capital structure, employees, and facilities as its marijuana sales.

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• Separate Trade or Business Issue:

  • ​The court rejected a narrow interpretation of IRC § 280E and held it may deny business-expense deductions to any trade or business that involves trafficking in controlled substances, even if that trade or business also engages in other activities.

  • The court acknowledged that “Dictionaries, the [Tax] Code, and caselaw all show that ‘consists of’ can introduce either an exhaustive list or a nonexhaustive list” of the activities of the taxpayer. However, the court favored the latter interpretation because it “is the only option that doesn’t render IRC § 280E ineffective and absurd.”

  • The Harborside tax court acknowledged that a marijuana business “can still deduct expenses for any separate, nontrafficking trades or businesses.” However, the court found that the taxpayer’s other activities (e.g., selling goods without marijuana and providing free therapeutic services) were not sufficiently distinct from its “primary purpose”, that of “selling marijuana and products containing marijuana.” The court found that the free therapeutic services the taxpayer offered to patients were merely incidental. 

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Alternative Health Care Advocates et al. v. Commissioner, 151 TC No.13, (2018), U.S. Tax Court

In 1999, the taxpayer founded a medical marijuana dispensary ("Berkeley Patients Group") located in Berkeley, California. In 2006, the taxpayer assisted with opening another medical marijuana dispensary in Los Angeles ("Alternative Health Care Advocates") as a California nonprofit mutual benefit corporation with members, rather than shareholders, that was treated as a C corporation for federal tax purposes. The taxpayer also served as a consultant for medical marijuana facilities in Palm Springs, Malibu, and other locations throughout California. The taxpayer's consulting activities included advising dispensary operators on best practices for screening members, securing the facility, and ensuring proper screening of medical marijuana.

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In 2008, the taxpayer also organized a second entity, Wellness Management Group (California corporation that elected S corporation status for federal tax purposes) to handle daily operations for Alternative and to perform functions for the medical marijuana dispensary such as hiring employees and paying expenses, including advertising, wages, and rent. While the taxpayer anticipated that Wellness might offer its management and operations services to other (unrelated and separate) medical marijuana dispensaries, Wellness performed services solely for Alternative during the tax years at issue. 

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• Separate Trade or Business Issue:​

  • 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.

  • Although the taxpayer (through "Wellness") hired a management company ("Alternative") to run his cannabis business, the court held both the dispensary and the management company (Wellness Management Group) were liable for IRS penalties and for taxes due pursuant to IRC § 280E.

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Alterman v. Commissioner, TC Memo 2018-83 (2018), U.S. Tax Court

The taxpayer in this case operated Altermeds, LLC, a disregarded entity. That entity sold marijuana-based products and, after initially buying the marijuana from a third party, began growing its own marijuana for sale. However, the tax court limited deductions to the cost of goods sold (COGS) amounts that the IRS had conceded in the case. Even there, the taxpayer’s poor and inconsistent records resulted in the allowed deductions being less than the amounts the taxpayer had originally claimed.

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Separate Trade or Business Issue:

• In Alterman, the court reaffirmed the “other line of business defense” argument as valid. However, the taxpayer must show that there is a separate business and account for those expenses that are tied separately to each business being conducted (the marijuana businesses and the others).  

• The court stated whether selling non-marijuana merchandise was a separate business from selling marijuana merchandise is an issue of fact that depends on, among other things, the degree of economic interrelationship between the two activities. And if selling non-marijuana merchandise were considered a separate business, then the expenses of that business would be deductible as held in CHAMP. See also Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173, 183 (2007).

• The tax court, however, did not find that the taxpayers had multiple businesses in Alterman, noting the following below.

  • Because Altermeds, LLC, derived almost all of its revenue from marijuana merchandise, and the types of non-marijuana products that it sold (e.g. pipes, other marijuana paraphernalia) complemented its efforts to sell marijuana, the tax court held that selling non-marijuana merchandise was not separate from the business of selling marijuana merchandise. Thus, Altermeds, LLC [taxpayer] had only one unitary business: selling marijuana. 

  • Moreover, the taxpayer’s failure to properly brief the amount of deductions that would be attributable to each proposed separate trade or business precluded the court from allowing any deductions for the separate non-trafficking business

  • The court specifically dealt with the taxpayer’s amount of claimed “non-marijuana” business related expenses:

    • The court dismissed the taxpayer's allocated “non-marijuana” business related expenses representing $54,707.03 in 2010 and $57,517.93 in 2011 (representing 40% of a list of COGS subtotals) in the brief filed by taxpayer as representing "vague descriptions" (e.g. “Non-COGS Utilities”) and failed to adequately explain the detailed amounts.

    • The court stated the brief failed to adequately explain why any portion of those subtotals is deductible. In particular the brief failed to:

      • identify any specific payments that make up these subtotals;

      • provide record citations to support these subtotals; and

      • propose findings of facts regarding these subtotals

    • See Rule 151(e)(3) (brief must include proposed findings of fact with references to the record); Rule 151(e)(5) (brief must include arguments regarding any disputed questions of fact).​

  • The court also disregarded the taxpayer's testimony that the dispensary also sold  (1) hats and T-shirts with the name and business logo of Altermeds, LLC, (2) magazines about marijuana, (3) and chicken soup as no documentary evidence corroborates the existence or extent of these sales.

    • On a preponderance of evidence, the court found no such items were sold, and these types of products as described by Alterman would generally complement the sales of marijuana by the dispensary. For example, the hats and T-shirts as described by Alterman bore the name and business logo of Altermeds, LLC. Thus, even if Altermeds, LLC, sold such hats and T-shirts, selling those items would have helped advertise medical marijuana.

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Canna Care, Inc. vs. the Commissioner, T.C. Memo. 2015-206 (2015), aff'd, 694 F.App'x 570 (9th Cir. 2017), U.S. Circuit Court of Appeals (9th Circuit)

Canna Care Inc. was a medical marijuana dispensary prohibited under California law from earning a profit on the sale of cannabis.  On audit, the IRS applied IRC § 280E to deny the deduction of all operating expenses, including substantial officer’s salaries and automobile expenses. Canna Care appealed the tax assessment to the U.S. Tax Court. The taxpayer in Canna Care was "in the business of distributing medical marijuana" was held to be engaged in a single trade or business and was not permitted to deduct expenses for the sale of its nonmarijuana items (books and socks) because those activities were “incident to its business of distributing medical marijuana.”

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Canna Care made the following three arguments before the U.S. Tax Court:

• (1) That medical marijuana is not a Schedule I controlled substance;

• (2) That Canna Care was not “trafficking” for purposes of IRC §280E because its activities were not illegal under the California Compassionate Use Act of 1996; and

• (3) That the tax court decision in CHAMP was incorrect.

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The Tax Court denied all three arguments and upheld the tax assessment against Canna Care.

• (1) First the tax court reiterated that medical marijuana is a Schedule I controlled substance.

• (2) Second, the tax court held that the sale of medical marijuana is always considered trafficking under IRC §280E, even when permitted by state law. Thus, operating expenses associated with the sale, manufacturing or production of cannabis are always disallowed under IRC § 280E.

• (3) Third, the tax court held that the CHAMP had been correctly decided. Canna Care’s argument that its sole business was providing charitable work like the taxpayer in CHAMP was without merit. The tax court held that because Canna Care’s only business was selling cannabis, none of its operating expenses could be deducted under IRC § 280E. However, the tax court did acknowledge that Canna Care arguably had a second trade or business selling clothing and could have argued these expenses should be deducted. However, that fact was not stipulated in the taxpayer's petition, thus the tax court could not consider that issue on the merits.

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Appeal to the Ninth Circuit Court of Appeals 

• Canna Care appealed to the Ninth Circuit Court of Appeals. None of the arguments (see above) before the tax court were made on appeal.  Instead, Canna Care raised three new arguments, two of which were unique to Canna Care’s facts and likely not applicable to most other cannabis businesses.

  • (1) Canna Care’s primary argument was that IRC § 280E violates the Excessive Fine Clause of the 8th Amendment of the United States Constitution. In oral argument before the Ninth Circuit Court of Appeals, Canna Care argued that IRC § 280E was enacted by Congress to punish drug dealers, and as such, it imposes a fine on cannabis dispensaries.

  • (2) Canna Care noted that its income tax liability was 1000% of its net income and a 1000% tax rate for engaging in an activity allowed under California law constituted a grossly disproportionate fine on such activity.

  • (3) The tax rate impact under IRC §280E is especially disproportionate when compared to the tax rate of other business (both legal and illegal). Accordingly, Canna Care’s income tax liability imposed under IRC §280E constitutes an excessive fine in violation of the 8th Amendment.

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In oral argument, the three-judge panel offered several observations:

• (1) A tax deduction is granted by the legislative grace of Congress. Congress has clear constitutional authority to deny a tax deduction.

• (2) IRC § 280E was enacted in 1982, well before enactment of the California Compassionate Use Act of 1996. This means that anyone getting into the cannabis industry was and is on notice of its the burdensome tax liabilities cannabis companies face. Thus, IRC § 280E is not outside Congress’ legislative authority.  

• (3) Given such notice, why does application of IRC § 280E constitute an excessive fine under the 8th Amendment?

• (4) Why isn’t Congress the appropriate branch of government to address IRC § 280E?

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The Ninth Circuit Court of Appeals dismissed Canna Care’s appeal and upheld the Tax Court’s holding. Because the arguments presented were not raised in the lower court, The Ninth Circuit Court of Appeals did not address the merits of each argument. 

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How does “trafficking” / IRC §280E apply to non-plant touching cannabis affiliated companies (e.g. transportation services, packaging testing facility)?

Whether or not a company is subject to the regulations and tax restrictions under IRC § 280E will often be subject to specific facts and circumstances surrounding a certain taxpayer's activities. However, the IRS and/or state taxing authority may still attempt to apply a more broad definition of “trafficking” than merely sales activity, to other related businesses operating ancillary within the cannabis industry. Nevertheless, thorough due diligence and transparency with federal and state authorities may be one safeguard to prevent future potential issues.

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For example, under Michigan marijuana licensing rules (see LARA Rule 25), a secure transporter does not take title ("legal custody") to any cannabis products  as it remains with the transferor or transferee. Or if a particular jurisdiction provides prohibitions on transfers or sales of cannabis, by a sole-purpose, unrelated separate trade or business providing testing services to a person other than the outside party contracted and requesting the testing being performed, there may be opportunities to avoid the negative tax implications of IRC § 280E for quality assurance cannabis testing companies.

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In general, cannabis companies that are not hemp businesses may still remain subject to IRC § 280E tax limitations as marijuana is still a Schedule I substance, including other "plant-touching" businesses dealing in marijuana depending on the facts and circumstances. In general, “plant-touching” cannabis-related businesses may face greater challenges and scrutiny when attempting to deduct non-Cost of Goods Sold business expenses for federal taxes or related tax credits. As such, expert tax law and accounting consultation should be pursued before taking any position regarding your business activities and overall tax strategy.