S Corporation Providing Management Services to Marijuana Dispensary Found to Be Trafficking in Controlled Substances for §280E Purposes

A business does not have to have title to marijuana to be engaged in trafficking in controlled substances, triggering the denial of deductions under IRC §280E, the Tax Court ruled in Alternative Health Care Advocates et al. v. Commissioner, 151 TC No. 13.

IRC §280E bars deductions, other than those for the cost of sales, to businesses that traffic in items considered controlled substances by federal law.  The fact that certain states have legalized the sale of marijuana in some situations does not change that federal tax result.

In this case, there were two entities that were formed to handle the sale of marijuana under California law.  Alternative Health Care Advocates (Advanced) was formed as a dispensary which grew and provided medical marijuana for patients. Advanced was a C corporation.

The taxpayers also formed Wellness Management Group, Inc. (Wellness), which taxed as an S corporation.  The reason for the formation was described by the Court as follows:

In 2008 Mr. Duncan also organized a second entity, Wellness — a California corporation that elected S corporation status for Federal tax purposes — to handle daily operations for Alternative.6 At the time Alternative was organized, Mr. Duncan was uncertain what dispensaries could do legally under California State law aside from growing and providing medical marijuana to patients. So Wellness was organized to perform functions for the medical marijuana dispensary such as hiring employees and paying expenses, including advertising, wages, and rent. While Mr. Duncan anticipated that Wellness might offer its management and operations services to other medical marijuana dispensaries, Wellness performed services solely for Alternative during the tax years at issue.

...During the taxable years at issue Alternative intended to distribute medical marijuana to its patient-members in accordance with California law. The dispensary employed (through Wellness) administrators, security personnel, marijuana processors, salespersons, and receptionists.

The taxpayers argued that Wellness was not involved in such trafficking as it never held title to the controlled substance.  As the Court noted:

Specifically, petitioners argue that because Wellness is a management company that does not engage in the sale and purchase of marijuana, section 280E does not apply. Petitioners cite Davis v. Commissioner, 29 T.C. 878 (1958), and Roselle v. Commissioner, T.C. Memo. 1981-394, to support their argument that a management services company can engage in a separate line of business from the entity it manages.

The IRS claimed that, despite not having title to the controlled substance, Wellness was nevertheless still trafficking in a controlled substance.

The Tax Court agreed with the IRS that what Wellness was doing still constituted trafficking in a controlled substance, and thus §280E applied.  The Court came to its conclusion as follows:

Because Alternative and Wellness are legally separate entities, we must analyze whether Wellness' own business activities also constituted “trafficking in controlled substances” as contemplated by section 280E. 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.

Since the deductions for these payments had been disallowed on Alternative’s return when it had paid Wellness, the taxpayers argued it would be unfair to deny them again on Wellness’s return.  The Tax Court basically responded by saying “tough luck.”  Specifically, the Court said:

Petitioners also argue that applying section 280E to both Alternative and Wellness is inequitable because deductions for the same activities would be disallowed twice. These tax consequences are a direct result of the organizational structure petitioners employed, and petitioners have identified no legal basis for remedy.

So, effectively, the taxpayers had created taxable income by having Alternative pay Wellness for managing the clinic (creating taxable income for Wellness, but no deduction for Alternative).  Since Wellness recognized that income but received no deduction for paying expenses, the structure ended up with an even less favorable tax result than normally takes place for a marijuana dispensary.