Twelve years onward, the Californians Helping to Alleviate Medical Problems (CHAMP) tax court decision, is still an important cornerstone to federal tax law for the Cannabis industry.
From a federal income tax standpoint, it doesn’t matter whether income is derived from legal or illegal source. All income is taxable. However, tax deductions are a “grace of congress.” In 1982, IRC section 280E was enacted, which disallows deductions and credits, other than cost of goods sold (COGS), in trafficking of controlled substances. Section 280E increases the effective tax rate and creates unique tax questions for cannabis companies.
There have been several cases in recent years, exploring the boundaries of applying 280E. However, the fundamental points made in the CHAMP case should still be referred to in tax planning for Cannabis businesses. What if a business has multiple activities only some of which are related to trafficking of controlled substances? Does 280E apply to the whole business or only the trafficking activities?
CHAMP started its operations in 1996 as a care giving facility for people with illness like AIDS and cancer. Its care giving program had many components such as providing meals, counseling, hygiene supplies, and work-out lessons. One of them was providing medical marijuana to its members, in compliance with California’s medical use laws. The IRS audited CHAMP and disallowed all its deductions, asserting the application of Section 280E. In 2007, the tax court disagreed with the IRS, because CHAMP was “regularly and extensively involved in the provision of care giving services which are substantially different” from the provision of medical marijuana. The court reasonably allowed for an allocation of a certain percentage of employee cost and other expenses between care giving service and medical marijuana. The expenses allocated to care giving were considered deductible and not subject Section 280E.
The principles from CHAMP should continue to be considered in any tax planning for a cannabis business with multiple activities.
It’s important to note that in CHAMP the care giving activity was a legitimate purpose of the organization and conceptually would be carried on without the medical marijuana activity. Post the CHAMP decision, many cannabis businesses engaged separate activities in apparent attempts to create a basis for allocating and deducting expenses that would have been disallowed under Section 280E. The Olive Martin case provided one of the earliest illustrations of the limit to the use of the CHAMP decision. The taxpayer in the Olive case did not charge for the activities that were separate from trafficking in marijuana. Thus, it was inconceivable that these separate activities would be carried on, for their own purposes. Another way to think about it, is that the activities did not have a distinct profit motive, in and of themselves. This same principle would go on to be reaffirmed in additional court cases in later years.
Another key to the favorable CHAMP result was that there was enough data to establish an appropriate expense allocation method. CHAMP apportioned employee related expenses based on the number of employees who worked in each activity. The facts of circumstances of CHAMP’s operations made that reasonable because they were able to identify the entire role of specific employees was either directly related or not to medical marijuana activity. Although unstated, I think it would be unreasonable to simply use the number of employees if there were dramatic differences in pay, benefits and other employee costs between employees. In other words, it is unreasonable to extend exactly the same percentage used for employee expenses in the CHAMP case or to even used the exact same methods, to other taxpayers. The circumstances for businesses operating in the recreational market today are most certainly different than those of the CHAMP organization back in 2002. CHAMP apportioned many of its costs based on relative square feet of the medical marijuana operations compared to the rest of its facility used for other activities. It also allocated specific costs, like laundry and cleaning, to the non-marijuana activity. In a later court case, Alterman, the taxpayer, used a simple percentage of sales to its allocation of the expenses and the court did not accept it. The bottom line is that CHAMP puts forth the principle that using reasonable apportionment and allocation methods can allow for deduction, but companies have to do the work to determine what that should look like for their particular circumstance.
Finally, CHAMP had good documentation. The principle that you need documentation for deductions applies to every business and every aspect of tax law, but especially critical when it comes to 280E and any attempt to apportion and allocate costs between activities. Unlike CHAMP, both Olive and Alterman did not have reliable books and records to support their arguments. Neither the IRS nor the court will accept your position without solid books and records.