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Bloomberg: Hidden Tax Dangers in Cannabis Outsourcing Arrangements

Bloomberg report

As cannabis becomes mainstream, we are seeing more of what we call outsourcing arrangements—that is, contracts where one entity (LicenseCo) pays another entity (OutsourceCo) to help run its business. There are many good reasons to do this. Maybe someone owns land, which is licensed and zoned for cultivation, but has no clue how to cultivate it. Or they may prefer to have another company act as the employer, to shift liability under state and federal employment law. Some tasks are best done by a specialist who does nothing else.

In this article, we focus on arrangements in which OutsourceCo takes responsibility for the conduct of LicenseCo’s entire business. In some sectors, this is becoming the norm. For example, under “Farm Service Management Arrangements,” the landowner only nominally owns the product, to comply with state licensing laws. Otherwise, he or she outsources all operations and plays a passive role. Also, we focus only on activities, which would clearly qualify as both trafficking and as production had LicenseCo undertaken them alone. Under tax code Section 280E, “traffickers” may not claim current tax deductions for their expenses; nevertheless, under Section 471, they may reduce future income by these amounts, to the extent allocable to the “production” of inventory.

Our concern is that when OutsourceCo is brought into the equation, this could cause LicenseCo to lose its status as a producer, and/or could cause OutsourceCo to become a trafficker but not a producer. If so, the outsourcing arrangement will trigger hefty taxes for that party.

The Meaning of ‘Produce’

This idea—that an outsourcing arrangement might affect a party’s status as “trafficker” and “producer” in different ways—is possible because, in the cases involving outsourcing, the courts apply different tests.

In the context of outsourcing arrangements, the term “produce” is based on control over the manufacturing process. See Patients Mutual Assistance Collective Corp. (d.b.a. Harborside Health Center) v. Commissioner (Harborside) (adopting the definition in Suzy’s Zoo v. Commissioner. In Suzy’s Zoo, the U.S. Court of Appeals for the Ninth Circuit held that a greeting card company was a producer, and not a “small reseller” (a pre-TCJA concept) where it hired an outside company to print its cards. The court explained that “production” turns on “ownership” as defined for tax purposes, and that tax ownership depends not upon state-law title but instead upon “the degree of control … exercise[d] over the manufacturing process.”

Applying the same test, the Tax Court in Harborside reached the opposite result, and held that Harborside was not a producer, where it “had complete discretion over whether to purchase what bud growers brought in, paid growers only if it bought their bud, and at times rejected the ‘vast majority’ of its growers’ bud.” The court also noted that Harborside “thought growers could do whatever they wanted with the rejected bud. … Harborside merely sold or gave members clones that it had bought from nurseries and bought back bud if and when it wanted. In between these two steps it had no ownership interest in the marijuana plants.”

These cases raise two concerns. First, under what circumstances might LicenseCo cease to be a producer? Second, under what circumstances might OutsourceCo be a producer? As summarized in Harborside, the critical factors are (1) degree of control exercised over the manufacturing process, and (2) retention of the exclusive right to sell the finished product.

In a Farm Service Management Arrangement, we get mixed results: that is, LicenseCo retains minimal control over the manufacturing process, yet it retains the exclusive right to sell. Thus, it is unclear which….

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