Complexities of Cannabis Outsourcing in a Murky Legal Landscape

LOS ANGELES– The rapid evolution of the cannabis industry, as it transitions from the shadows of illicit trade to the forefront of mainstream commerce, has brought about a host of challenges for businesses. In response, companies are increasingly turning to outsourcing arrangements as a strategy to overcome these hurdles. However, industry experts and legal professionals are warning that the legal and tax implications of such strategies are far from straightforward.

Outsourcing arrangements in the cannabis industry typically involve a contract between a licensed entity (LicenseCo) and an outsourcing entity (OutsourceCo). These agreements can arise from various circumstances, such as LicenseCo owning suitable land but lacking cultivation expertise, or the desire to shift employment liability to a third party.

Certain sectors within the industry have embraced outsourcing as a standard business model. For example, in a “Farm Service Management Arrangement,” the landowner effectively becomes a passive participant, outsourcing all operations while retaining nominal ownership of the product to comply with state licensing laws.

One of the primary concerns surrounding outsourcing in the cannabis industry revolves around the tax implications of Section 280E. This section of the tax code prohibits “traffickers” from claiming current tax deductions for their expenses, while allowing the reduction of future income under Section 471 for expenses tied to the “production” of inventory.

The involvement of an outsourcing entity complicates matters. Does LicenseCo lose its producer status, along with the associated tax benefits, due to the involvement of OutsourceCo? Furthermore, could OutsourceCo be classified as a trafficker, subjecting it to substantial taxes?

The interpretation of the terms “produce” and “traffic” is critical in determining the implications of outsourcing. These terms can determine whether an entity is viewed as a producer or a trafficker, significantly impacting tax obligations.

“Produce” in this context depends on control over the manufacturing process. Precedents, such as the Patients Mutual Assistance Collective Corp. v. Commissioner (Harborside) and Suzy’s Zoo v. Commissioner cases, indicate that “production” is contingent on the degree of control over the manufacturing process and not solely on ownership.

The definition of “traffic” was clarified in the Alternative Health Care Advocates v. Commissioner case. Here, the court rejected the argument that a management services company could not be a trafficker because it did not directly engage in the purchase and sale of cannabis. However, the ruling left room for interpretation regarding what constitutes “direct involvement.”

These ambiguities can leave LicenseCo and OutsourceCo in precarious positions. In the worst-case scenario, one or both parties may be classified as traffickers without being recognized as producers, leading to potentially crippling tax liabilities.

In light of these uncertainties, experts advise caution. For LicenseCo, retaining control over the manufacturing process is crucial to ensure its status as a producer and the ability to claim tax benefits. On the other hand, to protect OutsourceCo from being labeled a trafficker, it may be wise to divide the work among multiple contractors, minimizing the risk of being deemed LicenseCo’s alter ego.

While the tax implications of outsourcing in the cannabis industry remain murky, businesses cannot afford to take chances with their fiscal future. It is essential to approach these arrangements with care, as the stakes are high. Missteps can result in significant tax liabilities under Section 280E, a burden that no emerging cannabis business can afford to bear.