                                 151 T.C. No. 11



                        UNITED STATES TAX COURT



 PATIENTS MUTUAL ASSISTANCE COLLECTIVE CORPORATION d.b.a.
           HARBORSIDE HEALTH CENTER, Petitioner v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 29212-11, 30851-12,                Filed November 29, 2018.
                14776-14.1



        California medical-marijuana dispensary P deducted I.R.C. section
     162 business expenses and adjusted for indirect COGS per the I.R.C.
     section 263A UNICAP rules for producers. R determined that P’s
     sole trade or business was trafficking in a controlled substance and
     that I.R.C. section 280E prevented it from deducting business
     expenses. R also determined that P had to calculate COGS using the
     I.R.C. section 471 regulations for resellers and was liable for
     accuracy-related penalties. P argued that I.R.C. section 280E didn’t
     apply to it, that it was a producer, and that a dismissed civil-forfeiture
     action precluded a deficiency action.



     1
       We consolidated the cases at docket numbers 29212-11, 30851-12, and
14776-14 for trial, briefing, and opinion.
                                         -2-

          Held: The Government’s dismissal with prejudice of a civil-
       forfeiture action against P does not bar deficiency determinations.

          Held, further, I.R.C. section 280E prevents P from deducting
       ordinary and necessary business expenses.

          Held, further, during the years at issue P was engaged in only one
       trade or business, which was trafficking in a controlled substance.

          Held, further, P must adjust for COGS according to the I.R.C.
       section 471 regulations for resellers.



       Henry G. Wykowski and Matthew A. Williams, for petitioner.

       Nicholas J. Singer and Julie Ann Fields, for respondent.



       HOLMES, Judge: Patients Mutual owns what may well be the largest

marijuana dispensary in America. To the Commissioner that just makes it a giant

drug trafficker, unentitled to the usual deductions that legitimate businesses can

claim, unable even to capitalize its indirect costs into its inventory, and subject to

penalties for taking contrary positions on its tax returns for the tax years ending

July 31, 2007 through 2012. Patients Mutual wants to be treated like any other

business because it follows California law, it does more than distribute marijuana,

and the federal government already decided not to pursue a civil-forfeiture action

against it.
                                        -3-

                               FINDINGS OF FACT

I.    California Medical-Marijuana Law

      Under federal law marijuana is a Schedule I controlled substance. See

Controlled Substances Act, Pub. L. No. 91-513, sec. 202, 84 Stat. at 1249

(codified as amended at 21 U.S.C. sec. 812 (2012)). This means that under federal

law the manufacture, distribution, dispensation, or possession of marijuana--even

medical marijuana recommended by a physician--is prohibited. See id. sec.

841(a); Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner

(CHAMP), 128 T.C. 173, 181 (2007) (citing United States v. Oakland Cannabis

Buyers’ Coop., 532 U.S. 483 (2001)).

      Under California law, things are somewhat different. In 1996 California

voters adopted Proposition 215--the California Compassionate Use Act of 1996

(CCUA)--to “ensure that seriously ill Californians have the right to obtain and use

marijuana for medical purposes.” See Cal. Health & Safety Code sec.

11362.5(b)(1)(A) (West 2007). The CCUA provides an exemption from

California laws penalizing the possession and cultivation of marijuana for patients

and their primary caregivers when the possession or cultivation is for the patient’s

personal medical purposes and recommended or approved by a physician. Id. sec.

11362.5(d). California later legalized collective or cooperative cultivation of
                                        -4-

marijuana for medicinal purposes. Id. sec. 11362.775; see also People v. Colvin,

137 Cal. Rptr. 3d 856, 860 (Ct. App. 2012). These laws led to the formation of the

first marijuana dispensaries.2

II.      DeAngelo and Harborside

         Steve DeAngelo saw these early dispensaries--which he described as being

run by either well-meaning marijuana activists with no business experience or

“thug operators”--and realized patients needed a better option. So in 2005

DeAngelo cofounded Patients Mutual Assistance Collective Corporation d.b.a.

Harborside Health Center (Harborside) to be the “gold standard” in medical-

marijuana dispensaries. His goal was to create a place where marijuana could be

distributed responsibly, that was focused on patient care, and that provided

benefits to both patients and the community. Harborside opened its doors in

October 2006 and has grown into a booming business with more than 100,000

patient visits per year. It also generated a gusher of revenue during the years at

issue:




         2
       On November 8, 2016, California voters adopted Proposition 64, which
made recreational marijuana use legal under California law. See Cal. Health &
Safety Code sec. 11362.1 (West 2017).
                                        -5-

           Nonmarijuana       Marijuana sales                          Marijuana
  Year     sales revenue         revenue            Total revenue      percentage
 2007            $487            $5,448,635           $5,449,122          99.99
 2008           3,990            10,916,914           10,920,904          99.96
 2009          16,878            17,334,597           17,351,475          99.90
 2010          42,492            22,047,372           22,089,864          99.81
 2011          58,588            20,895,823           20,954,411          99.72
 2012         320,651            25,199,997           25,520,648          98.74
  Total       443,086           101,843,338         102,286,424           99.57

At all relevant times Harborside operated out of an approximately 7,500-square-

foot space that had a reception area, healing room, purchasing office, processing

room, clone room, and multipurpose room. The facility also had a large sales

floor, offices, storage areas, restrooms, and a break room with a kitchen.

      But operating a dispensary is no small task. DeAngelo had to make sure

Harborside complied with California and local laws. This included getting proper

permits, running as a nonprofit, and operating under a “closed-loop” system.

Harborside interpreted the “closed-loop” requirement to mean that all of its

marijuana must be provided by its patients; sold exclusively to its patients;

handled only by its employees, all of whom were its patients; and not diverted into

the illegal market. How Harborside achieved all of this is important, so we will

start with how Harborside sourced and processed its inventory.
                                        -6-

      A.     Sourcing and Processing

      Harborside sold a wide variety of products, which we will divide into four

main groups--clones, marijuana flowers, marijuana-containing products, and non-

marijuana-containing products.

             1.    Clones

      Clones are cuttings from a female cannabis plant that can be transplanted

and used to cultivate marijuana. Harborside bought clones from clone nurseries,

cared for them while they were in its store, repackaged them, and then sold them

to its patients. It stored the clones in a clone room and sold them at a clone

counter--the portion of the floor space dedicated to clone sales. During the years

at issue Harborside had at least four employees who spent their time entirely in the

purchase and sale of clones.

             2.    Marijuana Flowers

      The Court learned at trial that it’s not the leaves of the marijuana plant, but

its flowers--or buds--that people can smoke.3 Harborside purchased all of its

marijuana flowers from its patient-growers. Some of these growers promised to

sell what they cultivated back to Harborside, and Harborside gave them either

      3
       The Court suspects, but makes no finding, that this may be why
repurposed beer-marketing material--“This Bud’s for you”--seems to be common
where marijuana is sold.
                                         -7-

seeds or clones to get started. Other growers, however, bought seeds and clones

from Harborside. However they acquired their starter supplies, growers who were

interested in selling to Harborside had to sign a cultivation agreement and were

encouraged to take one of Harborside’s free grow classes and follow its best-

practices guides.

      Once a grower had cultivated, harvested, trimmed, flushed, dried, and cured

his marijuana buds, he would bring them to Harborside to sell. Harborside had a

purchasing office to inspect and test the incoming marijuana. Harborside would

reject marijuana if it wasn’t properly cured, if it hadn’t been sufficiently trimmed,

if it had an incurable safety issue such as pathogenic mold, or if it didn’t contain

the right “cannabinoid profile.” If, for example, Harborside was in need of a strain

of marijuana that was rich in CBD,4 it might reject a batch of marijuana that was

rich in THC.5 There were times Harborside rejected the “vast majority” of the bud

that growers brought in, and a grower whose marijuana was rejected got no

compensation (though he was free to sell it to another collective if he could).




      4
      CBD is the abbreviation for cannabidiol, a potent antiinflammatory
compound.
      5
        THC stands for tetrahydrocannabinol, the compound in marijuana believed
to be responsible for providing a euphoric effect, or “high”, as users call it.
                                        -8-

      On the other hand, if Harborside agreed to buy the marijuana, it would

negotiate a price with the grower--typically enough to cover the grower’s actual

growing expenses and a reasonable amount for his time and labor. It stored the

marijuana in a vault--a reinforced concrete room with a bank-vault door and

biometric locks--and sent a sample of the marijuana out for testing by a third-party

laboratory. If all went well, the marijuana would go to a processing room where it

was reinspected, remanicured, retrimmed, and then weighed, packaged, and

labeled. Harborside staff would put it on display on the sales floor or put it back

in the vault until needed. Harborside had at least three employees dedicated to

acquiring inventory, at least four devoted to managing inventory, and still others

whose sole job was to process the bulk marijuana and ready it for resale.

             3.    Marijuana-Containing Products

      Harborside’s marijuana-containing products included edibles, beverages,

extracts, concentrates, oils, topicals, and tinctures--marijuana-infused alcohol,

vinegar, or glycerin. Harborside bought these items from other collectives, tested

them, repackaged them if they came in bulk or needed child-proof packaging,

relabeled them, and then sold them to its own patients. Harborside’s human-

resources director credibly estimated that about 55% to 60% of its employees’
                                        -9-

total time was spent on buying and processing marijuana--both the buds and

marijuana-containing products--and another 25% to 30% selling it.

             4.    Non-Marijuana-Containing Products

      Harborside also sold non-marijuana-containing products. These included

branded gear such as shirts, hats, and pins; nonbranded gear such as socks and

hemp bags; and a variety of other products including books, dabbing equipment,6

rolling papers, and lighters. Harborside bought these items from outside vendors,

stored them, and resold them to patients. Depending on the volume on hand,

Harborside stored the non-marijuana-containing products on the sales floor and in

one or more of its various storage rooms. A little less than 25% of the sales floor

was used to display and sell these items and around 5% to 10% of Harborside’s

employees’ time was dedicated to buying and selling these entirely legal products.

      B.     Sales and Pricing

      Harborside took great care to avoid its marijuana’s leaking into the black

market. For example, no one could enter the sales floor without going through a

“very rigorous identification process.” This process required new patients to


      6
        “Dabbing” means heating products that contain marijuana so as to create
an intoxicating vapor. It may or may not have a connection to the strange fad
among the young that seems to consist of pointing to the sky with one arm while
putting one’s face in the crook of the other arm while seeming to sneeze or sniff.
                                        - 10 -

present valid photo IDs, have written recommendations from physicians licensed

to practice in California, sign a collective cultivation agreement giving other

Harborside patients the right to cultivate marijuana on their behalf, and agree to

abide by Harborside’s rules and regulations. Harborside also sold its marijuana at

a premium above the black-market rate to discourage its patients from reselling it.

The exact method used to determine the sale price is unclear from the record, but

DeAngelo testified that Harborside looked “at [its] general overall picture and

determined the margin that we needed to place on every bit of cannabis that came

in.”

       C.    Community Outreach

       With premium prices, however, come significant profits. Harborside is a C

corporation for federal tax purposes,7 but to comply with California’s nonprofit

requirement,8 its bylaws prohibited it from paying dividends or selling equity, and



       7
        The IRS has determined that a marijuana dispensary generally cannot
qualify as a tax-exempt organization under section 501(c)(3) because it is engaged
in what federal law regards as a criminal enterprise and thus is not operated
exclusively for charitable purposes. Rev. Rul. 75-384, 1975-2 C.B. 204; see also
Priv. Ltr. Rul. 201224036 (June 15, 2012). (Unless we say otherwise, all section
references are to the Internal Revenue Code in effect for the years at issue.)
       8
        California laws decriminalizing medical marijuana specifically stated that
they did not “authorize any individual or group to cultivate or distribute cannabis
for profit.” Cal. Health & Safety Code sec. 11362.765(a) (West 2007).
                                        - 11 -

required it to use any excess revenue for the benefit of its patients or the

community. To this end, Harborside provided its patients with a wide variety of

services at no additional cost. It told patients during their orientation--and again

with signs on the premises--that part of the purchase price of the marijuana would

be used to pay for patient services and community outreach. But patients were not

required to buy marijuana to use the services.

      The services included one-on-one therapeutic sessions for reiki,

hypnotherapy, naturopathy, acupuncture, and chiropractic consultations as well as

group sessions for yoga, qigong, the Alexander technique, and tai chi. Harborside

also offered grow classes, support groups, addiction treatment counseling, and a

“sliding scale program” that gave discounts to patients with financial difficulties.

All of the services were coordinated by Harborside’s holistic-services director and

took place in either Harborside’s healing room or its multipurpose room.

Harborside footed the bill and paid the service providers--all of whom were

independent contractors. The total amounts paid were:
                                          - 12 -

                             Year                      Amount
                             2007                      $30,290
                             2008                       93,341
                             2009                      119,884
                             2010                      144,441
                             2011                      141,926
                             2012                      150,466

      D.       Administrative Functions

      Harborside had other employees in support roles. The security department,

for example, spent most of its time checking in both patients and vendors and then

escorting vendors into the back of the building to meet with a purchasing manager.

Harborside’s human-resources director estimated that the security group spent

60% of its time checking in patients who came to buy marijuana, another 5%

checking in people on site to receive a service, and the rest in assisting vendors.

Harborside also had an administrative group, which included employees in its

ombuds,9 finance, human resources, and facilities departments as well as its

executives.




      9
          This is not a typo. It’s Harborside’s pun.
                                        - 13 -

III.   Forfeiture Action

       All seemed well until July 2012, when the federal government filed a civil-

forfeiture action in the U.S. District Court for the Northern District of California.

The lawsuit alleged that the property which Harborside rents and on which it

operates its business was subject to forfeiture because it was used to commit the

distribution, cultivation, and possession of marijuana in violation of 21 U.S.C.

sections 841(a)10 and 856.11 The action was dismissed with prejudice in May 2016

by stipulation of the parties.

IV.    Tax Returns and Audit

       The forfeiture action wasn’t Harborside’s only run-in with the federal

government--it also caught the attention of the IRS. Recall that Harborside is a C

corporation for federal tax purposes with tax years ending July 31. It filed Forms

1120, U.S. Corporation Income Tax Return, for 2007 to 2012 and later amended

its 2007, 2008, and 2009 returns. These returns were selected for audits that led to



       10
         Title 21 U.S.C. section 841(a)(1) (2012) states that “it shall be unlawful
for any person knowingly or intentionally * * * to manufacture, distribute, or
dispense, or possess with intent to manufacture, distribute, or dispense, a
controlled substance.”
       11
         21 U.S.C. section 856(a)(1) states that it shall be unlawful to “knowingly
open, lease, rent, use, or maintain any place, whether permanently or temporarily,
for the purpose of manufacturing, distributing, or using any controlled substance.”
                                        - 14 -

the issuance of three notices of deficiency--one for 2007 and 2008, one for 2009

and 2010, and one for 2011 and 2012. The notices denied most of Harborside’s

claimed deductions and costs of goods sold, and asserted tens of millions in

deficiencies and accuracy-related penalties.

      The IRS’s primary reason for its adjustments was that “[n]o deduction or

credit shall be allowed for any amount paid or incurred during the taxable year in

carrying on a trade or business that consists of trafficking in controlled

substances.”

      Harborside filed timely petitions for all years at issue. Its principal place of

business was in California at all relevant times, so absent a stipulation by the

parties these cases are appealable to the Ninth Circuit. See sec. 7482(b)(1)(B).

                                      OPINION

I.    Background

      The CCUA did not decriminalize marijuana in California. See, e.g., People

v. Harris, 52 Cal. Rptr. 3d 577, 582 (Ct. App. 2006) (marijuana remained a

controlled substance under California law). It instead created an affirmative

defense to charges of possessing or cultivating marijuana for persons who did so

for personal, physician-approved use. Cal. Health & Safety Code sec. 11362.5(d);
                                       - 15 -

People v. Wright, 146 P.3d 531, 533 (Cal. 2006). Primary caregivers of such

persons could also raise the defense. Cal. Health & Safety Code sec. 11362.5(d).

      In 2003 California enacted the Medical Marijuana Program Act (MMPA),

also known as Senate Bill 420 and now codified at California Health and Safety

Code sections 11362.7-11362.83. The MMPA extended the CCUA’s affirmative

defense to charges of transporting marijuana for patients and primary caregivers

who “associate within the State of California in order collectively or cooperatively

to cultivate marijuana for medical purposes.”12 Cal. Health & Safety Code sec.

11362.775; People v. Urziceanu, 33 Cal. Rptr. 3d 859, 883-84 (Ct. App. 2005). It

also instructed California’s attorney general to develop guidelines to “ensure the

security and nondiversion of marijuana grown for medical use.” Cal. Health &

Safety Code sec. 11362.81(d). Those guidelines stated that medical-marijuana

cooperatives should be formally organized, not operate for profit, maintain

business licenses and permits, pay tax, verify each member’s status as a patient,

execute an agreement with each member regarding the use and distribution of

      12
         The MMPA also set per-person quantity limits for harvested marijuana
and marijuana plants, although the California Supreme Court invalidated these as
impermissible amendments to the CCUA. People v. Kelley, 222 P.3d 186, 197-
200, 213-14 (Cal. 2010). Patients and caregivers were thereafter allowed to
possess, cultivate, or transport whatever amount of marijuana was “reasonably
related to the patient’s current medical needs.” Id. at 188 (quoting People v.
Trippet, 66 Cal. Rptr. 2d 559, 570 (Ct. App. 1997)).
                                        - 16 -

marijuana, keep records of distribution, and neither buy marijuana from nor

distribute marijuana to nonmembers. Qualified Patients Assoc. v. City of

Anaheim, 115 Cal. Rptr. 3d 89, 97-98 (Ct. App. 2010); People v. Hochanadel, 98

Cal. Rptr. 3d 347, 356-58 (Ct. App. 2009); Cal. Att’y Gen., Guidelines for the

Security and Non-Diversion of Marijuana Grown for Medical Use 8-10 (2008).

      Federal law did not follow. The conflict between federal and state law went

to the Supreme Court in 2005 when two California medical-marijuana users tried

to enjoin the U.S. Attorney General and the Drug Enforcement Agency from

enforcing federal marijuana law against them. See Gonzales v. Raich, 545 U.S. 1,

7 (2005). The Court upheld the federal prohibition on marijuana sale and

possession with respect to medical-marijuana users, both under the Commerce

Clause, U.S. Const. art. I, sec. 8, cl. 3, and the Supremacy Clause, U.S. Const. art.

VI, cl. 2. Raich, 545 U.S. at 22, 29.

      One might think the Supremacy Clause would have stifled the spread of

state attempts at legalizing what remained illegal under federal law. But one

would be wrong. And Congress complicated the situation by enacting a series of

appropriations riders that prevent the Department of Justice (DOJ) from using any

funds “to prevent * * * [States that permit medical-marijuana use] from

implementing their own laws that authorize the use, distribution, possession, or
                                      - 17 -

cultivation of medical marijuana.” Consolidated Appropriations Act, 2017, Pub.

L. No. 115-31, sec. 537, 131 Stat. at 228; see also Consolidated Appropriations

Act, 2016, Pub. L. No. 114-113, sec. 542, 129 Stat. at 2332-33 (2015);

Consolidated and Further Continuing Appropriations Act, 2015, Pub. L. No. 113-

235, sec. 538, 128 Stat. at 2217 (2014). When interpreting such a rider, the Ninth

Circuit said that DOJ prosecutions of individuals who complied with state

medical-marijuana laws interfered with the implementation of such laws and were

therefore impermissible. United States v. McIntosh, 833 F.3d 1163, 1177-78 (9th
                                        - 18 -

Cir. 2016).13 So, medical marijuana is illegal under federal law, but the statutes

criminalizing it may not be enforced--at least not by the DOJ.

      But the IRS is part of the Department of the Treasury, and marijuana sellers

must still contend with the Code. Here their major problem is section 280E, which

prevents any trade or business that “consists of trafficking in controlled

substances” from deducting any business expenses. Congress enacted this section

in 1982 as a response to our decision in Edmondson v. Commissioner, T.C. Memo.

1981-623, where we allowed a cocaine dealer to deduct the ordinary and necessary

expenses of his illicit trade. See S. Rept. No. 97-494, at 309 (1982), 1982

      13
          Note as well that these appropriations riders limit DOJ prosecutions of
activity that would be legal under medical-marijuana laws. Thirty-three states
now allow medical marijuana use: Alaska, Arizona, Arkansas, California,
Colorado, Connecticut, Delaware, Florida, Hawaii, Illinois, Louisiana, Maine,
Maryland, Massachusetts, Michigan, Minnesota, Missouri, Montana, Nevada,
New Hampshire, New Jersey, New Mexico, New York, North Dakota, Ohio,
Oklahoma, Oregon, Pennsylvania, Rhode Island, Utah, Vermont, Washington, and
West Virginia. Nat’l Conference of State Legislatures, State Medical Marijuana
Laws, Tbl. 1 (last updated Nov. 8, 2018), http://www.ncsl.org/research/health/
state-medical-marijuana-laws.aspx. So do the District of Columbia, Guam, and
Puerto Rico. Id. Thirteen states permit medical use of some low-potency
marijuana products: Alabama, Georgia, Iowa, Indiana, Kentucky, Mississippi,
North Carolina, South Carolina, Tennessee, Texas, Virginia, Wisconsin, and
Wyoming. Id. Tbl. 2.
       Alaska, California, Colorado, Maine, Massachusetts, Michigan, Nevada,
Oregon, Vermont, Washington, the District of Columbia, and the Northern
Mariana Islands have repealed bans on recreational marijuana use. Id. Tbl. 1. No
caselaw on how these appropriations riders will affect federal enforcement of
federal law in these states has yet emerged.
                                        - 19 -

U.S.C.C.A.N. 781, 1050. In 1986 new uniform capitalization (UNICAP) rules

under section 263A raised the possibility that traffickers of controlled substances

could capitalize indirect inventory costs that section 280E prevented them from

deducting as expenses. See Tax Reform Act of 1986 (TRA), Pub. L. No. 99-514,

sec. 803, 100 Stat. at 2350. But in 1988 Congress amended section 263A(a)(2) to

say that taxpayers couldn’t capitalize costs that were otherwise nondeductible.

See Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Pub. L. No.

100-647, sec. 1008(b)(1), 102 Stat. at 3437. It’s within this confusing legal

environment that Harborside operated.

      Given this state of the law it’s perhaps not surprising that Harborside isn’t

the first marijuana dispensary to appear in our Court. In our first major medical-

marijuana case, we found that the taxpayer operated two separate trades or

businesses--one that provided caregiving services and one that sold marijuana.

CHAMP, 128 T.C. at 183-84. We therefore required the taxpayer to allocate its

expenses between its two businesses according to the number of its employees and

the portion of its facilities devoted to each. Id. at 185. We allowed it to deduct the

expenses that it properly allocated to its caregiving business, but not those

allocated to its marijuana-sales business. Id. at 173-74.
                                       - 20 -

      In our next medical-marijuana case, Olive v. Commissioner, 139 T.C. 19, 42

(2012), aff’d, 792 F.3d 1146 (9th Cir. 2015), we held that a dispensary that

derived all its revenue from marijuana sales but also provided free activities and

services to its patrons was but a single trade or business. Because that single trade

or business was selling marijuana, we also held that section 280E precluded the

deduction of any of the taxpayer’s operating expenses, but did not prevent the

taxpayer from adjusting for costs of goods sold, id. at 32-36, 38 n.19. And in

Canna Care, Inc. v. Commissioner, T.C. Memo. 2015-206, at *12, aff’d, 694 F.

App’x 570 (9th Cir. 2017), we found that the taxpayer--which stipulated that it

was “in the business of distributing medical marijuana”--was engaged in one trade

or business because its sale of nonmarijuana items such as books and socks “was

an activity incident to its business of distributing medical marijuana.” We

therefore held that section 280E banned deductions for any of its business

expenses. Id. at *13.

      While Harborside raises some of the same issues we addressed in these

cases, it also presents some new ones. Here we are asked to decide

      •      whether res judicata precludes the Commissioner from arguing
             Harborside was engaged in trafficking in a controlled substance;

      •      whether Harborside’s business “consists of” trafficking in a
             controlled substance under section 280E;
                                        - 21 -

      •      whether Harborside has more than one trade or business;

      •      what Harborside may include in its cost of goods sold; and

      •      whether Harborside is liable for accuracy-related penalties.

We will take each in turn.

II.   Res Judicata

      Harborside first argues that res judicata is a complete defense to its tax

woes. Its position is that these cases and the 2012 civil-forfeiture action are all

based on the same claim--that Harborside was trafficking in a controlled

substance. It argues that the U.S. attorney’s decision to dismiss the forfeiture

action with prejudice means that as a matter of law Harborside was not a drug

trafficker and cannot be subject to section 280E.

      Res judicata--or claim preclusion--is an affirmative defense that bars suits

on the same cause of action, and it does apply to tax litigation. See Russell v.

Commissioner, 678 F.2d 782, 785-86 (9th Cir. 1982); Koprowski v.

Commissioner, 138 T.C. 54, 59-60 (2012). The rule is easy to state:

      [W]hen a court of competent jurisdiction has entered a final judgment
      on the merits of a cause of action, the parties to the suit and their
      privies are thereafter bound “not only as to every matter which was
      offered and received to sustain or defeat the claim or demand, but as
      to any other admissible matter which might have been offered for that
      purpose.”
                                        - 22 -

Commissioner v. Sunnen, 333 U.S. 591, 597 (1948) (quoting Cromwell v. County

of Sac, 94 U.S. 351, 352 (1876)). To successfully assert a res judicata claim,

Harborside would have to clear these hurdles:

      •      an identity of claims between the actions;

      •      privity between the parties in the actions; and

      •      a final judgment on the merits in the civil-forfeiture action.

See Tahoe-Sierra Pres. Council, Inc. v. Tahoe Reg’l Planning Agency, 322 F.3d

1064, 1077 (9th Cir. 2003).

      We think Harborside smashes right into the first. For there to be an identity

of claims, two cases must “arise out of the same transactional nucleus of facts.”

Cent. Delta Water Agency v. United States, 306 F.3d 938, 952 (9th Cir. 2002)

(quoting Fund for Animals v. Lujan, 962 F.2d 1391, 1398 (9th Cir. 1992)).14 This

almost always means that res judicata applies only when the second claim could

have been asserted in the previous action. See Tahoe-Sierra Pres. Council, 322

F.3d at 1078; Sawyer Tr. of May 1992 v. Commissioner, 133 T.C. 60, 77-78


      14
         Other questions that affect a decision about whether two claims share a
single identity are whether: (1) “rights or interests established in the prior
judgment would be destroyed or impaired by prosecution of the second action;”
(2) “substantially the same evidence is presented in the two actions;” and (3) “the
two suits involve infringement of the same right.” Cent. Delta Water Agency, 306
F.3d at 952 n.11 (quoting Fund for Animals, 962 F.2d at 1398).
                                        - 23 -

(2009). Harborside’s cases here are about its tax deficiencies, and the parties

agree that the government could not have brought such actions as part of the civil-

forfeiture case in district court.

       Harborside insists, however, this doesn’t matter and points to United States

v. Liquidators of European Fed. Credit Bank, 630 F.3d 1139 (9th Cir. 2011). In

Liquidators, the Ninth Circuit explained that in most cases the answer to the

question of whether two cases share the “same transactional nucleus of facts” will

be synonymous with the question of whether the contested claim in the second

case could have been brought in the first. Id. at 1151. But it found an exception

when it looked closely at forfeiture actions, and it held that res judicata barred a

later criminal-forfeiture claim against the same property that had been the object

of an earlier civil-forfeiture case. Id. at 1151-52. It reasoned that the two types of

forfeiture actions always seek exactly the same result, arise from exactly the same

facts, and offer the government two paths to reach the same goal. Id. at 1152

(which might have led one to think that the doctrine to apply was “election of

remedy” rather than res judicata). But whether one looks at this puzzle as one of

election of remedy or res judicata doesn’t matter here. The forfeiture action in

district court sought just that--the forfeiture of the property leased by Harborside--

whereas these cases seek to impose a civil tax liability. And while the two actions
                                        - 24 -

share some of the same facts, they are not--unlike civil and criminal forfeiture--

different paths to the same goal. We will therefore decline to extend Liquidators

beyond the “peculiarities of the forfeiture context.” See United States v. Wanland,

830 F.3d 947, 957 (9th Cir. 2016). Instead we hold that these deficiency cases

could not have been raised in the same case, and did not arise from the same

transactional nucleus of fact. Identity of claims does not exist here and res

judicata does not bar the Commissioner’s deficiency actions. See Sawyer Tr., 133

T.C. at 78.

III.   Section 280E

       The Code allows a business to deduct all of its “ordinary and necessary

expenses paid or incurred during the taxable year in carrying on any trade or

business.” Sec. 162(a). But it also has exceptions, one of which is section 280E.

See Olive, 792 F.3d at 1148 (noting that sections 261 through 280H list “Items

Not Deductible”). Section 280E states:

       No deduction or credit shall be allowed for any amount paid or
       incurred during the taxable year in carrying on any trade or business
       if such trade or business (or the activities which comprise such trade
       or business) consists of trafficking in controlled substances (within
       the meaning of schedule I and II of the Controlled Substances Act)
       which is prohibited by Federal law or the law of any State in which
       such trade or business is conducted. [Emphasis added.]
                                         - 25 -

Medical marijuana is a Schedule I controlled substance, and dispensing it pursuant

to the CCUA is “trafficking” within the meaning of section 280E. See CHAMP,

128 T.C. at 182-83; Beck v. Commissioner, T.C. Memo. 2015-149, at *15. But

Harborside asks us to focus on the two words that we’ve italicized above: What

does it mean for a business to consist of trafficking?

      Harborside argues that “consists of” means an exhaustive list--or in other

words that section 280E applies only to businesses that exclusively or solely traffic

in controlled substances and not to those that also engage in other activities. The

Commissioner argues that a single trade or business can have several activities and

that section 280E applies to an entire trade or business if any one of its activities is

trafficking in a controlled substance. Both parties say their interpretations match

other Code sections’ use of “consists of” and best fit section 280E’s purpose.

      We’ve seen Harborside’s argument before. In Olive, 139 T.C. at 39, the

taxpayer made a nearly identical argument, which we cursorily rejected.15 And, on

appeal, the Ninth Circuit focused on the taxpayer’s misuse of CHAMP. See Olive,

792 F.3d at 1149-50. We could stop there with a nod to stare decisis, but the

parties argue the question at great length and, given the importance of these cases


      15
        We note that this part of Harborside’s brief repeats verbatim part of the
taxpayer’s brief in Olive.
                                        - 26 -

to the industry, we will similarly explain our reasoning at greater length than we

did when we first considered it.

      A.     Statutory Interpretation

      Harborside begins with an appeal to the “ordinary, everyday usage” of the

phrase. And we do agree that Harborside is right about the meaning of “consists

of” in everyday use: For example, one says “The AFC East consists of the Bills,

Patriots, Jets, and Dolphins,” and anyone fluent in English would understand that

to mean that those are both all, and the only, teams in that division. Harborside

also has some excellent secondary sources behind it on this point. See, e.g.,

Antonin Scalia & Bryan A. Garner, Reading Law: The Interpretation of Legal

Texts 132 (2012) (contrasting “includes”, which sets off a nonexhaustive list, with

“consists of” or “comprises”, each of which generally introduces an exhaustive

list); Black’s Law Dictionary 279 (5th ed. 1979) (explaining that “consisting” “is

not synonymous with ‘including’” because “including”, when used in connection

with a number of specified objects, always connotes incompleteness). This might

seem as though it should be the end of our analysis--after all, “[t]he ordinary-

meaning rule is the most fundamental semantic rule of interpretation.” Scalia &

Garner, supra, at 69.
                                         - 27 -

      Another fundamental canon of construction, however, tells us to prefer

textually permissible readings that don’t render a statute ineffective.16 Id. at 63

(citing Citizens Bank of Bryan v. First State Bank, 580 S.W.2d 344, 348 (Tex.

1979) (“[I]f the language is susceptible of two constructions, one of which will

carry out and the other defeat * * * [the statute’s] object, it should receive the

former construction.”)). Following the most common usage of “consists of,” as

Harborside suggests, would indeed make section 280E ineffective. If that section

denies deductions only to businesses that exclusively traffic in controlled

substances, then any street-level drug dealer could circumvent it by selling a single

item that wasn’t a controlled substance--like a pack of gum, or even drug

paraphernalia such as a hypodermic needle or a glass pipe. This reading would

edge us close to absurdity, which is another result our reading of a statute should

avoid if possible. See id. at 234-35.

      One might imagine--as a strictly theoretical matter--that a legislature might

enact an absurdity, and our job as judges would be to enforce it. But the

Commissioner reminds us that we shouldn’t do so if there is an effective-and-not-

absurd meaning that is also permissible. We must both avoid “a sterile literalism

      16
        When canons of construction compete with one another, we must decide
which is most appropriate under the circumstances. See Antonin Scalia & Bryan
A. Garner, Reading Law: The Interpretation of Legal Texts 59 (2012).
                                         - 28 -

which loses sight of the forest for the trees” and maintain “a proper scruple against

imputing meanings for which the words give no warrant.” N.Y. Tr. Co. v.

Commissioner, 68 F.2d 19, 20 (2d Cir. 1933) (L. Hand, J.), aff’d sub nom.

Helvering v. N.Y. Tr. Co., 292 U.S. 455 (1934); see also Scalia & Garner, supra,

at 356.

      But can “consists of” ever introduce a nonexhaustive list?

             1.     Dictionaries

      Harborside says “no”, and urges us to take a hint from the fourth edition of

the American Heritage Dictionary. Harborside quotes a usage note in the entry for

“include”. See American Heritage Dictionary 887 (4th ed. 2006). The note

explains that “include” connotes, but does not necessarily mean, that a list

immediately following it is incomplete. Id. It also suggests that authors

introducing exhaustive lists use “comprise” or “consist of” instead. Id. It doesn’t

say, however, that “consists of” necessarily introduces an exhaustive list. See id.

And the dictionary’s definition of “consist” is “[t]o be made up of or composed,”

“[t]o have a basis; reside or lie,” or “[t]o be compatible.” Id. at 392.

      Harborside’s other dictionary citation is similarly ambiguous. An old

edition of Black’s Law Dictionary defines “consisting” as “[b]eing composed or
                                       - 29 -

made up of.” Black’s Law Dictionary 279 (5th ed. 1979).17 It also explains that

“consisting” is not synonymous with “including” because “including” always

connotes incompleteness, and “consisting” doesn’t. Id. The entry doesn’t say that

“consisting” and “including” are antonyms; that is, although “consisting” doesn’t

connote an incomplete list, it also doesn’t connote an exhaustive list. Id. And

even if “consisting” were the antonym of “including”, that would mean only that it

connotes completeness--not that it necessarily means completeness. Harborside

doesn’t mention it, but the same dictionary also defines “consist” as “[t]o stand

together, to be composed of or made up of.” Id.

      Harborside even points us to an odd opinion that cites a precursor of the

Oxford English Dictionary18 that says “‘[c]onsisting of’ can have the meaning of

‘to have its essential character in’ or ‘foundation in.’” Madison Teachers, Inc. v.

Madison Metro. Sch. Dist., 541 N.W.2d 786, 801 (Wis. Ct. App. 1995) (Sundby,

J., concurring in part and dissenting in part) (citing IIC A New English Dictionary



      17
         The seventh, eighth, and ninth editions of Black’s Law Dictionary don’t
define “consisting” at all. See Black’s Law Dictionary 303 (7th ed. 1999); Black’s
Law Dictionary 327 (8th ed. 2004); Black’s Law Dictionary 350 (9th ed. 2009).
The tenth edition defines “consisting of,” but only for the specialized purposes of
patent law. Black’s Law Dictionary 373 (10th ed. 2014).
      18
          See OED, History of the OED, http://public.oed.com/history-of-the-oed/
(last visited Nov. 2, 2018).
                                        - 30 -

on Historical Principles 861-62 (1893)).19 The takeaway here is that none of the

dictionary definitions that Harborside provides preclude reading “consists of” as

setting off a nonexhaustive list.

             2.     The Code

      But this is a tax case, and before we go too far afield in dictionaries or

literature, we should draw back to other sections of the law we have to apply to

these cases. See, e.g., United States v. Olympic Radio & Television, Inc., 349

U.S. 232, 236 (1955) (interpreting phrase consistently within Code chapter and

saying courts should give Code “as great an internal symmetry and consistency as

its words permit”). But see Util. Air Regulatory Grp. v. EPA, 573 U.S.        ,    ,

134 S. Ct. 2427, 2441 (2014) (“the presumption of consistent usage ‘readily

yields’ to context” (quoting Environmental Defense v. Duke Energy Corp., 549

U.S. 561, 574 (2007))). What does the Code itself tell us about how to read

“consists of”?




      19
        See, e.g.,William Shakespeare, The Merchant of Venice act 3, sc. 3 (“The
duke cannot deny the course of law: / For the commodity that strangers have /
With us in Venice, if it be denied, / Will much impeach the justice of his state; /
Since that the trade and profit of the city / Consisteth of all nations” -- Venice
being open to foreign trade, or depending on foreign trade, but not literally trading
with every nation in the world.)
                                        - 31 -

      There are some similar phrases. Section 401(a)(22) says that if more than

10% of the assets in an employee’s defined-contribution plan account are stock in

his closely held employer, section 409(e)’s voting-rights rules don’t apply so long

as “the trade or business of such employer consists of publishing on a regular basis

a newspaper for general circulation.” Section 451(i)(3)(B) provides an optional

rule for determining in what year income is realized for “any stock or partnership

interest in a corporation or partnership * * * whose principal trade or business

consists of providing electric transmission services.” And section 513(h)(1)(B)

excludes from the definition of unrelated trade or business “any trade or business

which consists of” exchanging or renting donor and member lists among

nonprofits. We haven’t found any cases construing what “consists of” means in

any of these sections.

      Harborside points out that in many Code sections Congress used the phrase

“consists of” but then modified it--as it did in the electricity-related section above

--to clarify that it doesn’t mean “is composed entirely of.” See, e.g., sec. 581 (“a

substantial part of the business of which consists of”); sec. 181(e)(2)(E) (added by

the Consolidated Appropriations Act, 2016, sec. 169(c), 129 Stat. at 3067

(“includes or consists of”)). Harborside suggests that Congress could have

similarly modified “consists of” in section 280E if it had intended to set off a
                                        - 32 -

nonexhaustive list there. The Commissioner, on the other hand, points to several

Code sections where Congress used the phrase “consists of” but then modified it

to clarify that it meant “is composed entirely of.” See, e.g., sec. 444(d)(3)(B)

(“consists only of”); sec. 416(g)(4)(H) (“consists solely of”). He suggests that

Congress would have done the same for section 280E if it had meant to indicate an

exhaustive list there.

      Unmodified uses of “consists of” do sometimes seem to introduce

exhaustive lists. See, e.g., sec. 108(e)(4)(B) (“family of an individual consists of

the individual’s spouse, the individual’s children, grandchildren, and parents, and

any spouse of the individual’s children or grandchildren”). But in other places

“consists of” would lead to an absurd result if it indicated an exhaustive list. The

Commissioner points us to a glaring example: A “computer” eligible for

accelerated depreciation “consists of a central processing unit containing extensive

storage, logic, arithmetic, and control capabilities.” Sec. 168(i)(2)(B)(ii)(II)

(emphasis added). Here, Harborside’s reading of “consists of” would mean that

anything other than a central processing unit isn’t a computer. Surely something

wouldn’t fail to be a computer because it had a monitor, a keyboard, a mouse, or a

power cord. See Dunford v. Commissioner, T.C. Memo. 2013-189, at *30-*31

(referring to a laptop as a “computer” when determining depreciation eligibility).
                                       - 33 -

      These examples show, we think, that the Code uses “consists of” in more

than one way. It sometimes sets off an exhaustive list, but it also sometimes

introduces a nonexclusive list.

             3.    Caselaw

      That leaves us with caselaw. Each party has precedent here, too.

Harborside’s chief example is one from Wisconsin which held that a statute

preventing “a collective bargaining unit consisting of school district professional

employees” from arbitrating certain issues didn’t preclude arbitration by a unit that

mainly had such employees but also had some other types of employees. Madison

Teachers, Inc., 541 N.W.2d at 790-91, 793-94. That court said that a “decent

respect for language makes it impossible to read ‘consisting of’ in the inclusive

sense.” Id. at 794. But it also explained that none of the 482 occurrences of the

phrase “consisting of” in Wisconsin’s statutes introduced nonexhaustive lists, and

it pointed out that the Wisconsin legislature was careful to modify that phrase

whenever it meant to use it inclusively. Id. Apparently Wisconsin’s code enjoys a

consistency missing from the Internal Revenue Code, which as we’ve seen uses

“consists of” multiple ways. It’s therefore hard for us--despite what we hope is

our decent respect for language--to do as Harborside asks and interpret the phrase

as mechanically as the Wisconsin Court of Appeals has.
                                        - 34 -

      The Commissioner, for his part, points us to a case that dealt with a section

of the Code itself--a statute excluding for tax purposes from a tax-exempt

organization’s unrelated trade or business “any trade or business which consists of

conducting bingo games.” Julius M. Israel Lodge of B’nai B’rith No. 2113 v.

Commissioner, T.C. Memo. 1995-439, 1995 WL 544877, at *3, aff’d, 98 F.3d 190

(5th Cir. 1996); see also sec. 513(f). But that case holds that “instant bingo” isn’t

“bingo” for section 513(f); it doesn’t explicitly address what it means to “consist[]

of conducting bingo games.” See Julius M. Israel Lodge, 1995 WL 544877, at *7

(although it implicitly suggests the same entity can have two businesses in that

situation, much as we did in CHAMP). It’s therefore of limited use here. Caselaw

doesn’t settle the meaning of “consists of” any better than the Code itself does.

      Dictionaries, the Code, and caselaw all show that “consists of” can

introduce either an exhaustive list or a nonexhaustive list.20 A nonexhaustive list

      20
       The Code is in good company. Shakespeare appears to use “consists of”
both ways in a single exchange:

      Sir Toby Belch: * * * Does not our life consist of the four elements?

      Sir Andrew Aguecheek: Faith, so they say; but I think it rather consists of
      eating and drinking.

      Sir Toby Belch: Thou’rt a scholar; let us therefore eat and drink.

                                                                        (continued...)
                                        - 35 -

is the only option that doesn’t render section 280E ineffective and absurd. We

therefore read section 280E to 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.

      B.     Purpose

      We also note that Harborside has a subtler argument about the play between

literal meaning and statutory purpose. It reminds us that dispensaries that are legal

under state law didn’t exist in 1982 and Congress even today won’t let the DOJ

prosecute them as if they were street-corner drug dealers. See Consolidated

Appropriations Act, 2017 sec. 537; Consolidated Appropriations Act, 2016 sec.

542; Consolidated and Further Continuing Appropriations Act, 2015 sec. 538; see

also McIntosh, 833 F.3d at 1177. These arguments aren’t new, either--the Ninth

Circuit disposed of them in Olive, 792 F.3d at 1150-51, so we mostly reiterate its

reasoning here to acknowledge that Harborside has preserved it.

      Although section 280E predates states’ legalization of medical marijuana,

“[t]hat Congress might not have imagined what some states would do in future

years has no bearing on our analysis. It is common for statutes to apply to new

      20
       (...continued)
William Shakespeare, Twelfth Night act 2, sc. 3. The four elements are an
exhaustive list, but eating and drinking aren’t all of life, even for Sir Andrew.
                                         - 36 -

situations. And here, application of the statute is clear.” Id. at 1150. The

restriction on how the DOJ uses funds is irrelevant here because “the government

is enforcing only a tax, which does not prevent people from using, distributing,

possessing, or cultivating marijuana in California. Enforcing these laws might

make it more costly to run a dispensary, but it does not change whether these

activities are authorized in the state.” Id. at 1150.

      Finally, we note that several members of Congress asked the IRS to issue

guidance saying that medical-marijuana dispensaries aren’t subject to section

280E, and the IRS said it couldn’t do that unless Congress amended the Code or

the Controlled Substances Act. See IRS Information Letter 2011-0005. Members

of Congress have subsequently introduced several bills that would exempt state-

legal marijuana businesses from section 280E. Small Business Tax Equity Act of

2011, H.R. 1985, 112th Cong. (2011); Small Business Tax Equity Act of 2013,

H.R. 2240, 113th Cong. (2013); Small Business Tax Equity Act of 2015, H.R.

1855, 114th Cong. (2015); Small Business Tax Equity Act of 2015, S. 987, 114th

Cong. (2015); Small Business Tax Equity Act of 2017, H.R. 1810, 115th Cong.

(2017); Small Business Tax Equity Act of 2017, S. 777, 115th Cong. (2017);

Responsibly Addressing the Marijuana Policy Gap Act of 2017, H.R. 1824, 115th
                                        - 37 -

Cong. (2017); Responsibly Addressing the Marijuana Policy Gap Act of 2017, S.

780, 115th Cong. (2017). None has been enacted.

      We hold that section 280E prevents Harborside from deducting its business

expenses.

IV.   More Than One Trade or Business?

      Harborside says that even if section 280E applies to its marijuana sales, it

can still deduct its expenses for any separate, nontrafficking trades or businesses.

That’s correct. See CHAMP, 128 T.C. at 184-85; see also Olive, 792 F.3d at

1149. We therefore need to determine which--if any--of Harborside’s activities

are separate trades or businesses.

      An activity is a trade or business if the taxpayer does it continuously and

regularly with the intent of making a profit. See, e.g., Commissioner v.

Groetzinger, 480 U.S. 23, 35 (1987); United States v. Am. Bar Endowment, 477

U.S. 105, 110 n.1 (1986). A single taxpayer can have more than one trade or

business, CHAMP, 128 T.C. at 183, or multiple activities that nevertheless are

only a single trade or business, see, e.g., Davis v. Commissioner, 29 T.C. 878, 891

(1958). Even separate entities’ activities can be a single trade or business if

they’re part of a “unified business enterprise” with a single profit motive. Morton

v. United States, 98 Fed. Cl. 596, 600 (2011).
                                       - 38 -

       Whether two activities are two trades or businesses or only one is a question

of fact. See, e.g., CHAMP, 128 T.C. at 183; Owens v. Commissioner, T.C. Memo.

2017-157, at *21. To answer it, we primarily consider the “degree of

organizational and economic interrelationship of various undertakings, the

business purpose which is (or might be) served by carrying on the various

undertakings separately or together * * *, and the similarity of the various

undertakings.” Olive, 139 T.C. at 41; sec. 1.183-1(d), Income Tax Regs.

       We’ve considered this issue with other California medical-marijuana

dispensaries. In CHAMP, 128 T.C. at 175, 183, we found that the taxpayer had

two distinct trades or businesses--caregiving services and medical-marijuana

sales--even though its customers paid a single fee that entitled them to unlimited

access to the services and a fixed amount of marijuana. We noted there that seven

of the taxpayer’s employees distributed marijuana, eighteen employees provided

caregiving services, and no employees did both. Id. at 185. Moreover, dispensing

marijuana occurred in only 10% of one of the taxpayer’s three facilities. Id. at

176. We found the taxpayer’s primary purpose was to provide caregiving

services, and that those services were both “substantially different” from and

“stood on * * * [their] own, separate and apart” from dispensing marijuana. Id. at

183.
                                       - 39 -

      In Olive, however, we held (and the Ninth Circuit agreed) 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. Olive,

139 T.C. at 38-42; Olive, 792 F.3d at 1148-50. The taxpayer in Olive charged

only for marijuana, and set a price based on the amount and type of marijuana its

patients bought; the cost of the other services was bundled into that price. Olive,

139 T.C. at 42; 792 F.3d at 1149. 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. Olive, 139 T.C. at 41.

The taxpayer also had a single bookkeeper and accountant. Id. at 42. These facts

led us to find that the services were “incident to” the sale of marijuana, and we

noted that the two activities had a “close and inseparable organizational and

economic relationship.” Id. at 41. We held that they were “one and the same

business.” Id.

      The most recent case where we had to figure out the number of a marijuana

dispensary’s trades or businesses is Canna Care, Inc. Like Harborside, the

taxpayer there sold medical marijuana and other items, including books, T-shirts,

and hats. Canna Care, Inc., at *4, *12. Unlike the taxpayer in Olive, the taxpayer
                                         - 40 -

in Canna Care, Inc. had at least a little bit of income from nonmarijuana sales. Id.

at *12. But we still found only a single trade or business--selling marijuana--and

“the sale of any other item was an activity incident to” those sales. Id. But our

analysis there was constrained: The parties had stipulated that the taxpayer “was

in the business of distributing medical marijuana” and the record didn’t enable us

to determine what percentage of the taxpayer’s income came from marijuana sales

and what percentage came from other sources. See id.; see also Alterman v.

Commissioner, T.C. Memo. 2018-83, at *27-*28 (refusing to allow business-

expense deductions where the taxpayers failed to identify specific payments,

provide record citations, or propose findings of fact sufficient for us to distinguish

expenses associated with the sale of marijuana from those associated with the sale

of nonmarijuana merchandise).

      Harborside presented its case in greater detail. It argues that it had four

activities, each of which was a separate trade or business:

      •      sales of marijuana and products containing marijuana;

      •      sales of products with no marijuana;

      •      therapeutic services; and

      •      brand development.

We consider each.
                                        - 41 -

      A.     Selling Marijuana and Products Containing Marijuana

      There’s no question that selling marijuana and products containing

marijuana was Harborside’s primary purpose. Sixty percent of the members

Harborside’s security checked in were there to buy marijuana in one form or

another. Marijuana and marijuana products took up around 75% of Harborside’s

sales floor. Harborside’s employees spent 80-90% of their time purchasing,

processing, and selling these products. And those sales generated at least 98.7%

of Harborside’s revenue during each of the years at issue. This was certainly a

trade or business--specifically, the trade or business of trafficking in a controlled

substance. See Olive, 139 T.C. at 38; CHAMP, 128 T.C. at 182-83.

      B.     Selling Products That Didn’t Contain Marijuana

      Harborside’s sale of items that didn’t contain marijuana--such as branded

clothing, hemp bags, books about marijuana, and marijuana paraphernalia such as

rolling papers, pipes, and lighters--generated the remaining 0.5% of its revenue.

The same Harborside employees who bought, processed, and sold marijuana also

sold these items, but selling them took up only 5-10% of their time. The

nonmarijuana items occupied only 25% of the sales floor where Harborside sold

marijuana, and that sales floor was accessible only to patrons who had already

presented their credentials to security--which means that no one who couldn’t buy
                                        - 42 -

marijuana could buy these nonmarijuana items. And the record shows no separate

entity, management, books, or capital for the nonmarijuana sales. This leads us to

find that the sale of non-marijuana-containing products had a “close and

inseparable organizational and economic relationship” with, and was “incident to,”

Harborside’s primary business of selling marijuana. See Olive, 139 T.C. at 41; see

also Tobin v. Commissioner, T.C. Memo. 1999-328, 1999 WL 773964, at *5-*6

(farm and garden one activity because same employees, equipment, management,

and books). There’s also an obvious business purpose for selling items that

facilitate and encourage marijuana use alongside actual marijuana. We also find

that the sale of items that are about marijuana, are branded with Harborside’s logo,

or enable use of marijuana is not “substantially different” from the sale of

marijuana itself. See CHAMP, 128 T.C. at 183.

      Harborside nevertheless argues that its sale of anything other than marijuana

is a separate trade or business. It cites an analogy the Ninth Circuit used in Olive,

792 F.3d at 1150, to explain why a store that charged for marijuana and gave away

incidental services had only a single trade or business. In that analogy, a

hypothetical bookstore that sold books and gave away coffee to attract customers

(“Bookstore A”) had only one trade or business, whereas a hypothetical bookstore
                                       - 43 -

that sold books and also sold coffee (“Bookstore B”) had two trades or businesses.

Id.

      We think Harborside misses the analogy’s point: It shows that a service a

taxpayer doesn’t charge for, but which attracts customers, isn’t a separate trade or

business. It doesn’t mean that selling two things is necessarily two separate trades

or businesses. Bookstore B is there to provide contrast to Bookstore A, which is

what the court compared to the taxpayer in Olive. Id.

      Finally, the analogy--though a good fit for Olive, which was selling

marijuana and giving away snacks and soft drinks--doesn’t suit Harborside. A

better analogy would be to a bookstore that derives 0.5% of its revenue from

selling stationery, bookmarks, and T-shirts with pictures of books on them

(“Bookstore C”). To be completely analogous to Harborside, Bookstore C would

sell these items using the same employees, sales floor, management, ledgers, and

business entity it used to sell books. That hypothetical bookstore would, we think,

be a single trade or business under the Ninth Circuit’s reasoning. And

Harborside’s sale of non-marijuana-containing items is, we find, not a separate

trade or business.
                                          - 44 -

       C.       Therapeutic Services

       Recognizing that an activity needs a profit motive to be a separate trade or

business, Harborside argues that a portion of each marijuana sale was actually a

purchase of its free holistic services.21 This is what it told its patrons, too.

       Harborside says this makes it like CHAMP. But in CHAMP, 128 T.C. at

175-76, members paid a set fee for unlimited access to extensive services and also

received a fixed amount of marijuana--the services’ price wasn’t “bundled” into

the amount paid for marijuana, to use Harborside’s terminology. And we found

that the services in CHAMP were the taxpayer’s primary purpose, took up most of

its employees’ time, and used almost all of its three facilities. Id. at 174-76, 183,

185.

       Harborside is more like the dispensary in Olive, 792 F.3d at 1148, where

patrons paid according to the amount and type of marijuana they wanted and in

return gained access to incidental services. Harborside tries to distinguish itself by

pointing out that it offered many more services than the much smaller taxpayer in

Olive did.22 But the services were still incidental; Harborside’s security spent only


       21
         Harborside argues that “the price for these services was rolled into the
price of the cannabis.”
       22
            In Olive, 792 F.3d at 1148, the taxpayer’s combined reported income and
                                                                        (continued...)
                                        - 45 -

5% of its time checking in people for the services, while spending 60% of its time

checking in people who were there to buy marijuana. And independent

contractors, rather than Harborside’s own employees, provided those services.

During the years at issue Harborside paid those contractors a total of only about

$680,000--less than 1% of its sales revenue from marijuana.

      The relationship between Harborside’s marijuana business and holistic

services closely fits Olive’s “Bookstore A” analogy. See id. at 1150. Just as a

bookstore that gives away coffee is still only a bookstore, a marijuana dispensary

that gives away services is still only a marijuana dispensary. See id. The fact that

Harborside used a tiny bit of its marijuana-sales revenue to pay for those services

doesn’t change anything--after all, Bookstore A necessarily pays for its coffee

with book sales. And we also find that there were business reasons to offer these

services alongside marijuana sales: It justified premium pricing and helped

Harborside meet the community-benefit standards California law required. We

therefore find that Harborside’s holistic services were not a separate trade or

business.


      22
       (...continued)
claimed expenses for each year we considered were under $500,000. In contrast,
Harborside had $5 million-$25 million in total revenue during each of the years at
issue.
                                         - 46 -

      D.     Branding

      Harborside’s final argument on this subject is that its brand-development

activity was a separate trade or business. Because this did not generate any

revenue until after the years at issue, the Commissioner compares it to

preoperational expenditures that have to be capitalized instead of deducted.

Harborside insists it is a trade or business eligible for section 162 deductions

because from day 1 it performed them with an independent profit motive. To

show a profit motive without any revenue, Harborside says its branding activities

were part of a “unified business enterprise” with its activities that did make money

during the years at issue.

      A separate entity purposely operating at a loss is still a trade or business

eligible for deductions if it and entities related to it together form a unified

business enterprise that itself has a profit motive. See Campbell v. Commissioner,

868 F.2d 833, 836-37 (6th Cir. 1989) (partnership leasing airplane to sister

corporation at loss had profit motive because common owners benefited), aff’g in

part, rev’g in part T.C. Memo. 1986-569; Kuhn v. Commissioner, T.C. Memo.

1992-460, 1992 WL 193604, at *5 (partnership’s below-market lease of land to

sister corporation had profit motive because corporation benefited); Morton, 98

Fed. Cl. at 602 (S corporation that owned airplane was part of unified business
                                         - 47 -

enterprise with shareholder’s other businesses and therefore had a profit motive).

In other words, the unified-business-enterprise doctrine Harborside relies on says

that separate but related entities can share a single profit motive; it doesn’t say that

a single entity’s unprofitable activities are a separate trade or business. Rather

than show that Harborside’s branding was separate from its marijuana sales, the

unified-business-enterprise doctrine instead suggests that it was part of a single

overall trade or business.

      There’s also no actual evidence to suggest that Harborside’s brand

development was in any way a separate trade or business. As far as we can tell,

Harborside did its branding using the same entity, management, capital structure,

employees, and facilities as its marijuana sales. See Tobin, 1999 WL 773964, at

*5-*6. And rather than being “substantially different” from the underlying sale of

marijuana, Harborside’s brand development was necessarily entwined with it. See

CHAMP, 128 T.C. at 183. Harborside’s branding, therefore, had a “close and

inseparable organizational and economic relationship” with, and was “one and the

same business” as, its marijuana sales. See Olive, 139 T.C. at 41. It was not a

separate trade or business.

      Harborside dedicated the lion’s share of its resources to selling marijuana

and marijuana products. Those sales accounted for over 99.5% of its revenue. Its
                                       - 48 -

other activities were neither economically separate nor substantially different. We

therefore hold that Harborside had a single trade or business--the sale of

marijuana. That’s trafficking in a controlled substance under federal law, so

Harborside cannot deduct any of its related expenses. See sec. 280E; see also

Olive, 139 T.C. at 38; CHAMP, 128 T.C. at 182-83.

V.    Cost of Goods Sold

      The fact that Harborside can’t deduct any of its business expenses doesn’t

mean it owes tax on its gross receipts. All taxpayers--even drug traffickers--pay

tax only on gross income, which is gross receipts minus the cost of goods sold

(COGS). See, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934);

CHAMP, 128 T.C. at 178 n.4; secs. 1.61-3(a), 1.162-1(a), Income Tax Regs.

Congress understood that when it enacted section 280E. See S. Rept. No. 97-494,

supra at 309, 1982 U.S.C.C.A.N. at 1050. We’ve understood it ourselves. See

Olive, 139 T.C. at 32-36.

      But what is the distinction between a business-expense deduction and an

adjustment for COGS? Deductions are subtractions from gross income that

taxpayers make when they calculate their taxable income. Sec. 63(a). Deductions

are statutory, and Congress can grant or deny them as it chooses--the standard

refrain is that they’re a matter of Congress’s “legislative grace.” INDOPCO, Inc.
                                        - 49 -

v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co., 292 U.S. at 440;

Olive, 139 T.C. at 32. We’ve already seen an example of Congress’s withholding

that grace from those whose works it rejects--it grants most taxpayers a deduction

for ordinary and necessary business expenses in section 162, but then uses section

280E to deny those deductions to drug traffickers. See Canna Care, Inc., at *7.

      COGS is the costs of acquiring inventory, through either purchase or

production. See, e.g., Reading v. Commissioner, 70 T.C. 730, 733 (1978) (COGS

is “expenditures necessary to acquire, construct or extract a physical product

which is to be sold”), aff’d, 614 F.2d 159 (8th Cir. 1980); secs. 1.61-3(a), 1.162-

1(a), Income Tax Regs. As we’ve said, all taxpayers, regardless of the business

they’re in, use COGS to offset their gross receipts when they calculate gross

income. See, e.g., Olive, 139 T.C. at 20 n.2.

      The big difference between deductions and COGS adjustments is timing.

See INDOPCO, 503 U.S. at 83-84; Wasco Real Props. I, LLC v. Commissioner,

T.C. Memo. 2016-224, at *19. Taxpayers can usually claim at least part of a

deductible expense for the year they incur it. See, e.g., INDOPCO, 503 U.S. at 83-

84; Wasco Real Properties I, LLC, at *19. But when accounting for COGS they

have to capitalize an item’s cost in the year of acquisition or production and either

amortize it or wait until the year the item’s sold to make the corresponding
                                        - 50 -

adjustment to gross income.23 See, e.g., INDOPCO, 503 U.S. at 83-84; Wasco

Real Props. I, LLC, at *19.

      A.     How Should Harborside Account for its COGS?

      The Code tells taxpayers what to include in COGS. See, e.g., secs. 263,

263A, 471. But there’s more than one set of rules, and the issue here is which set

applies to Harborside. The Commissioner thinks Harborside needs to follow the

rules under section 471, but Harborside insists it’s subject to the rules of section

263A. We consider each.

             1.     Section 471

      Section 471 was in place when Congress enacted section 280E. It

empowers the Commissioner to write regulations that govern how taxpayers

account for inventories. See sec. 471. This the Commissioner did--with separate

regulations for resellers and producers. See secs. 1.471-3(b) and (c), 1.471-11,

Income Tax Regs.

      23
         A simple example illustrates the difference. If in year 1 a taxpayer incurs
a deductible expense of $100, he can reduce his taxable income for year 1 by
$100. If in year 1 he instead buys 100 units of inventory for $100 and manages to
sell 10 of those units per year, he has to take a $10 COGS adjustment in year 1, a
$10 adjustment in year 2, and so on, through year 10, when he runs out of
inventory. In each case, the taxpayer reduces the amount of income he’s taxed on
by a total of $100. The difference is that he recovers the entire deductible expense
in year 1, but recovers his inventory cost as he sells the inventory, which in this
example means he doesn’t get the full $100 back until year 10.
                                        - 51 -

      The regulations tell resellers to use as their COGS the price they pay for

inventory plus any “transportation or other necessary charges incurred in acquiring

possession of the goods.” Sec. 1.471-3(b), Income Tax Regs. The regulations for

producers are more complex. Producers must include in COGS both the direct and

indirect costs of creating their inventory. See secs. 1.471-3(c), 1.471-11, Income

Tax Regs. The regulations tell producers to capitalize the “cost of raw materials,”

“expenditures for direct labor,” and “indirect production costs incident to and

necessary for the production of the particular article, including * * * an

appropriate portion of management expenses.” Sec. 1.471-3(c), Income Tax Regs.

Direct and indirect production costs are further explained in section 1.471-11(b),

Income Tax Regs.

      In their current forms, section 471 and its regulations also direct taxpayers

to section 263A for additional rules.

             2.    Section 263A

      Congress enacted section 263A in 1986. TRA sec. 803. That section

instructs both producers and resellers to include “indirect” inventory costs in their

COGS. Sec. 263A(a)(2)(B), (b); sec. 1.263A-1(a)(3), (c)(1), (e), Income Tax

Regs. It also broadens the definition of indirect costs for both types of taxpayers.

Compare sec. 1.263A-1(e)(3), Income Tax Regs., with sec. 1.471-11, Income Tax
                                         - 52 -

Regs. Congress thought this would treat taxpayers more fairly. S. Rept. No. 99-

313, at 140 (1986), 1986-3 C.B. (Vol. 3) 1, 140. It also thought this would do a

better job of matching COGS adjustments to the years in which taxpayers realized

the related income. Id.; see also Office of the Sec’y, Dep’t of the Treasury, 1 Tax

Reform for Fairness, Simplicity, and Economic Growth: Treasury Department

Report to the President 126-28 (1984).

      These sections are also about timing. A business that could immediately

deduct indirect costs under section 471 now has to treat those costs as capital

expenditures and wait until it realizes related income to adjust for them. In a sense

Congress is taking away some current deductions but allowing them in later years,

renamed COGS. It is legislative grace deferred, but not denied.

      Most business don’t like this. They’d rather have a deduction now than

increased COGS later. See, e.g., Frontier Custom Builders, Inc. v. Commissioner,

T.C. Memo. 2013-231, at *14 (homebuilder argued it was a seller, not a producer,

in attempt to avoid capitalization), aff’d, 626 F. App’x 89 (5th Cir. 2015). But

drug traffickers have a different attitude. Although section 280E prevents them

from deducting expenses, they are still entitled to COGS adjustments. Olive, 139

T.C. at 32-36. By renaming COGS what had been deductions, Congress made it

possible for traffickers to adjust for expenses that they couldn’t previously claim.
                                         - 53 -

They have to make those adjustments in the later year when the inventory is sold,

but later is better than never.

      Except that maybe it’s still never. In 1988 Congress amended section

263A(a)(2), adding flush language that says: “Any cost which (but for this

subsection) could not be taken into account in computing taxable income for any

taxable year shall not be treated as a cost described in this paragraph.” TAMRA

sec. 1008(b)(1). The regulations show that “cost” here means expenses that would

otherwise be deductible. See sec. 1.263A-1(c)(2), Income Tax Regs. In their

explanation of how section 263A(a)(2)’s flush language works, the regulations

point out that if a business meal is entirely attributable to the acquisition or

production of inventory, the taxpayer capitalizes only 80% of it because section

274(n), at that time, limited business meal deductions to 80% of their “cost”

(which the section itself calls an “expense”, see sec. 274(n)); the taxpayer doesn’t

get to capitalize the whole meal and escape the 80% limitation on the deduction,

sec. 1.263A-1(c)(2)(i), Income Tax Regs. So if something wasn’t deductible

before Congress enacted section 263A, taxpayers cannot use that section to

capitalize it. Section 263A makes taxpayers defer the benefit of what used to be

deductions--it doesn’t shower that as grace on those previously damned.
                                       - 54 -

            3.     Harborside’s Argument

      Can Congress get away with this? Harborside argues that limiting its COGS

to “only the actual cost used to purchase inventory” violates the Sixteenth

Amendment. Its theory is that section 263A represents the most accurate tax-

accounting method for calculating COGS and that not letting marijuana

dispensaries use it forces them to pay tax on more than their gross income. In

other words, Harborside thinks section 263A somehow defines COGS for

constitutional purposes.

      That’s wrong. The Sixteenth Amendment’s meaning didn’t change when

Congress enacted section 263A. See U.S. Const. art. V (providing only method

for changing constitution). Section 471 wasn’t found unconstitutional during the

many decades when it was the only means of calculating COGS, and it wouldn’t

be unconstitutional now if Congress repealed section 263A. The Constitution

does limit Congress to taxing only gross income, and courts have consistently

held--including in cases Harborside cites--that gross income is gross receipts

minus direct costs. See Reading, 70 T.C. at 733 (COGS are direct investment in

item sold); Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707, 715 (1956) (gross

income on sales is income for Sixteenth Amendment); Anderson Oldsmobile, Inc.

v. Hofferbert, 102 F. Supp. 902, 905 (D. Md. 1952) (IRS can tax only amount
                                          - 55 -

realized on sale minus basis), aff’d, 197 F.2d 504 (4th Cir. 1952). Harborside, like

all taxpayers, can still adjust for its direct costs--or, to use its terminology, “the

actual cost used to purchase inventory.” It therefore pays tax only on the amount

it realizes on sales, which is what the Constitution requires.

      Harborside compares itself to the taxpayer in Anderson Oldsmobile, but that

case doesn’t help it. There the taxpayer paid more for its inventory than since-

repealed federal price controls allowed, and the Commissioner tried to limit the

taxpayer’s COGS to the highest legal price. Id. at 903. The court held that

because Congress can tax only gross income, the taxpayer was entitled to a COGS

adjustment for the actual amount it paid for its inventory even though that amount

was illegally high. Id. at 903, 905, 909.

      As Harborside correctly points out, Anderson Oldsmobile says that statutes

can’t let the Commissioner tax more than gross income. Id. at 905. But that’s not

what’s happening here. Unlike Anderson Oldsmobile, where the Commissioner

wanted to use a statute to deny the taxpayer a COGS adjustment for part of its

direct cost of purchasing inventory, these cases find the Commissioner saying only

that Harborside can’t use section 263A to capitalize indirect costs that it wouldn’t

otherwise be able to deduct. Harborside still gets to do exactly what the taxpayer
                                        - 56 -

in Anderson Oldsmobile did: calculate its gross income by subtracting the direct

cost of its inventory from its gross receipts. See id. at 905.

      What Anderson Oldsmobile really holds is that taxpayers can adjust for

COGS whether or not their direct costs are legal. See id. at 903; see also

Pittsburgh Milk Co., 26 T.C. at 717 (taxpayer who sold milk below legal price

used actual price when calculating income). This tells us what we already know:

Harborside would get COGS adjustments for its direct inventory costs no matter

what--even if it was trafficking cocaine or any other controlled substance not legal

under California law. The only things Harborside doesn’t get are indirect

inventory costs granted as deductions and then deferred under section 263A.

      The section 263A capitalization rules don’t apply to drug traffickers.

Unlike most businesses, drug traffickers can’t capitalize indirect expenses beyond

what’s listed in the section 471 regulations. Section 263A expressly prohibits

capitalizing expenses that wouldn’t otherwise be deductible, and drug traffickers

don’t get deductions. Because federal law labels Harborside a drug trafficker, it

must calculate its COGS according to section 471.

      B.     Is Harborside a Producer or a Reseller?

      Because the section 471 regulations have different rules for resellers and

producers, how Harborside calculates its COGS depends on which type of
                                        - 57 -

taxpayer it is. Harborside was without question a reseller of the marijuana edibles

and non-marijuana-containing products it bought from third parties and sold at its

facility. But the situation is more complex for the marijuana bud it sold.

Harborside insists it produced this marijuana and can include in its COGS the

indirect inventory costs that section 1.471-3(c), Income Tax Regs., describes. The

Commissioner says Harborside is a reseller and, under section 1.471-3(b), Income

Tax Regs., it can include only its inventory price and transportation costs.

             1.    What Does “Produce” Mean?

      To sort this out we first need to know what “produce” means. The

Commissioner, citing a Court of Claims case, says that under section 471

“production” means “manufacturing”. See Heaven Hill Distilleries, Inc. v. United

States, 476 F.2d 1327, 1335 (Ct. Cl. 1973). He then cites a line of cases saying

that “manufacturing” requires a change to the essential character of the

merchandise. Marcor, Inc. v. Commissioner, 89 T.C. 181, 193 (1987); see also

Anheuser-Busch Brewing Ass’n v. United States, 207 U.S. 556, 562 (1908); In re

I. Rheinstrom & Sons Co., 207 F. 119 (E.D. Ky. 1913), aff’d sub nom. Cent. Tr.

Co. v. George Lueders & Co., 221 F. 829 (6th Cir. 1915); People ex rel. New

England Dressed Meat & Wool Co. v. Roberts, 155 N.Y. 408, 412 (1898); People

v. Knickerbocker Ice Co., 1 N.E. 669 (N.Y. 1885). His argument, then, is that
                                       - 58 -

“production” means “change”. Look at the dates of most of these cases, though--

they predate the Sixteenth Amendment.

      Harborside at least points us to something more recent, the Ninth Circuit

case, Suzy’s Zoo v. Commissioner, 273 F.3d 875 (9th Cir. 2001), aff’g 114 T.C. 1

(2000). That case, however, isn’t about section 471. It’s about section

263A(g)(1)’s definition of “produce”--which says that term “includes construct,

build, install, manufacture, develop, or improve”--and section 1.263A-2(a)(1)(i),

Income Tax Regs., which says that “produce includes the following: construct,

build, install, manufacture, develop, improve, create, raise, or grow.” Suzy’s Zoo,

273 F.3d at 878 (emphasis added).

      Although Suzy’s Zoo is about section 263A, it’s useful for construing

section 471’s regulations which, like section 263A’s regulations, provide different

methods of accounting for inventory that’s “purchased” or “produced” but don’t

define those terms. See sec. 1.471-3(b) and (c), Income Tax Regs. We think

“produce” should mean the same thing in section 471 as it does in section 263A.

We also think we should follow the Ninth Circuit’s reasoning in a case appealable

to that court. See Golsen, 54 T.C. at 757.

      In Suzy’s Zoo, the taxpayer, a greeting-card company, designed images and

sent them to a contract printer who did color separations, made proofs, and printed
                                       - 59 -

them using its own materials. A trucking company then picked up the prints and

took them to a finisher. The finisher cut and folded the prints into greeting cards

and returned them to the taxpayer. The printer and the finisher each bore the risk

of loss while they had the materials. Suzy’s Zoo, 273 F.3d at 877.

      We held--and the Ninth Circuit affirmed--that the taxpayer was a “producer”

because it retained title to the items throughout the contract-production process.

Id. at 877, 880. Citing regulations under section 263A, the court said: “The only

requirement for being a ‘producer’ * * * is that the taxpayer be ‘considered an

owner of the property produced,’” that “ownership is ‘based on all of the facts and

circumstances,’” and that “[a] taxpayer may be considered an owner of property

produced, even though the taxpayer does not have legal title to the property.” Id.

at 880 (citing section 1.263A-2(a)(1)(ii)(A), Income Tax Regs.). A taxpayer can

be a “producer”, moreover, even if it uses contract manufacturers to do the actual

production. Id. at 878 (citing section 263A(g)(2)). The Ninth Circuit explained

that achieving section 263A’s purpose of treating all taxpayers fairly required a

broad construction of “produce”. Id. at 879; see also Von-Lusk v. Commissioner,

104 T.C. 207, 215 (1995); S. Rept. No. 99-313, supra at 140, 1986-3 C.B. (Vol. 3)

at 140. We’ve said this before ourselves, not coincidentally in a case holding that
                                        - 60 -

“production” for section 263A doesn’t require a physical change. See Von-Lusk,

104 T.C. at 217.

      “Produce” is therefore broader than “manufacture”. That’s also evident

from the Code and regulations. We saw that already in section 263A(g)(1) and

section 1.263A-2(a)(1)(i), Income Tax Regs. See supra pp. 58-59. The section

471 regulations also show that “production” and “manufacturing” are distinct, if

related, concepts. Section 1.471-11, Income Tax Regs., discusses “production”

costs, but refers in several places to costs “incident to and necessary for

production or manufacturing,” a construction implying that the two terms are not

identical, even if they are closely related and receive identical tax treatment.24 For

purposes of section 471, production turns on ownership--ownership as determined

by facts and circumstances, not formal title.

             2.     Did Harborside Own What Its Growers Grew?

      In finding that Suzy’s Zoo was a producer, the Ninth Circuit emphasized the

“degree of control * * * [the taxpayer] exercise[d] over the manufacturing


      24
        The heading of section 1.471-11, Income Tax Regs., is “Inventories of
Manufacturers,” but this doesn’t change our analysis of its text. Statutory titles
and headings are useful when interpreting ambiguous words or phrases, but “they
cannot undo or limit that which the text makes plain.” Bhd. of R.R. Trainmen v.
Baltimore & Ohio R.R. Co., 331 U.S. 519, 528-29 (1947); see also Dixon v.
Commissioner, 132 T.C. 55, 81 (2009).
                                         - 61 -

process.” Suzy’s Zoo, 273 F.3d at 880. Harborside says it also exercised a high

degree of control over the growers it purchased marijuana from. It points out that

it bought marijuana only from its members, and even then only if the members

used Harborside’s clones (which they either bought or received for free), took

Harborside’s growing class, followed Harborside’s best practices, and met

Harborside’s quality-control standards.

      But there was more to Suzy’s Zoo. There the taxpayer acquired ownership

when it first designed the characters because that was the most important step and

the one that required the most skill and expertise. Suzy’s Zoo, 114 T.C. at 8.

Suzy’s Zoo’s contractors couldn’t sell, copy, or use those characters without

breaching Suzy’s Zoo’s license. Id. Suzy’s Zoo retained the “exclusive right to

sell the finished product,” id. at 9, and it accepted all the finished products it

ordered, see Suzy’s Zoo, 273 F.3d at 877.

      Harborside, unlike Suzy’s Zoo, see id.; Suzy’s Zoo, 114 T.C. at 8-10, didn’t

create the clones, maintain tight control over them, order specific quantities,

prevent sales to third parties, or take possession of everything produced.

Harborside bought clones from nurseries and either sold them to growers with no

strings attached or gave clones to growers expecting that they’d sell bud back to

Harborside. Nothing prevented either type of grower from selling to another
                                       - 62 -

collective, and DeAngelo thought it would be futile to try to use the courts to stop

them.25 Harborside had complete discretion over whether to purchase what bud

growers brought in, paid growers only if it purchased their bud, and at times

rejected the “vast majority” of its growers’ bud. And Harborside thought growers

could do whatever they wanted with the rejected bud.

      This was not the type of contract-manufacturing arrangement we saw in

Suzy’s Zoo, 273 F.3d at 877, where a designer hired others to make its products

but owned those products at all stages of their creation. Harborside merely sold or

gave members clones that it had purchased 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. Harborside is therefore a reseller for purposes of section 471

and must adjust for its COGS according to section 1.471-3(b), Income Tax Regs.26

      This leaves only the issue of whether Harborside owes accuracy-related

penalties under section 6662(a). We will address this issue in a separate opinion.



      25
         DeAngelo said he never sued anyone for breach of contract because “the
possibility o[f] prevailing on contract disputes in something that involves a
controlled substance is slim and would be expensive.”
      26
         Harborside did have a “processing room.” See supra p. 8. But the
“processing” that went on there--reinspection, packaging, and labeling--fall within
the category of “purchasing, handling, and storage” that resellers do without losing
their character as resellers. See sec. 1.263A-3(c), Income Tax Regs.
