Taxable Talk

Where there’s smoke, there’s fire. Where there’s a marijuana business, there’s Section 280E and the desire to find a means around it. The Tax Court looked at two cases today involving semi-legal marijuana dispensaries (legal on the state level, but decidedly illegal on the federal level). Would inventiveness allow the deduction of general and administrative expenses? Would a dispensary get out of the Section 6662(a) accuracy-related penalties because what they did was reasonable?

In the first case, a marijuana dispensary knew about the problem of Section 280E. That section disallows all deductions except Cost of Goods Sold for a business trafficking in illegal drugs. So what are means around that? Well, you can have a second line of business, but it has to be real and the books have to clearly separate this out. But that wasn’t what this dispensary came up with.

Why not have a management company provide management services to the dispensary? And we’ll be able to deduct all the expenses of the management company (including general and administrative expenses)–that’s a different business. It was a Eureka! moment for the dispensary…until the IRS disallowed all of the expenses of the management company. (The IRS also disallowed the general and administrative expenses of the dispensary, and additional Cost of Goods Sold expenses of the dispensary.) The dispute ended up in Tax Court.

First, Section 280E is very clear about deductions for illegal drugs:

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.

Marijuana is a Schedule I drug federally; thus, only Cost of Goods Sold can be deducted. The petitioners’ argument that it’s legal on the state level doesn’t hold up; it’s illegal federally. Out go the G&A expenses of the dispensary.

But what about the management company? The IRS argued that the management company was trafficking in controlled substances; the petitioners said it was simply a managing company:

Petitioners argue that, as a management services company, Wellness did not itself engage in the purchase and sale of marijuana. But the only difference between what Alternative did and what Wellness did (since Alternative acted only through Wellness) is that Alternative had title to the marijuana and Wellness did not. Wellness employees were directly involved in the provision of medical marijuana to the patientmembers of Alternative’s dispensary. While Wellness and Alternative were legally separate, Wellness employees were engaged in the purchase and sale of marijuana (albeit on behalf of Alternative); that was Wellness’ primary business. We do not read the term “trafficking” to require Wellness to have had title to the marijuana its employees were purchasing and selling. Neither that section nor the nontax statute on trafficking limits application to sales on one’s own behalf rather than on behalf of another. Without clear authority, we will not read such a limitation into these provisions…

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

Thus, the management company (which was an S-Corporation) can’t take business expenses and its shareholders have unreported income.

Overall, the first case was quite inventive in trying to find a way around Section 280E. But once again the deductions went up in smoke.

The second case was looking at another dispensary and whether it was subject to an accuracy-related penalty. The Tax Court had previously ruled that the IRS was correct in disallowing deductions for the dispensary when they tried to capitalize those expenses under Section 263A(a)(2)—another inventive attempt to get around Section 280E that failed.

There wasn’t any dispute that the amount of underreporting was significant enough that this dispensary could be liable for the penalty. Rather, the issue was on whether or not the dispensary’s position on its returns was reasonable. As Judge Holmes notes,

In any event, Olive did not become final and unappealable until years after Harborside filed the last of the returns at issue in these cases. And Harborside also points out that, apart from CHAMP and Olive, there was very limited guidance available to marijuana dispensaries. Harborside correctly points out that the IRS has never promulgated regulations for section 280E and didn’t issue any guidance on marijuana businesses’ capitalization of inventory costs until 2015. See Chief Counsel Advice 201504011 (Jan. 23, 2015).

Judge Holmes draws the conclusion I would draw:

This leads us to the conclusion that Harborside’s reporting position was reasonable. Not only had its main argument for the inapplicability of section 280E to its business not yet been the subject of a final unappealable decision, but as discussed at length in Patients Mutual I, the meaning of “consists of” as used in section 280E is subject to more than one reasonable interpretation. Even by 2012–the last of the tax years at issue here–the only addition to this caselaw was our own opinion in Olive, and it too was still years away from a final appellate decision. [citation omitted]

There’s more:

As to Harborside’s good faith: We released Olive shortly after Harborside’s 2012 tax year ended, and Harborside began allocating a percentage of its operating expenses to a “non-deductible” category starting that year and did not even wait for Olive to be affirmed on appeal…We therefore find that Harborside acted with reasonable cause and in good faith when taking its tax positions for the years at issue. Harborside isn’t liable for penalties.

Another point in their favor: They kept excellent records. This is something I cannot overstate: If you’re in business, you are expected to keep good records. If all of your expenses are substantiated, you will be in much better shape than a business that doesn’t have such substantiation.

So what’s the other takeaway from today’s decisions? First, marijuana dispensaries will likely keep trying to find a way around Section 280E. And the Tax Court will continue to slap such schemes down. It will take Congress to pass a law legalizing marijuana on the federal level before marijuana dispensaries can ignore Section 280E.

Cases:
Alternative Health Care Advocates, et. al., v Commissioner, 151 T.C. No. 13
Patients Mutual Assistance Collective Corporation v Commissioner, T.C. Memo. 2018-208

Another medical marijuana dispensary owner found himself at Tax Court today. And another marijuana dispensary owner isn’t happy with the results, though in this case much of the damage was self-inflicted.

Jason Beck owned two medical marijuana dispensaries in California (he still owns one of the two locations). He kept records, but his recordkeeping rules reminded me of something out of Get Smart!. In one episode of the 1960s classic television series, the practice of the government agency called Control was to make two copies of vital records, and then destroy them. It’s a method that works well for comedic value, but is best not practiced in accounting:

It was petitioner’s ordinary practice to shred all sales and inventory records at the end of the day or by the next day. However, petitioner was able to recover and produce some of these records.

Tapes and other records were made…but were shredded. Now, in petitioner’s defense, the legal climate regarding marijuana was very different back in 2007. However, the substantiation rules for taxes haven’t changed one iota. Even an illegal business will need records or the IRS’s allegations will be assumed to be correct.

The petitioner asked to deduct business expenses for the dispensary. While a marijuana dispensary can deduct Cost of Good Sold, it cannot deduct business expenses; Section 280E of the Tax Code prohibits business expenses for any business trafficking in a controlled substance. Marijuana is a federally controlled substance. Just one month ago the 9th Circuit Court of Appeals upheld the Tax Court on this issue.

But even if the petitioner could deduct expenses, there’s the problem of substantiation.

Where a taxpayer reports a business expense but cannot fully substantiate it, the Court generally may approximate the allowable amount. However, we may do so only when the taxpayer provides evidence sufficient to establish a rational basis upon which an estimate can be made.

Here, petitioner intentionally and routinely destroyed most documents pertaining to the operation of both dispensaries. Petitioner was able to recover and produce some records; however, those records do not reconcile with the categories or amounts reported on petitioner’s tax return. Petitioner is not entitled to deduct the Schedule C expenses because they are unsubstantiated. [citations omitted]

The Court then disallows the expenses a second time based on Section 280E.

Next, there was the matter of a raid by the Drug Enforcement Administration (DEA). The DEA in early 2007 executed a search warrant and seize marijuana and other items that the petitioner valued at $600,000. He wanted to include them in Cost of Goods Sold, or take a casualty loss on the seized marijuana.

Because of his complete failure to substantiate the value of the seized marijuana, petitioner is not entitled to claim $600,000 as part of his Schedule C COGS. Additionally, if petitioner had provided substantiation, the seized marijuana would still not be allowable as COGS because the marijuana was confiscated and not sold.

In general, section 165(a) allows a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. Sec. 165(a). However, section 280E provides that no deduction or credit (including a deduction pursuant to section 165) shall be allowed for any amount paid or incurred in connection with trafficking in a controlled substance. Therefore, petitioner is not entitled to a section 165 loss deduction for the marijuana seized by the DEA.

All-in-all, it was not a good day at Tax Court for the petitioner, especially after the accuracy-related penalty was upheld.

CASE: Beck v. Commissioner, T.C. Memo 2015-149

Martin Olive operates “The Vapor Room,” a medical marijuana dispensary in San Francisco. His business, a sole proprietorship, was audited by the IRS for 2004 and 2005. He lost. He took that case to Tax Court. Back in August 2012 he lost (Olive v. Commissioner, 139 T.C. No. 2). He appealed that decision to the Ninth Circuit Court of Appeals. On Thursday the Ninth Circuit agreed with the Tax Court.

The issue in this case was 26 U.S.C. § 280E. That section of law prohibits a taxpayer from deducting any expenses (but not Cost of Goods Sold) related to a trade or business of trafficking in a controlled substance prohibited by Federal law. Marijuana–which may be legal under state law–is decidedly a controlled substance under Federal law.

The first argument of Mr. Olive was that he had multiple lines of businesses. The Court disagreed.

An analogy may help to illustrate the difference between the Vapor Room and the business at issue in CHAMP. Bookstore A sells books. It also provides some complimentary amenities: Patrons can sit in comfortable seating areas while considering whether to buy a book; they can drink coffee or tea and eat cookies, all of which the bookstore offers at no charge; they can obtain advice from the staff about new authors, book clubs, community events, and the like; they can bring their children to a weekend story time or an after-school reading circle. The “trade or business” of Bookstore A “consists of” selling books. Its many amenities do not alter that conclusion; presumably, the owner hopes to attract buyers of books by creating an alluring atmosphere. By contrast, Bookstore B sells books but also sells coffee and pastries, which customers can consume in a cafe-like seating area. Bookstore B has two “trade[s] or business[es],” one of which “consists of” selling books and the other of which “consists of” selling food and beverages.

Mr. Olive also argued that congressional intent and public policy should have § 280E not apply to medical marijuana.

Application of the statute does not depend on the illegality of marijuana sales under state law; the only question Congress allows us to ask is whether marijuana is a controlled substance “prohibited by Federal law.” I.R.C. § 280E. If Congress now thinks that the policy embodied in § 280E is unwise as applied to medical marijuana sold in conformance with state law, it can change the statute. We may not.

What this means for marijuana distributors and sellers is that they can deduct their Cost of Goods Sold but that they cannot deduct business expenses on their federal tax returns. It is likely, though, that on many state tax returns those business expenses will be deductible; after all, the business is selling a legal product on the state level. (This will likely depend on both the legality of marijuana under state law and the degree of conformity between the state and federal tax law in that state.)

Case: Olive v. Commissioner, No. 13-70510 (July 9, 2015)

Yet another important case came up while I am on vacation. Martin Olive operates the Vapor Room, a medical marijuana dispensary in California. He was audited, and the IRS held:

– That the dispensary underreported gross receipts;
– Could only deduct a small fraction of the claimed gross receipts;
– Couldn’t deduct any of the business expenses; and
– Was liable for the accuracy-related penalty.

Mr. Olive took his case to the Tax Court, and the Court made a full decision today (which serves as a precedent). And it’s not good news for the medical marijuana industry in California (or elsewhere).

First, let’s give the (somewhat) good news. The Court held that the Cost of Goods Sold (COGS) could be deducted where proven. But the petitioner (Mr. Olive) conducted his business in cash (rather than checks), and didn’t keep good records. Mr. Olive stated that the medical marijuana industry, “shun[s] formal ‘substantiation’ in the form of receipts.” That may be true, but:

The substantiation rules require a taxpayer to maintain sufficient reliable records to allow the Commissioner to verify the taxpayer’s income and expenditures…Neither Congress nor the Commissioner has prescribed a rule stating that a medical marijuana dispensary may meet that substantiation requirement merely by maintaining a self-prepared ledger listing the amounts and general categories of its expenditures. It is not this Court’s role to prescribe the special substantiation rule that petitioner desires for medical marijuana dispensaries and we decline to do so.

Still, the Court did allow an estimated COGS of just over 70% of gross receipts.

After that, the news was not good for the dispensary. First, the cash receipts were understated. The ledgers used had omissions, and the Court believed that the IRS’s calculated additional receipts were accurate.

Second, we turn to the “ordinary and necessary” business expenses. Most taxpayers can deduct these. However, Section 280E of the Tax Code prohibits deducting expenses for a trade or business that consists of trafficking in controlled substances in violation of federal law. “We have previously held, and the parties agree, that medical marijuana is a controlled substance under section 280E.”

Petitioner argues that he may deduct the Vapor Room’s expenses notwithstanding section 280E because, he claims, the Vapor Room’s business did not consist of the illegal trafficking in a controlled substance. He argues that the illegal trafficking in controlled substances is the only activity covered by section 280E. We disagree that section 280E is that narrow and does not apply here. We therefore reject petitioner’s contention that section 280E does not apply because the Vapor Room was a legitimate operation under California law. We have previously held that a California medical marijuana dispensary’s dispensing of medical marijuana pursuant to the CCUA was “trafficking” within the meaning of section 280E. See CHAMP, 128 T.C. at 182-183. That holding applies here with full force…

Congress in section 280E has set an illegality under Federal law as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business. This is true even if the business is legal under State law.

Mr. Olive attempted to show his business had two components (providing medical marijuana and ‘caregiving’), but the Tax Court didn’t buy that. There were no revenues for caregiving, and the Tax Court,

…perceive[d] his claim now that the Vapor Room actually consists of two businesses as simply an after-the-fact attempt to artificially equate the Vapor Room with the medical marijuana dispensary in CHAMP so as to avoid the disallowance of all of the Vapor Room’s expenses under section 280E.

This decision does not bode well at all for the medical marijuana cases that are moving through audit and the Tax Court. This is a full precedential case and I don’t see the Tax Court changing its view on the issues in the future.

Case: Olive v. Commissioner, 139 T.C. No. 2