I have written before about the battles being fought by cannabis businesses facing IRS examinations. IRS audits raise many issues for state legal cannabis businesses operating in violation of the Controlled Substances Act. In some situations, taxpayers have struggled to resolve IRS examinations while addressing concerns that incriminating evidence provided to the IRS could fall into the hands of law enforcement. This week, the Tenth Circuit issued its ruling addressing these very concerns.
The Tax Court ruled in Feinberg v. Comm’r, T.C. Memo 2017-211, that the taxpayer failed to substantiate cost of goods sold when instead of submitting evidence of the amounts spend on inventory, it submitted an expert report in an effort to convince the court to make a determination of cost of goods sold based on industry averages. However, the expert report was excluded and the court determined that without actual documents, the IRS determination of cost of goods sold would stand. Further, because there was no substantiation of ordinary and necessary expenses claimed under Section 162, the Tax Court held that it did not need to address the application of Section 280E (the code section which disallows ordinary and necessary business deductions for businesses trafficking in controlled substances). My discussion of the Tax Court opinion is available here.
At oral argument, the taxpayer is argued that it was backed into a corner when, after the IRS agreed that whether Section 162 deductions where substantiated was not an issue for trial, the Tax Court determined that Section 280E did not apply because of a lack of evidence that the taxpayer was trafficking in controlled substances, yet denied Section 162 deductions for lack of substantiation. The Commissioner agreed that substantiation was not an issue for trial, but argued that the taxpayer did not in fact substantiate any expenses – because it asserted its Fifth Amendment privilege in response to discovery requests – and that there was enough evidence in the record to support a finding that the taxpayer was trafficking in controlled substances, allowing the court to agree that the IRS was correct in determining that Section 280E applied to the taxpayer.
The Tenth Circuit’s ruling is enlightening. The panel agreed with the parties that the Tax Court erred in denying the business expense deductions for failure to substantiate them under Section 162 because substantiation was a new matter upon which the IRS carried the burden of proof. However, the panel went on to conclude that based on the evidence in the record, it could affirm the Tax Court’s ruling on the alternative ground that the taxpayer did not meet their burden of proving that the IRS erred in denying the deductions under Section 280E.
The Tenth Circuit rejected the taxpayer’s argument that requiring them to prove that they were not trafficking in a controlled substance violated their Fifth Amendment privilege. The taxpayer cited several Fifth Amendment cases where petitioners “were prosecuted for failing to comply with a statute compelling them to provide self-incriminating information.” In those cases, the Fifth Amendment privilege provided a complete defense. Those situations were distinguished from the instant case, involving the filing of a tax return, because the taxpayer failed “to explain how requiring them to bear the burden of proving the IRS erred in applying § 280E to calculate their civil tax liability is a form of compulsion equivalent to a statute that imposes criminal liability for failing to provide information subjecting the party to liability under another criminal statute.” The court concluded that “the Taxpayers must choose between providing evidence that they are not engaged in the trafficking of a controlled substance or forgoing the tax deductions available by the grace of Congress.” In other words, whether you get to take a deduction is a different matter altogether than facing criminal prosecution for failing to comply with a statute. The court further noted that when asserting the privilege against self-incrimination, one must bear the consequences of the lack of evidence. While normally the lack of evidence could benefit a party facing criminal prosecution, here the lack of evidence results in a particular application of the tax laws, not criminal liability.
The court next picked up where the Tax Court left off and considered whether the taxpayer had provided evidence refuting the IRS determination that the taxpayer was trafficking in a controlled substance. Because the taxpayer did not identify any evidence showing the IRS had erred in this determination, the court concluded that they had not met their burden. This was the court’s basis for affirming the Tax Court’s conclusion.
This ruling breaks new ground by directly addressing the issue of Fifth Amendment privilege in examinations where the IRS takes the position that Section 280E applies. Because the court determined there is no violation of the taxpayer’s Fifth Amendment privilege, taxpayers in the Tenth Circuit should be cooperative during examinations to avoid denial of costs to which they are entitled.