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.

 

Yesterday the Tax Court issued two decisions discussing the impact of Section 280E on cannabis businesses.  One of these cases addresses the application of Section 280E to licensed and non-licensed entities.  Both cases address the application of penalties to cannabis businesses.

Alternative Health Care Advocates v. Comm’r

This case involves a California dispensary, Alternative Healthcare Advocates (“Alternative”), that operated similarly to the dispensary at issue in the Patients Mutual I case issued last month and discussed here.  Alternative was taxed as a C corporation.  Alternative sold marijuana and non-marijuana products.  Alternative claimed deductions other than cost of goods sold (“COGS”) on its tax returns.

In addition,  a management company, Wellness Management Group, Inc. (“Wellness”), was established for purposes of providing employees to dispensaries.  Wellness elected to be taxed as an S corporation.   Wellness’s deductions consisted of compensation, salaries and wages, rent, taxes and licenses, advertising, and other deductions.  Wellness’s only customer was Alternative.

The IRS allowed Alternative to deduction the total COGS claimed on its returns.  Applying Section 280E, the IRS disallowed all deductions claimed on Alternative’s return.  The IRS also disallowed all deduction claimed on Wellness’s returns, asserting that it also was subject to Section 280E.  This is the first case dealing with whether Section 280E applies to a non-licensed taxpayer.

Alternative argued that selling medical marijuana under state law did not fall within the Section 280E requirement that the taxpayer’s activities consist of drug trafficking and that it was permitted to allocate expenses between its trafficking and non-trafficking activities.  For the same reasons set forth in Patients Mutual, the court rejected these arguments and held that Alternative was not entitled to the deductions claimed on the returns.

Wellness argued that its activities did not consist of trafficking in a controlled substance.  The court concluded that “the only difference between what Alternative did and what Wellness did (since Alternative acted only through Wellness) is that Alternative had title to marijuana and Wellness did not.”  Slip Op. at 28.  The court held that Wellness employees were engaged in the purchase and sale of marijuana on behalf of Alternative and that Wellness did not need to obtain title to the marijuana in order to be involved in the trafficking of marijuana.

Given the harsh result, Wellness argued that applying Section 280E to both Alternative and Wellness was “inequitable because deductions for the same activities would be disallowed twice.”  As we have previously highlighted, the courts have not been sympathetic to the inequities of Section 280E.  Here, the court bluntly concluded that “[t]hese tax consequences are a direct result of the organizational structure petitioners employed.”

Other Observations

  • The Tax Court gave an detailed discussion of the definition of trafficking that should be reviewed by any business solely engaged in the cannabis industry, even if not a state-licensed entity.
  • The amount of cost of goods sold claimed on the return was sustained.  The importance of engaging good accountants to prepare returns and properly determine COGS cannot be underestimated.

The Applicability of Penalties to Cannabis Companies

The Tax Court held that Alternative was subject to penalties because in determining their liabilities they relied on the CHAMP case, which the court concluded was factually distinguishable from Alternative’s facts, and because they provided no evidence that it relied on their accountant for advice on whether Section 280E applied.  As we have seen in other cases, while the facts are not clear, this finding leads us to believe that no expenses were disallowed pursuant to Section 280E.

In contrast, the Tax Court ruled in the Patients Mutual II case that the taxpayer’s reporting positions were reasonable based on the timing of prior Section 280E litigation, such as CHAMP and Olive, in relation to when the tax returns were filed.  The court also noted that “[k]eeping good books and records was one of Harborside’s strengths.”  Slip. Op. at 6.

 

 

In the latest Tax Court opinion addressing the application of Section 280E to cannabis businesses there is no good news.  However, there is some new guidance.  In Patients Mutual Assistance Collective Corp. v. Comm’r, 151 T.C. No. 11, the taxpayer made a litany of arguments to convince the court that their business, or a portion of their business was not subject to Section 280E.  These include arguments we have seen before, including (1) that the business was not trafficking in controlled substances, here, because the government had abandoned a civil forfeiture action, and (2) that because a portion of the business involved branding and the sales of non-marijuana products, deductions related to these operations should not be subject to Section 280E.  These arguments failed and only make it clear that similar arguments are likely to be unavailing.  In fact, the Court spends ten pages discussing why the entire business is integrated and subject to Section 280E.  Taxpayers hoping to establish a separate trade or business that is not subject to Section 280E now have clarity, but also an extremely high bar.

New Holdings:  Inventory Accounting Rules

The new developments addressed in this case involve the application of inventory rules to cannabis businesses.  Previous cases focused primarily on the previously discussed arguments and failed to give any detailed guidance on how to apply the inventory rules.  The Court clearly and strongly concluded that the more expansive Section 263A  inventory cost rules do not apply to businesses subject to Section 280E.  The Court reasoned that “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.”  Slip Op. at 53.

The Court’s conclusion is based on the notion that we go back in time to 1982 to determine what is includible in inventory costs.  The Court refers to Treas. Reg. section 1.263A-1(c)(2) which states:

Any cost which (but for section 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale under section 263A and the regulations thereunder. Thus, for example, if a business meal deduction is limited by section 274(n) to 80 percent of the cost of the meal, the amount properly allocable to property produced or acquired for resale under section 263A is also limited to 80 percent of the cost of the meal.

While this reasoning is understandable, if we turn the question on its head, we could also ask whether the section 280E disallowance is determined before or after inventory costs are calculated.  For example, even if there is a meals and entertainment expense that is clearly includible in inventory costs, no one is going to argue that 100% of meals and entertainment is includible in inventory costs.  In this case, you are determining inventory costs and deductions, and then applying Section 274.   So, it is easy to see how those provisions overlap.  However, if inventory costs are determined based on the applicable inventory rules and then Section 280E is applied, then you have a different result because Section 263A expands what can be included in inventory costs, and the remaining deductions are subject to Section 280E.  That result is not inconsistent with the notion that items such as meals and entertainment and penalties are not deducted in determining taxable income regardless of whether they are a deduction under Section 162 or an inventory cost under Section 471 or 263A.

The Harsh Result

It is important to note that the Court analyzed and concluded that the taxpayer was a reseller and not a producer.  Because the taxpayer did not itself grow marijuana, this is not surprising.  The Section 471 rules that apply to resellers do not allow for extensive indirect costs to be included in inventory.  Thus, for businesses that do not produce or manufacture, they will continue to face significant challenges by the IRS if they are including indirect costs in inventory costs.  For cultivators and producers, careful consideration should be given to how the 471 rules apply, depending on the activities of the business.

Still to Come

The Court reserved its analysis of whether penalties apply for a opinion to be issued at a later date.  However, the Court hints that there might be some relief when it states that the overlap between Section 280E and 263A created a “confusing legal environment.”  One can hope that given the lack of guidance addressing the specifics of how the inventory rules apply to cannabis businesses, the IRS and the court will give taxpayers  doing their best to apply Section 280E the benefit of reprieve from penalties.

Other Notes

If you are entertained by Judge Holmes’ opinions, be sure you read the footnotes.  Footnotes 3 and 6 are my favorites.

Our colleague Joseph A. McNelis III has written an excellent article for the In the Weeds blog about a recent statement from the U.S. Attorney in Massachusetts regarding his office’s enforcement priorities surrounding recreational marijuana.  In his statement, U.S. Attorney Andrew Lelling noted that while he cannot “immunize the residents of the Commonwealth from federal marijuana enforcement,” his office’s resources will be focused on (1) unauthorized out-of-state marijuana sales; (2) targeted sales to minors; and (3) organized criminal groups which use illicit drug sales to fund their activities.  You can read the blog post here.

For more up-to-date coverage from Tax Controversy and Financial Crimes Report, please subscribe by clicking here.

I have recently penned a Law360 article discussing lessons learned from recent tax decisions impacting cannabis businesses.  We will continue to cover this topic on this blog.

To be alerted of updates from Tax Controversy and Financial Crimes Report, please subscribe by clicking here.

There is not too much to say about the Tax Court’s latest decision involving a marijuana company.  In Loughman v. Commissioner, T.C. Memo 2018-85, the operators of a Colorado marijuana dispensary argued that for a marijuana dispensary operating as an S corporation, Section 280E discriminates against S corporation shareholders by double taxing income when shareholder salary is disallowed pursuant to Section 280E as a deduction from flow-through S corporation income and also included on the shareholder’s individual tax return as W-2 wages.  The Tax Court noted that the regime was not discriminatory, but rather applied equally, because Section 280E disallows salaries not attributable to cost of goods sold whether or not the salaries are paid to the shareholder.

One of the harsh realities of operating a marijuana business is that Section 280E creates double taxation for owners who receive payments for services from marijuana companies.  It would seem the only way to avoid this is if the owner’s sole responsibility is activities related to the production of inventory. However, any officer/owner’s responsibilities are bound to include some sort of management and oversight.  While making an election to be taxed as a C corporation can minimize the cost of double taxation in this situation, it won’t eliminate it.

The Tax Court has shown little sympathy for marijuana companies when it comes to the harsh realities of Section 280E.  The court notes that the taxpayers can elect to be taxed as any type of entity and also elect to operate in any line of business.   Simply, in order to avoid double taxation caused by Section 280E, you are advised to operate a business not subject to Section 280E.

Attorneys representing cannabis businesses are often faced with questions about what happens when the cannabis business has not paid its taxes and the IRS is proceeding with collection actions.  No one thinks the IRS will seize and sell cannabis to satisfy tax liabilities, because in doing so the IRS would engage in criminal violations of the Controlled Substances Act.  However, recently, IRS Chief Counsel issued advice addressing questions posed by the field about whether an IRS sale of equipment used in a cannabis business would result in a violation of criminal laws.

In CCA 2018042616201420, Chief Counsel determined that Gas Chromatographer Mass Spectrometers (GCMS) and Liquid Chromatographer Mass Spectrometers (LCMS) used by taxpayers involved in the marijuana industry to measure the amount of cannabinoids in marijuana were not drug paraphernalia under the Drug Paraphernalia Statute, 21 U.S.C. § 863.  The conclusion was that because the equipment, which is used to measure organize material, can be used for purposes other than measuring cannabinoids, such as in fire investigations, explosive investigations, and even the identification of foreign material collected from outer space, the equipment was not drug paraphernalia.

The CCA also concluded that the existence of marijuana residue on the equipment did not prohibit the sale because, pursuant to 21 U.S.C. § 841(a), the existence of a residual amount of a controlled substance did not create the intent to distribute a controlled substance.

The CCA advised that the equipment should be subject to a “deep cleaning” prior to sale not only to avoid any possibility of a criminal violation but also to maximize the value of the equipment at auction.    The cost of this cleaning should be considered by Collections when determining collection potential of the property.

Our colleagues Joseph A. McNelis III and William Bogot have published a client alert addressing yesterday’s announcement by Attorney General Jeff Sessions that effectively ends the Obama Administration’s “hands off” approach to licensed cannabis operations in states where cannabis has been legalized for medicinal or recreational purposes. This announcement is important for all licensed cannabis businesses because the federal Controlled Substances Act classifies cannabis as a Schedule 1 substance, making it illegal to produce, sell, or possess cannabis. It also comes on the heels of the official roll-out of California’s recreational cannabis program, the largest in the country.  You can read their alert here.

For more up-to-date coverage from Tax Controversy Sentinel, please subscribe by clicking here.

Over at the In the Weeds blog, we report on new federal data showing a steady increase in the number of depository institutions that actively bank U.S. marijuana businesses. As of September 30, 2017, a total of 400 banks and credit unions provided services to marijuana-related businesses, up from 334 as of December 31, 2016. FinCEN’s data is based upon Suspicious Activity Reports (SARs) required to be filed by financial institutions on activity involving a marijuana-related business.  FinCEN’s SAR filing data shows a positive and encouraging trend for marijuana businesses, which have typically struggled to find financial institutions willing to provide banking services. You can read our blog post here.

Marijuana-related businesses present myriad anti-money laundering compliance challenges, as well as complex federal tax issues as our colleague Jennifer E. Benda has addressed here, here, here. and here.

For more up-to-date coverage from Tax Controversy Sentinel, please subscribe by clicking here.

Today, the Tax Court issued its opinion in Feinberg v. Commissioner, a case involving an ongoing and hard fought battle between the IRS and a medical marijuana dispensary, Total Health Concepts, LLC.  The IRS examined THC’s 2009 through 2011 tax returns.  As a result of the examination, the IRS adjusted the member taxpayers’ returns to reflect a cost of goods sold allowance in excess of the amount originally claimed on the return by reclassifying expenses that were originally claimed as below-the-line expenses.  However, the IRS also disallowed expenses not reclassified as cost of goods sold.  Accordingly, the IRS computed deficiencies on the member’s individual tax returns.

During earlier phases of this case, the taxpayer argued that the Commissioner did not have jurisdiction to administratively determine whether petitioners committed a federal crime outside of the U.S. tax code, that section 280E as applied by the Commissioner is unconstitutional as it violates petitioners rights against self-incrimination under the Fifth Amendment of the Constitution, and that section 280E exceeds the authority granted to Congress under the Sixteenth Amendment of the Constitution.  The Tax Court denied the taxpayer’s request for summary judgment and compelled them to respond to IRS discovery requests.  The taxpayer’s sought a writ of mandamus, seeking review of the Tax Court’s order compelling them to produce documents.  The Tenth Circuit determined that if the discovery request harmed them, the proper time to address that harm would be after the Tax Court case was fully resolved.  As a result, the taxpayer’s case proceeded to trial.

At trial, the taxpayer did not submit documentation to substantiate the cost of goods sold allowance or the ordinary and necessary business expenses.  Instead, an expert report was submitted to substantiate a cost of goods sold allowance in excess of what the IRS allowed during the examination.  The Tax Court ruled that the expert report was unreliable because it contained statements which failed to refer to underlying source information, failed to include underlying source information which the expert relied upon, and failed to include sufficient information and data to support the report’s conclusions.  As a result, the expert report was inadmissible.

Next, the court looked to evidence which would support a higher cost of goods sold allowance than the allowance determined in the IRS report.  Without documentation, the court concluded that the IRS determination of cost of goods sold would stand.  Further, because there was no substantiation of ordinary and necessary business expenses claimed under Section 162, the court determined 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).

What is the lesson here?  This case provides no guidance on the limits that will be applied to cannabis companies in determining cost of goods sold.  Rather, this case tells us that a cannabis company should prepare for an IRS examination the same way any other taxpayer should, by maintaining documentation to support the deductions claimed on the return and by provided that documentation when the IRS requests it.  This is especially true in this case, where the court determined that “there was not enough evidence in the record to make a finding of fact that THC sold medical marijuana.”  Based on this statement, if the taxpayer would have substantiated its below-the-line expenses, they would not have been subject to Section 280E, which would have been a huge win for the taxpayer.