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.

The IRS recently reminded taxpayers that like-kind exchanges are now generally only available for exchanges of real property.  This change was enacted as part of the Tax Cuts and Jobs Act passed in December of last year.  Now, exchanges of personal or intangible property do not qualify for nonrecognition of gain or loss as like-kind exchanges.  Personal or intangible property effected by the Tax Cuts and Jobs Act includes machinery, equipment, vehicles, artwork, collectibles, patents, as well as other intellectual property.

To be eligible for like-kind exchange treatment, real property must be held for use in a trade or business or investment.  Thus, real property held primarily for sale is ineligible for like-kind exchange treatment.  Real property includes land and generally anything built on the land or attached to it.

There is a transition rule that provides like-kind exchange treatment for some exchanges of personal or intangible property that would otherwise be ineligible for like-kind exchange treatment under the Tax Cuts and Jobs Act.  This transition rule may apply if a taxpayer disposed of personal or intangible property, or received replacement property, on or before December 31, 2017.

New Jersey recently announced the New Jersey Tax Amnesty program.  The New Jersey Division of Taxation has indicated that both individuals and businesses may qualify for the program.  The amnesty program began on November 15, 2018 and goes through January 15, 2019.  The New Jersey Division of Taxation will waive late filing and late payment penalties for taxpayers who come forward through the program.  The New Jersey Division of Taxation will also waive half of any interest due as of November 1, 2018.  Taxpayers who choose not to participate, however, face stiff penalties.  These taxpayers will incur a 5% penalty, which the New Jersey Division of Taxation will not waive.  The 5% penalty is in addition to the other penalties and interest.

Taxpayers with outstanding New Jersey tax issues should strongly consider participating in the program.  The New Jersey Division of Taxation offers guidance for how to apply for amnesty here.

The Bipartisan Budget Act of 2018 eases the requirements for combat-zone contractors to claim the foreign earned income exclusion.  A U.S. citizen is generally taxed on his worldwide income.  The foreign earned income exclusion, however, allows a taxpayer to exclude foreign income from his gross income for U.S. tax purposes, up to a certain dollar threshold.  For 2018, the threshold is $103,900.

But the exclusion only applies to a taxpayer whose tax home is in a foreign country.  Under prior law, a taxpayer could not have a tax home in a foreign country if his “abode,” which is generally his home or residence, was in the U.S.  See Tax Court Broadens Foreign Earned Income Exclusion.  Before the Bipartisan Budget Act of 2018, combat-zone contractors had difficulty qualifying for the foreign earned income exclusion because it was difficult to prove their abodes were not in the U.S.  The new law removes the “abode” requirement by providing that a contractor who supports the U.S. Armed Forces in a combat zone is entitled to the foreign earned income exclusion even if his “abode” is in the U.S.  The new law went into effect in 2018.  This is a significant development for contractors supporting the military overseas.

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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.

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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.

Yesterday, the Tax Court issued its opinion in Alterman v. Commissioner, T.C. Memo 2018-83.  This case involved the operation of a medical marijuana dispensary which was reported on Schedule C.  The opinion includes a long recitation of intricate accounting details that I will address on a summary basis so as to not lose readers other than accountants.  Readers interested in the details should read the opinion linked above.

The important facts are as follows:

  • The taxpayer sold marijuana and non-marijuana products.  The sales of non-marijuana products were 1.4% of gross receipts in 2010 and 3.5% of gross receipts in 2011.
  • On the tax returns, the taxpayer reduced gross receipts by cost of goods sold.  The taxpayer also deducted business expenses.  It does not appear based on the findings of fact that on the original return the taxpayer disallowed any expenses pursuant to Section 280E.
  • It appears the amount of cost of goods sold claimed on the return was, for the most part, amounts paid for purchases of inventory and did not include production costs.  At trial, the taxpayer asserted that it incurred over $100,000 of production costs each year in addition to the amounts paid for purchases of inventory.

The court found:

  • The sales of non-marijuana products were complimentary to the sales of marijuana products and therefore, were not a separate trade or business.  Even if the non-marijuana product sales were a separate trade or business, the record did not give the court any basis for determining the expenses attributable to the secondary business of sales of non-marijuana products.
  • The court applied Section 471 to determine cost of goods sold.  Section 471 allows taxpayers to include direct and indirect production costs in cost of goods sold.
  • The amount of cost of goods sold conceded by the IRS, which does not appear to include production costs, was the allowable amount of cost of goods sold because the taxpayers failed to properly account for beginning and ending inventories.
  • The taxpayer was negligent and subject to the negligence penalty because they did not keep adequate records to compute beginning and ending inventories or adequate books and records.  Further, there was no reasonable cause because the taxpayers did not seek advice regarding inventory accounting or the application of Section 280E.

Lessons and observations:

  • It is important that taxpayers subject to Section 280E use their best efforts to apply Section 280E when filing returns.
  • It is important that taxpayers subject to Section 280E properly classify costs as inventory costs when filing returns and maintain beginning and ending inventories with integrity.
  • It is important that taxpayers retain records needed to substantiate all accounting entries.
  • The substantiation issues are not unique to the marijuana industry.  However, due to high audit rates and the impact of Section 280E, the cost of the failure to substantiate is uniquely burdensome.  That being said, here, it is unclear how the failure to substantiate beginning and ending inventory also creates a restriction on the production costs that should be allowed.  Careful documentation and preparation of returns should overcome some of these burdens.

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.