General Tax Controversy News & Updates

The Tax Court’s recent decision in Walquist v. Commissioner, 152 T.C. No. 3, further clarified the application of the supervisor approval requirement under section 6751(b)(1), which has been a key issue since Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017).  In Walquist, the Tax Court held that accuracy-related penalties determined by an IRS computer program without human review are “automatically calculated through electronic means” under section 6751(b)(2)(B).  As a result, those penalties are exempt from the written supervisor approval requirement under section 6751(b)(1).

The petitioners in Walquist failed to report compensation for 2014.  The IRS’ computer document matching recognized the underreporting, and the IRS processed the examination of the Walquist’s return through its Automated Correspondence Exam system using its Correspondence Examination Automated Support (CEAS) software program.  The Tax Court explained that this software is designed to process cases “with minimal to no tax examiner involvement until a taxpayer reply is received.”  The CEAS program eventually issued the petitioners a general 30-day letter, which systematically included an accuracy-related penalty.  The petitioners failed to respond to the 30-day letter, so the CEAS program issued them a notice of deficiency, which included the accuracy-related penalty from the 30-day letter.

The petitioners filed a purported petition with the Tax Court, which consisted of the notice of deficiency and appended various documents containing assertions commonly advanced by tax protesters.  Even in such cases, the IRS’ burden of production generally includes establishing compliance with section 6751(b), which requires that penalties be “personally approved (in writing) by the immediate supervisor of the individual making such determination.”  See Chai, 851 F.3d at 217.

Supervisor approval, however, is not required for “any other penalty automatically calculated through electronic means.”  IRC 6751(b)(2)(B).  The Tax Court held that an accuracy-related penalty determined by an IRS computer program is a “penalty automatically calculated through electronic means.”  The Tax Court pointed out that if the penalty at issue was not a “penalty automatically calculated through electronic means,” it would be difficult to conceive what type of penalty would qualify for the statutory exception to the supervisor approval requirement.

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.

 

The IRS has been cracking down on conservation easement transactions for over ten years. Nevertheless, taxpayers have continued to claim charitable contribution deductions attributable to the donation of conservation easements and promoters have continued to assemble investments utilizing conservation easement charitable deductions. The IRS began focusing on syndicated conservation easement transactions when it issued Notice 2017-10, designating syndicated conservation easement transactions as listed transactions. These syndicated investments involve the use of partnerships to raise funds from investors, who are allocated a share of a charitable contribution deduction attributable to conservation easements donated on land owned by the partnership. In fall of 2018, the IRS doubled down on its attacks of these investments when syndicated conservation easements were added to the list of LB&I compliance campaigns. While the IRS continues to crack down on these arrangements, taxpayers have continued litigating the finer points of these transactions. On the flipside, DOJ has begun cracking down on promoters who market these transactions. Below are details on the most recent developments.

Pine Mountain Preserve v. Comm’r

This case involves three conservation easements covering various portions of an assemblage of over 2,000 acres of land. The land was located in what sounds like a beautiful location in Alabama for development of recreational and horse properties. Over three years, three different easements were granted on various portions of 1,300 of the 2,000 acres. The first two easements reserved the right to allow for small parcels of development, in a location to be agreed upon between the property owner and the charity holding the easement.

Relying on its prior rulings in Belk v. Comm’r, 140 T.C. 1 (2013), supplemented by T.C. Memo. 2013-154, aff’d 774 F.3d 221 (4th Cir. 2014) and Bosque Canyon Ranch v. Comm’r, T.C. Memo. 2015-130, vacated and remanded sub nom. 867 F.3d 547 (5th Cir. 2017), the court determined that the first two easements did not a qualified real property interest due to the uncertainty created by the reservation to create pockets of development on the property subject to the conservation easement. [We note that the Tax Court was not persuaded by the Fifth Circuit opinion in Bosque Canyon and declined to follow it since this case is not appealable to the Fifth Circuit.] However, while the third easement contained a reservation for installing a water tower, it did not allow for the parties to choose after the easement areas for development within the easement area. Thus, the third easement was determined to be a qualified real property interest.

Valuation of the third easement was discussed in a Memorandum opinion issued simultaneously with the full Tax Court opinion addressing the validity of the easement. The court found the taxpayer’s expert overvalued the potential development of the property in determining the value of the easement but that the IRS expert undervalued the easement by ignoring the development potential of the property. The court went to great lengths to discuss in detail the misgivings of both valuation expert’s opinions but the result for the taxpayer was not horrible. In the end, the court valued the easement based on 50% of the value determined by both experts. Considering this meant a $4.8 million charitable contribution deduction was allowed, this was not a total loss for the taxpayer.

Wendell Falls v. Comm’r

Sometimes developers want open space or a park included in a master plan for a residential community as a way to make the community more desirable. In that instance, because the developer expects to benefit as a result of the easement, the law does not allow a charitable contribution deduction, essentially because the contribution lacks donative intent or because the donation lacks value when weighed against the value of the expected benefit. This is exactly what happened in Wendell Falls. Here, a developer chose to place an easement on a parcel of land after it had already designed the parcel as a park in the master plan. In April of 2018, the court determined that because the highest and best use of the eased parcel was as a park, as outlined in the developer’s master plan, the easement requiring it to be preserved as a park did not diminish its value, therefore the easement had no value. However, the court did determine that the taxpayer was not subject to penalties.

The taxpayer asked the court to reconsider several of its findings, arguing that the court should have considered the value of the easement and separately considered the value of the enhancement to the donor’s property separately. The taxpayer also asserted that the receipt of a substantial benefits did not alone result in denial of a deduction and that the highest and best use of the parcel was for development rather than a park, attempting to get the court to reconsider values. On November 20, 2018, the court issued its opinion that the value of the substantial benefit expected was in excess of the value of the easement, and that parkland was the highest and best use of the property based on the proposed development. Unfortunately, the taxpayer lost all of its $1.8 million charitable contribution deduction.

Lawsuits against Promoters

The government had has enlisted another tactic for shutting down conservation easements by bringing actions against the organizers of conservation easement syndication schemes. On December 28, 2018, the Department of Justice filed a compliant in the Northern District of Georgia asserting that a group of defendants assembled partnership which were “nothing more than a thinly veiled sale of grossly overvalued federal tax deductions under the guise of investing in a partnership.” The complaint asserts that the defendants’ conservation easement syndicates have generated $2 billion in conservation easement charitable contribution deductions. The complaint seeks to enjoin the defendants from continuing to promote such schemes, and asks the court to order the defendants to disgorge all profits received as a result of the conservation easement syndicates.

The defendants include a conservation manager/broker dealer, an appraiser, and various professionals associated with EcoVest Capital, Inc., an entity that sponsors real estate investments focused on conservation. The promotional materials mentioned in the compliant set forth an example where in exchange for a $750,000 investment, an investor would receive $2 million of deductions, generating tax savings of $1 million. The syndicates were sold as securities exempt from registration through broker-dealers. The easement syndicates involved properties located in Alabama, Georgia, Indiana, Kentucky, North Carolina, South Caroline, Tennessee, and Texas.

Any taxpayer who may have invested in a syndicated conservation easement through Ecovest or any other investment advisor should carefully review Notice 2017-10 and related the disclosure requirements for listed transactions. Those taxpayers should also consult with a tax attorney to consider strategies for mitigating any damages.

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

Please join us for Fox Rothschild’s Second Annual Federal Tax Controversy Summit on December 12 in Philadelphia. We’ll be covering the latest developments in federal tax controversy and civil and criminal tax enforcement. CPE and CLE (PA) credits pending. Please click here to register.

Schedule:

8:00 a.m. – registration and breakfast
8:30 a.m. to 11:30 a.m. – program

Speakers:

Matthew D. Lee, Fox Rothschild LLP
Jennifer E. Benda, Fox Rothschild LLP
Ian M. Comisky, Fox Rothschild LLP

Topics:

  • The Internal Revenue Service’s focus on captive insurance arrangements
  • Tax audits and Section 280E litigation involving cannabis businesses
  • Offshore tax enforcement in a post-Offshore Voluntary Disclosure Program (OVDP) world
  • Updated IRS Voluntary Disclosure Practice (announced Nov. 29, 2018)
  • When tax engagements, client representation and advocacy become a crime
  • New initiatives at the IRS Criminal Investigation Division
  • Recent developments in federal taxation of cryptocurrency
  • When to call the Taxpayer Advocate

Location:

2000 Market Street, 20th Floor, Philadelphia, PA 19103

Please join us for Fox Rothschild’s Second Annual Federal Tax Controversy Summit on December 12 in Philadelphia. We’ll be covering the latest developments in federal tax controversy and civil and criminal tax enforcement. CPE and CLE (PA) credits pending. Please click here to register.

Schedule:

8:00 a.m. – registration and breakfast
8:30 a.m. to 11:30 a.m. – program

Speakers:

Matthew D. Lee, Fox Rothschild LLP
Jennifer E. Benda, Fox Rothschild LLP
Ian M. Comisky, Fox Rothschild LLP

Topics:

  • The Internal Revenue Service’s focus on captive insurance arrangements
  • Tax audits and Section 280E litigation involving cannabis businesses
  • Offshore tax enforcement in a post-Offshore Voluntary Disclosure Program (OVDP) world
  • Updated IRS Voluntary Disclosure Practice (announced Nov. 29, 2018)
  • When tax engagements, client representation and advocacy become a crime
  • New initiatives at the IRS Criminal Investigation Division
  • Recent developments in federal taxation of cryptocurrency
  • When to call the Taxpayer Advocate

Location:

2000 Market Street, 20th Floor, Philadelphia, PA 19103

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.

We recently wrote on the new proposed regulations addressing the availability of charitable deductions when taxpayers receive or expect to receive corresponding state or local tax credits for contributions.  The proposed regulations require a taxpayer who makes a contribution to a charitable organization to reduce his charitable deduction by any state or local tax credit that he receives or expects to receive.  Readers may find more about the proposed regulations here.  After the proposed regulations were issued, the IRS published a clarification for business taxpayers.  The IRS clarified that business taxpayers who make business-related payments to charities or government entities for which the taxpayers receive state or local tax credits may still generally deduct the payments as business expenses.  This general deductibility rule is not affected by the proposed regulations dealing with charitable deductions for donations to state or local tax credit programs.

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

In its 5-4 decision in South Dakota v. Wayfair, the U.S. Supreme Court gave states the authority to require online retailers to collect state sales taxes even if the retailer has no physical presence in a state. The decision overturned pre-internet era rulings that had prohibited states from forcing online retailers to collect sales taxes unless a retailer had a “physical presence” in a state.

Wayfair will likely increase states’ sales tax revenue. The Supreme Court noted that the physical presence standard may have cost states up to $33 billion in sales tax revenue every year. South Dakota alone estimated that it lost $48 to $58 million yearly. This was a serious problem for states like South Dakota that do not have an income tax.

On the other hand, the decision will drive up costs for small online retailers, and those without the resources to comply with numerous taxing jurisdictions will be hit hard. Members of the House Judiciary Committee issued a statement calling Wayfair a “nightmare for … small online sellers, who will now have to comply with the different tax rates and rules of, and be subject to audits by, over 10,000 taxing jurisdictions across the U.S.”

But Justice Anthony Kennedy, who authored the majority opinion in Wayfair, thought there was “nothing unfair about requiring companies that avail themselves of the states’ benefits to bear an equal share of the burden of tax collection.”

Regardless of the policy arguments, the Wayfair ruling will likely significantly increase compliance costs and state audits for online retailers.

Now online retailers must determine whether the states where they have no physical presence require them to collect and remit sales tax. A state may require an online retailer to collect and remit sales tax based on the revenue the online retailer generates or the number of sales it makes in the state.

Online retailers should bear in mind, however, that states cannot impose collection requirements on an online retailer if it does not have a substantial nexus in the state.

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.

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.