Tax Court

The issue before the Tax Court in Huzella v. Commissioner, T.C. Memo. 2017-210, centered around a coin business on eBay, and whether the petitioner, Thomas Huzella, could substantiate his cost of goods sold and expense deductions for his business.

The petitioner had been collecting coins as far back as 1958.  The problem was that the petitioner did not keep records to establish the basis in any of his coins.  In 2013, the petitioner actively bought and sold coins on eBay and was paid through PayPal.  PayPal issued the petitioner a Form 1099-K, Payment Card and Third Party Network Transactions, which reflected the payments he received from PayPal.  The petitioner earned $37,000 from almost 400 separate transactions in 2013.  But he also incurred eBay fees and Paypal fees, as well as packaging and shipping costs.

When he filed his tax return, the petitioner did not report anything on his Schedule C, and the IRS audited his return and issued a notice of deficiency.  The IRS alleged that the petitioner had unreported income of $37,000 from his eBay business and asserted penalties.  At trial, the IRS conceded that the petitioner was engaged in a trade or business in 2013.  The IRS also conceded that the petitioner was entitled to deduct the eBay and PayPal fees, and the Tax Court held that he was entitled to deduct $700 of postage and packaging costs.  The petitioner conceded that he earned – but did not report – gross proceeds of $37,000 from his eBay business.

The court then turned to the cost of goods sold issue.  Taxpayers are required to substantiate any amount they claim as cost of goods sold, and they must maintain sufficient records.  If a taxpayer with insufficient records, however, proves he incurred expenses but cannot substantiate the exact amount, the Tax Court may, in certain circumstances, estimate the amount.

Here, the Tax Court (and the petitioner) relied on the Cohan decision.  See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).  In that case, the taxpayer was an actor, playwright, and producer who spent large sums travelling and entertaining actors, employees, and critics.  Although Cohan did not keep a record of his spending on travel and entertainment, he estimated that he incurred $55,000 in expenses over several years.

The Board of Tax Appeals, now the Tax Court, disallowed these deductions in full based on Cohan’s lack of supporting documentation.  On appeal, however, the Second Circuit concluded that Cohan’s testimony established that legitimate deductible expenses had been incurred, holding that “the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making.”  The Cohan rule has been followed by the Tax Court and other federal courts in numerous decisions.

The petitioner in Huzella did not have any records to establish his cost or bases in the coins.  He purchased some coins and inherited others.  But the Tax Court relied on Cohan and, after evaluating the evidence and the petitioner’s testimony, held that the petitioner could substantiate a cost of goods sold of $12,000.  Thus, the petitioner had taxable income of just under $20,600 (gross receipts of $37,000, less cost of goods sold and deductions).

In a case of first impression, the Tax Court held that the U.S.–Canada Tax Treaty (Treaty) did not exempt a Canadian citizen from U.S. income tax on the unemployment compensation she received from the State of Ohio. Pei Fang Guo v. Commissioner, 149 T.C. No. 14. The taxpayer came to the U.S. in 2010 as a post-doctoral fellow at the University of Cincinnati. She worked at UC from 2010 through 2011 on a nonimmigrant professional visa. When her employment contract ended in November 2011, she returned to Canada after she was unable to find other work in the U.S., where she stayed through 2012. When her UC employment contract ended, the taxpayer applied to the State of Ohio for unemployment compensation, which she received in 2012. When the taxpayer filed her 2012 U.S. tax return, she took the position that her unemployment compensation was exemption from income tax under Article XV of the Treaty. Instead, she reported the unemployment compensation on her Canadian tax return. The IRS disagreed, and the taxpayer filed a petition in Tax Court.

Tax Court SealThe Tax Court said that the taxpayer was a nonresident alien in 2012, which means she was neither a U.S. citizen nor resident. Generally, nonresident aliens must pay U.S. tax on their U.S.–source income. Everyone agreed that the taxpayer’s unemployment compensation was U.S.–source income. As a result, the only question left for the Tax Court to decide was whether the taxpayer’s unemployment compensation was exempt from U.S. income tax under the Treaty. But the Treaty does not mention unemployment compensation, except to say it does not count as social security.

The taxpayer focused her argument on the term “remunerations” in Article XV of the Treaty. Article XV governs the treatment of “salaries, wages, and other similar remunerations derived . . . in respect of an employment.” But the Treaty does not define “remunerations” either, so the Tax Court turned to the Code. “Remuneration” appears twice in the Code. Section 3401(a) says that “the term ‘wages’ means all remunerations . . . for services performed by an employee for his employer,” and section 3121(b) says that the “term ‘wages’ means all remuneration for employment.”

The Tax Court held that, just as unemployment compensation is not the same thing as “wages,” unemployment compensation does not constitute “similar remuneration derived. . . in respect to employment” under Article XV. The taxpayer wasn’t employed by UC when she received her unemployment compensation. And she did not receive it from her former employer.  She received it from the State of Ohio. As a result, the Tax Court concluded she was required to pay U.S. taxes on her unemployment compensation.

Tax and accounting issues you should not ignore when setting up your cannabis business:

The Trouble With Cash-Based Businesses

  • Internal Controls – any cash-based business is closely scrutinized by the IRS and other taxing authorities. Having robust internal control procedures, in writing, which are strictly enforced, will go a long way in establishing credibility with taxing authorities.
  • Form 8300 requirements – educate yourself or hire an accountant who can work with you to comply with this filing requirement.
  • Bank Secrecy Act – take precautions to avoid violations

Find Good Help

  • Hiring reputable Certified Public Accountants (CPA) and legal counsel to assist you in operating your business is very important.
  • CPAs often do not have guidance from their licensing boards regarding representation of marijuana businesses and many are therefore reluctant to offer advice.
  • Many large law firms are still reluctant to assist marijuana businesses despite actions by numerous state bar associations to assure attorneys they will not be violating state ethics rules when representing businesses in the legalized marijuana industry.
  • However, sophisticated advisers are starting to work with the industry, both in-house and as external advisers.

Comply, Comply, Comply

  • Abide by Internal Revenue Code section 280E – this requires knowledgeable and diligent accounting advice.
  • Be ready for an audit and for dealing with very aggressive revenue agents. Even though federal law enforcement in many cases is easing up on enforcement under CSA, the IRS has not adopted that view – marijuana businesses have a huge target on their back and the IRS is holding marijuana businesses to a very high standard.
  • Be timely and fully pay your taxes – tax liens can create issues with licensing authorities.