Expert's Testimony Cannot Substitute for Records Taxpayer Failed to Produce

In the case of Feinberg v. Commissioner, T.C. Memo 2017-211, a taxpayer attempted to use the expert opinion of a CPA whom was claimed to be an expert in cost accounting, with an emphasis in the marijuana industry.

The taxpayers were shareholders in an LLC that ran a marijuana dispensary in Colorado.  On the original tax return filed for their S corporation claimed several deductions as ordinary trade or business deductions that the IRS determined were costs of sales—and important issue, since under IRC §280E only costs of goods sold may be deducted by a business that traffics in controlled substances under federal law.  Despite being legalized in Colorado, marijuana remains a controlled substance under federal law.

All expenses not so reclassified by the IRS were disallowed pursuant to IRC §280E.

At trial the taxpayers recognized that expenses that were cost of goods sold were clearly much more valuable if IRC §280E applied to the operation, so the taxpayer took the position that even though the IRS was now allowing more cost of goods sold than were originally claimed on the return, that number was below the “real” cost of goods sold for their operation.

However, there was a complication with the taxpayer being able to prove that assertion—the entity did not produce any business records to support these claimed expenses.  Instead they brought forward a CPA as an expert to give his expert opinion on the proper cost of goods sold for this business.

The opinion describes the expert report as follows:

The report states that during the tax years in issue the average wholesale purchase price for medical marijuana remained between $2,000 and $3,000 per pound. The report later posits an average purchase price of $2,500 per pound and reconstructs an income and expense schedule for THC “assuming” that COGS equaled 55% of gross sales. The report does not explain how or on what basis Marty determined these sales figures, and the exhibits do not include any sales records or other documents that would support them. The report asserts that tax returns Marty’s firm prepared show that “actual” COGS for medical marijuana businesses during the tax years in issue was between 66% and 100% (or more) of gross sales.

The Tax Court was not impressed by this evidence of the cost of goods sold.  The opinion first notes:

The Marty report is brief and summary, and its content is unreliable. Multiple statements in the report refer to no underlying source of information. For other statements that do cite an underlying source, Marty has failed to include the information or data on which he relied. In many instances the report does not reference or provide sufficient information or data for us to conclude that the opinions expressed are based on anything other than his own conjecture.

The Court objects as well to the fact that this report was not based on any knowledge of the taxpayer’s business:

The conclusions in the Marty report are an attempt to present reconstructed income tax returns as evidence of petitioners’ correct tax liabilities. The report is not based on personal knowledge of THC’s business. To determine the correct COGS for THC, substantiation of THC’s expenses is necessary. A reconstructed income tax return based on industry averages does not take the place of substantiation and does not help determine a fact in issue.

Finally, the Court concludes that the expert committed what is the unforgivable sin for an expert witness—giving testimony about the proper application of the law, a responsibility reserved to the Court:

By relying on returns that Marty and his firm prepared for other businesses, the Marty report provides the Court with legal conclusions as to which types of expenses may be treated as COGS. Expert testimony about what the law is or that directs the finder of fact on how to apply the law does not assist the trier of fact. Stobie Creek Invs., LLC v. United States, 81 Fed. Cl. 358, 364 (2008). Expert opinions on law are inadmissable. Fed. R. Evid. 702(a); see Hosp. Corp. of Am. v. Commissioner, 109 T.C. 21, 59 (1997).

The Court concludes that the report was not admissible in the case, thus removing from the case all evidence the taxpayer had submitted.

This case is instructive about the limits of using “expert testimony,” specially to attempt to reconstruct records that either the taxpayer didn’t want to make available or failed to keep.  It also gives a good outline of the types of information any expert needs to be able to provide for his/her report to be useful in a tax matter.