Fifth Amendment Does Not Allow Taxpayer to Avoid Burden of Proving Business Did Not Traffic in Controlled Substances

The Tenth Circuit denied a taxpayer’s attempt to force the IRS to bear the burden of proof that an LLC operating as an S corporation was trafficking in a controlled substance that would lead to a denial of most business deductions per IRC §280E in the case of Feinberg, et at v. Commissioner, Case No. 18-9005, CA10.  The taxpayer argued that, despite the fact that the burden of proof generally falls on the taxpayer to prove the right to a deduction, to do so in this case would involve a violation of the taxpayers’ Fifth Amendment privilege.

This was the second trip up to the Tenth Circuit for the taxpayers in this exam.  While their first trip was ultimately successful in the eventual result, if not 100% in the decision, this second trip was not fruitful for the clients.

IRC §280E denies deductions, other than costs of sales, for any business found to trafficking in controlled substances.  Total Health Concepts, LLC, the entity in question, was an entity licensed by the state of Colorado to operate two medical marijuana dispensaries.  The IRS presumed the entity did just that in its business for the years in question.

During the examination in question the IRS issued a request for information about the nature of the entity’s business.  The taxpayers objected that the material in question was protected by their Fifth Amendment privilege and eventually took the matter to the Tenth Circuit, resulting in first decision from the Court (Feinberg v. Commissioner, 808 F.3d 813, 814 (10th Cir. 2015), which the Court refers to as Feinberg I in the current decision).

The current decision summarized the results in that case as follows:

We noted the tax court proceedings “took an especially curious turn” when the Commissioner sought to compel discovery because “[i]n tax court, after all, it's the petitioners who carry the burden of showing the IRS erred in denying their deductions — and by invoking the privilege and refusing to produce materials that might support their deductions the petitioners no doubt made their task just that much harder.” Id. We then denied the writ, concluding the Taxpayers' Fifth Amendment privilege could be protected by an appeal in the normal course. Id. at 816.

After the ruling in Feinberg I, the Commissioner abandoned the discovery request…

The IRS went to trial without having obtained the material relating to the nature of THC’s business.  THC did not produce any evidence of its own regarding the nature of its business in the trial.  The Tax Court ruled against the taxpayer, but not based on THC being involved in trafficking. 

Rather, the Tax Court ruled that the taxpayers had not substantiated the business expenses for which a deduction was claimed.  Both THC and the IRS agreed that the agency had never advanced the argument that THC had not substantiated deductions and that the deductions should not be disallowed on that basis.

Not surprising THC appealed the decision.  The IRS, while agreeing that the Tax Court’s decision itself was flawed, argued that the Tax Court had erred when it did not deny the deductions based on the IRS’s position that THC was trafficking in a controlled substance.  Thus, the IRS argued for the same result based on information already on the record.

The IRS pointed out that the taxpayers had not presented any evidence to overcome the presumption that the IRS had correctly categorized their business as trafficking in controlled substances.  Having not even attempted to meet their burden of proof on this issue, the taxpayers had presented no facts that could have reasonably led the Tax Court to determine they had met their burden to show the IRS position was in error.

The taxpayers argued that a series of Supreme Court cases supported their position that they should not be sanctioned for failing to produce information that could itself be incriminating.  As the Court of Appeals summarized the rulings “the Fifth Amendment privilege barred prosecution for failing to provide self-incriminating information.” But in this case the taxpayers were not being criminally prosecuted for failing to provide proof regarding their §280E status.

As the panel noted:

The Taxpayers fail 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. Here, 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 the cases cited by the Taxpayers, the petitioners were faced with a choice of whether to be prosecuted criminally because they did not provide the information, or to be prosecuted criminally because they did. The circumstances are easily distinguishable.

The panel notes that THC had been warned in Feinberg I about the potential consequences of refusing to produce evidence of the nature of their business in a tax case:

To be sure, “by invoking the privilege and refusing to produce the materials that might support their deductions the [Taxpayers] no doubt made their task [of proving the IRS erred in denying their deductions] that much harder.” Feinberg I, 808 F.3d at 815. But “a party who asserts the privilege against self-incrimination must bear the consequences of [the] lack of evidence.” United States v. Goodman, 527 F. App'x 697, 700 (10th Cir. 2013) (quotation marks omitted). Rylander teaches that the Taxpayers' possible failure of proof on an issue on which they bear the burden is not “compulsion” for purposes of the Fifth Amendment.

In a footnote at the very end of the opinion the Court summarizes the issues of taxation of state legal marijuana businesses:

The Taxpayers are understandably frustrated with the loss of their business expense deductions under § 280E. Despite operating in accordance with state law controlling the distribution of medical marijuana, the Taxpayers are subject to greater federal tax liability than other legitimate state businesses. But state legalization of marijuana cannot overcome federal law. See Hancock v. Train, 426 U.S. 167, 178 (1976) (“It is a seminal principle of our law 'that the [United States C]onstitution and the laws made in pursuance thereof are supreme; that they control the constitution and laws of the respective States, and cannot be controlled by them.'” (quoting McCulloch v. Maryland, Wheat. 316, 426 (1819))). Thus, the Taxpayers' remedy must come from Congressional change to § 280E or 21 U.S.C. § 812(c)(Schedule I) rather than from the courts.