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.

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Simplified Inventory Election for Small Businesses May Be a Tax Disaster for Marijuana Businesses

An interesting article appeared in Tax Notes Today on February 1, 2019 that raised a question regarding whether a business that is deemed to be trafficking in a federally controlled substance might significantly increase its federal tax if it makes the election added by the Tax Cuts and Jobs Act to escape the provisions of IRC §471(a) and account for its inventory either:

  • By accounting for such inventory as non-incidental materials and supplies pursuant to Reg. §1.162-3, or

  • Conforms to such taxpayer’s method of accounting reflected in an applicable financial statement of the taxpayer with respect to such taxable year or, if the taxpayer does not have any applicable financial statement with respect to such taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.

This election is open to businesses that have average annual gross receipts of $25 million or less for the prior three years (adjusted for inflation) and which is not a tax shelter as defined by IRC §448(a)(3)..

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S Corporation Providing Management Services to Marijuana Dispensary Found to Be Trafficking in Controlled Substances for §280E Purposes

A business does not have to have title to marijuana to be engaged in trafficking in controlled substances, triggering the denial of deductions under IRC §280E, the Tax Court ruled in Alternative Health Care Advocates et al. v. Commissioner, 151 TC No. 13.

IRC §280E bars deductions, other than those for the cost of sales, to businesses that traffic in items considered controlled substances by federal law.  The fact that certain states have legalized the sale of marijuana in some situations does not change that federal tax result.

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Business Consisted Solely of Selling Controlled Substances, No Deductions Other Than Cost of Sales Allowed

As marijuana has become, at the state level in certain states, legal to sell in some form (medical or recreational) those looking to enter that market find that federal law does not condone this business.  In addition to still being treated as an illegal substance under federal law, the Internal Code has a nasty treatment for any such business found at IRC §280E.  The taxpayer in the case of Alterman v. Commissioner, TC Memo 2018-83, discovered just how harsh the federal tax law is in this area.

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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.

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Court Finds IRS Allowed to Enforce Summons to Obtain Information from State of Colorado to Show Business Sold Controlled Substances

A taxpayer seeking to quash a summons from the IRS to the Colorado Department of Revenue’s Marijuana Enforcement Division failed to obtain the requested relief in the case of Rifle Remedies, LLC v. United States, USDC Colorado, Case No. No. 1:17-mc-00062.

The taxpayer had claimed that this subpoena was “really” a front for conducting a criminal investigation into the taxpayer’s marijuana business and, if the court didn’t accept that objection, the taxpayer had a series of other objections. 

Image copyright vikayatskina / 123RF Stock Photo

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Cost of Marijuana Seized by DEA Not Deductible as Cost of Sale

The marijuana cases continue in the Tax Court as a consequence of various state laws allowing for state (though not federal) legal sales of marijuana.  In the case of Beck v. Comissioner, TC Memo 2015-149 another unique issue for such operations was addressed.

IRC §280E generally does allow deductions, aside from cost of sales, for a taxpayer selling a federally controlled substance such as marijuana, even if the that sale is deemed to be legal under state law.  In this case, one key issue was what was considered a cost of sale.

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Washington Excise Tax on Marijuana Sales a Reduction in Sales Proceeds and Therefore Not a Deduction Blocked by IRC §280E

With the increasing number of states enacting statutes that authorize legal marijuana sales in various circumstances, the provisions of IRC §280E are becoming an increasingly frequent topic in both court cases and IRS guidance.  Chief Counsel Advice 201531016 looks at the impact of an excise tax imposed by the state of Washington on sales of marijuana on federal taxes.

Under IRC §280E no deductions or credits (aside from cost of sales) are allowed to taxpayers trafficking in federally controlled substances, of which marijuana is one.  That is true regardless of whether the sale of such a substance is deemed legal in the state in question.

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Medical Marijuana Facility Found Not to Have Other Business, All General Expenses Disallowed Under §280E

The taxation of medical marijuana clinics came back into the Tax Court in the case of Olive v. Commissioner, 139 TC No. 2, later appealed to the Ninth Circuit who affirmed the lower court.  In this case, in addition to reminding us of the Tax Court’s previous holding that IRC §280E holds to prevent the deduction of expenses other than costs of sales related to the operation of such a clinic (a position the Court put forward in the 2007 case of Californians Helping to Alleviate Med. Problems, Inc., 128 TC 173), the Court dealt with some additional items.

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