151 T.C. No. 13
UNITED STATES TAX COURT
ALTERNATIVE HEALTH CARE ADVOCATES, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 16123-14, 30186-14, Filed December 20, 2018. 8813-15, 8850-15, 8852-15, 12321-15.
In these consolidated cases C, a corporation, operates a medical marijuana dispensary in California. Other Ps were individual shareholders of S, an S corporation that was organized to handle daily operations for C including paying employee wages and salaries. C deducted I.R.C. sec. 162 business expenses and later adjusted COGS to include indirect expenses per I.R.C. sec. 263A. R determined that both C’s and S’s sole trade or business was trafficking in a controlled substance and that I.R.C. sec. 280E precluded C’s and S’s deducting business expenses. In light of that determination, R further
1 Cases of the following petitioners are consolidated herewith: Donald Duncan a.k.a. Don D. Duncan a.k.a. Don Duncan, docket No. 30186-14; Jeremy S. Kwit, docket Nos. 8813-15 and 12321-15; and Grant Rozmarin, docket Nos. 8850- 15 and 8852-15. -2-
determined that Ps had underreported their flowthrough income from S. R also determined that C is not entitled to COGS in an amount greater than what R already allowed and that C is liable for I.R.C. sec. 6662(a) accuracy-related penalties.
Held: I.R.C. sec. 280E precludes C from deducting I.R.C. sec. 162 business expenses.
Held, further, I.R.C. sec. 280E precludes S from deducting I.R.C. sec. 162 business expenses.
Held, further, Ps underreported their flowthrough income from S.
Held, further, C is not entitled to a COGS greater than what respondent has allowed.
Held, further, C is liable for I.R.C. sec. 6662(a) accuracy- related penalties.
Henry G. Wykowski, Christopher J. Wood, and Matthew A. Williams, for
petitioners.
Audra M. Dineen and Ina Susan Weiner, for respondent.
PUGH, Judge: Respondent determined deficiencies, additions to tax, and
penalties as follows:2
2 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the years at issue. Rule (continued...) -3-
Alternative Health Care Advocates, docket No. 16123-14
Addition to tax Penalty Year Deficiency sec. 6651(a)(1) sec. 6662(a) 2009 $384,665 $38,447 $76,933 2010 367,316 91,829 73,463
Donald Duncan, docket No. 30186-14
Addition to tax Year Deficiency sec. 6651(a)(1) 2009 $245,151 $61,023 2010 247,891 37,062 2011 163,118 38,530 2012 308,174 46,175
2 (...continued) references are to the Tax Court Rules of Practice and Procedure. All monetary amounts are rounded to the nearest dollar. The notices of deficiency were sent on the following dates: Petitioner Alternative Health Care Advocates (Alternative) on April 14, 2014; petitioner Donald Duncan on October 8, 2014; petitioner Jeremy Kwit on Jan. 7, 2015, for the 2012 tax year and on April 6, 2015, for the 2011 tax year; and petitioner Grant Rozmarin on Jan. 7, 2015. -4-
Jeremy S. Kwit, docket Nos. 8813-15 and 12321-15
Additions to tax Sec. Sec. Penalty Year Deficiency 6651(a)(1) Sec. 6651(a)(2) 6654(a) sec. 6662(a) 2011 $7,920 $826 --- --- --- 2012 39,693 8,931 $4,168 $712 $7,939
Grant Rozmarin, docket Nos. 8850-15 and 8852-15
Additions to tax Sec. Sec. Penalty Year Deficiency 6651(a)(1) Sec. 6651(a)(2) 6654(a) sec. 6662(a) 2011 $10,213 $2,298 $1,685 $202 $2,043 2012 19,846 2,084 2,084 356 3,969 -5-
After concessions,3 the issues for decision are: (1) whether respondent
properly disallowed deductions for Alternative’s expenses pursuant to section
280E; (2) whether Mr. Duncan, Mr. Kwit, and Mr. Rozmarin underreported their
flowthrough income from their S corporation, Wellness Management Group, Inc.
(Wellness), because section 280E also applied to disallow Wellness’ deductions;
(3) whether Alternative is entitled to deduct cost of goods sold (COGS) in
amounts greater than those respondent allowed; and (4) whether Alternative is
liable for a section 6662(a) accuracy-related penalty for 2009 or 2010.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. Alternative was a
California corporation with its primary place of business in West Hollywood,
3 On December 6, 2016, the parties filed a Stipulation of Settled Issues in which the following concessions were made: (1) Alternative is liable for a sec. 6651(a)(1) addition to tax for its 2009 and 2010 taxable years to the extent there is an underpayment for each year; (2) Mr. Duncan is liable for a sec. 6651(a)(1) addition to tax for the taxable years 2009 through 2012 to the extent there is an underpayment for each year; (3) Mr. Kwit is liable for a sec. 6651(a)(1) addition to tax for the 2011 and 2012 taxable years to the extent there is an underpayment for each year; (4) Mr. Kwit is not liable for the sec. 6651(a)(2) addition to tax, adjustment for other taxes, sec. 6654(a) addition to tax, or the sec. 6662(a) accuracy-related penalty for the 2012 taxable year; (5) Mr. Rozmarin is liable for the sec. 6651(a)(1) addition to tax for the 2011 and 2012 taxable years and the sec. 6654(a) addition to tax for the 2011 and 2012 taxable years to the extent there is an underpayment for each tax year; and (6) Mr. Rozmarin is not liable for the sec. 6651(a)(2) addition to tax, adjustment for other taxes, or the sec. 6662(a) accuracy-related penalties for the 2011 and 2012 taxable years. -6-
California, when its petition was timely filed. Mr. Duncan and Mr. Rozmarin
resided in California, and Mr. Kwit resided in Oregon, when their petitions were
timely filed.
I. Background on Petitioners and Wellness
A. Donald Duncan
Mr. Duncan--a graduate of the University of North Texas and former
business student at Vista Community College--is a businessman and consultant
experienced in the formation and operation of medical marijuana dispensaries in
California.4 In 1999 Mr. Duncan founded Berkeley Patients Group, a medical
marijuana dispensary located in Berkeley, California. In 2006 Mr. Duncan
assisted with opening California Patients Group, a medical marijuana dispensary
in Los Angeles, and served as a consultant for medical marijuana facilities in Palm
Springs, Malibu, and other locations throughout California. Mr. Duncan’s
consulting activities included advising dispensary operators on best practices for
screening members, securing the facility, and ensuring proper screening of
4 The provision of medical marijuana to patients in the State of California is permitted by the Compassionate Use Act of 1996. See Cal. Health & Safety Code sec. 11362.5 (West 1996). Pursuant to California Senate Bill No. 420 (Medical Marijuana Program Act of 2003), individuals or groups are prohibited from cultivating or distributing marijuana for profit. See Cal. Health & Safety Code, sec. 11362.765; Canna Care, Inc. v. Commissioner, T.C. Memo. 2015-206, aff’d, 694 F. App’x 570 (9th Cir. 2017). -7-
medical marijuana. Mr. Duncan is also a cofounder and member of the board of
directors of Americans for Safe Access, a patient advocacy organization.
B. Alternative
While operating Berkeley Patients Group, Mr. Duncan and his colleagues
identified an opportunity for growth in a new market, observing that members of
Berkeley Patients Group were traveling long distances from southern California to
obtain medical marijuana. Therefore, in 2004 Mr. Duncan opened a second
location in Los Angeles, initially naming the new dispensary Los Angeles Patients
and Caregivers Group. In 2008 Mr. Duncan organized Alternative--a California
corporation5--to operate this medical marijuana dispensary. Alternative is a
California nonprofit mutual benefit corporation with members, rather than
shareholders, that is treated as a C corporation for Federal tax purposes.
Mr. Duncan served as Alternative’s president, and Richard Kearns served as
its secretary. Mr. Kwit was a patient-member of the dispensary and served as a
cultivator and consultant. Mr. Rozmarin served as a manager of the dispensary
5 Alternative originally was named LAPC [Los Angeles Patients & Caregivers] Foundations, Inc. On September 8, 2010, Amended and Restated Articles of Incorporation were filed with the California secretary of state, changing the name of the corporation to Alternative. -8-
and was responsible for handling administrative and staffing matters, performing
human resource functions, and procuring and processing marijuana.
C. Wellness
In 2008 Mr. Duncan also organized a second entity, Wellness--a California
corporation that elected S corporation status for Federal tax purposes--to handle
daily operations for Alternative.6 At the time Alternative was organized, Mr.
Duncan was uncertain what dispensaries could do legally under California State
law aside from growing and providing medical marijuana to patients. So Wellness
was organized to perform functions for the medical marijuana dispensary such as
hiring employees and paying expenses, including advertising, wages, and rent.
While Mr. Duncan anticipated that Wellness might offer its management and
operations services to other medical marijuana dispensaries, Wellness performed
services solely for Alternative during the tax years at issue.
Wellness was owned by four shareholders: Mr. Duncan owned 80%; Mr.
Kwit owned 10%; Mr. Rozmarin owned 5%; and Cori Escalante--a manager of the
dispensary--owned 5%. Wellness maintained an office separate from Alternative
6 Wellness originally was named Los Angeles Patients & Caregivers Group, Inc. On August 19, 2010, a Certificate of Amendment of Articles of Incorporation was filed with the California secretary of state, changing the name of the corporation to Wellness and listing Mr. Duncan as its president and Mr. Rozmarin as its secretary. -9-
but also used the dispensary’s address as a mailing address during the taxable
years at issue.
II. Operations of the Dispensary
During the taxable years at issue Alternative intended to distribute medical
marijuana to its patient-members in accordance with California law. The
dispensary employed (through Wellness) administrators, security personnel,
marijuana processors, salespersons, and receptionists. The following is a detailed
description of the dispensary’s business operations and processes.
A. Patient Intake Process
Upon patients’ arrival at Alternative’s dispensary, security personnel would
check their credentials, including proper identification and a doctor’s letter
recommending use of medical marijuana. Patients then entered the dispensary
facility and were greeted by a receptionist who would determine whether the
patients were current members of the collective or were new patients. New
patients were required to present their doctor’s letter and identification for
verification, and dispensary staff would call their doctor to verify the
recommendation. Dispensary staff also would check the California Department of
Consumer Affairs online directory to confirm that the doctor was licensed to
practice medicine in the State of California. Dispensary staff would conduct an - 10 -
intake interview to explain the rules of the facility and complete necessary
paperwork. Patient-members then were able to enter the sales floor of the
dispensary. Patient-members who purchased marijuana used cash or credit cards
and were charged sales tax on their purchases.
B. Acquisition of Marijuana
Pursuant to guidelines published by the California State attorney general in
August 2008, collective and cooperative associations engaged in acquiring and
distributing medical marijuana conducted their sales in a closed circuit.
Guidelines for the Security and Non-Diversion of Marijuana Grown for Medical
Use (August 2008). The closed-circuit process ensured that medical marijuana
was only purchased from or sold to members of the collective. Id. Alternative, in
compliance with these guidelines, acquired various forms of medical marijuana
from its patient-members. Alternative’s medical marijuana offerings included
hash, kief, cuttings (or clones), edibles, tinctures, and oils. Alternative also
offered forms of marijuana that could be applied topically.
Before acquiring the medical marijuana from a patient-member, a manager
of the dispensary conducted a quality inspection to ensure the overall appearance,
smell, and desirability of the product. Cash payments were issued to patient-
members upon successful completion of the inspection. - 11 -
C. Processing of Marijuana Products
Alternative acquired marijuana from its members in various preparations or
forms. Hash is a concentrated resin of the cannabis plant, and kief is a
nonconcentrated resin of the cannabis plant. A cutting, or clone, is the cannabis
plant itself that patient-members can take home, grow, and bring back to the
dispensary. Edible preparations are foods--typically made with oil and butter--that
contain marijuana. Tinctures, or alcohol tinctures, are a form of marijuana that can
be taken under the tongue. Finally, oils are extracted from the cannabis plant and
can be taken orally or smoked. The edibles, tinctures, oils, and forms of marijuana
meant for topical applications were purchased in a condition ready for resale, but
other products required some additional preparation and maintenance.
The dispensary employed (through Wellness) processors whose
responsibilities included preparing the acquired marijuana products for sale.
Marijuana was typically divided into quarter-pound increments for processing.
Processors would break up and package marijuana in smaller increments (typically
bags of one gram or 3-1/2 grams). In some instances processors were required to
dry marijuana that arrived damp, to prevent mold or mildew. Sometimes
processors would have to prepare cannabis flowers--the portion of the cannabis
plant used as medicine--for resale by trimming and removing undesirable leaves - 12 -
and stems from the cannabis plant. Additionally, dispensary employees were
responsible for maintaining the clones (live cannabis plants) in a humid
environment pending resale. Dispensary staff worked to ensure roots were kept
moist and monitored the clones daily for pest infestations.
Most of the dispensary’s floor space was used to acquire, process, or sell
marijuana. Similarly, employee time was spent mostly on acquiring, processing,
or selling marijuana. Security personnel spent 15% of their time processing
marijuana products and 75% of their time selling marijuana; receptionists
spent 10% of their time processing marijuana and 80% selling marijuana;7
customer service representatives spent 10% of their time processing marijuana and
80% of their time selling marijuana; processors spent all of their time processing
marijuana products; and managers spent 40% of their time acquiring marijuana
and 30% to 40% selling marijuana.
D. Sale of Nonmarijuana Items
While medical marijuana accounted for most of Alternative’s sales, it also
offered nonmarijuana items. Specifically, Alternative sold books, T-shirts and
7 At trial Susana de la Rionda--the general manager of the dispensary-- estimated that receptionists spent between 42% and 49% of their time on marijuana sales but otherwise estimated that most employee time was spent on marijuana-related activities. - 13 -
hats, rolling papers, pipes, grinders, incense, lighters, ashtrays, and cleaning
supplies for pipes and bongs. These items did not take up much floor space. Mr.
Duncan estimated the following percentage breakdown of employee time related
to the sale of nonmarijuana products: 10% for security personnel; 10% for
receptionists;8 10% for customer service representatives; and 15% for managers.
E. Finances
Alternative paid patient-members for the marijuana products that they
provided and made all sales tax payments. But Wellness paid Alternative’s other
expenses, such as advertising, wages, and rent, and was reimbursed by Alternative
for the expenses it paid. At times, however, those expenses were paid directly by
Alternative.
Alternative maintained two bank accounts with JP Morgan Chase Bank and
held a credit card machine merchant account and related deposit account with
Bank of America. Several bank accounts were held by Alternative (under its prior
name, Los Angeles Patients & Caregivers Group): credit card machine merchant
accounts with Bank of America, American Express, and Discover, and a bank
8 Ms. de la Rionda recalled at trial that receptionists spent between 21% and 28% of their time on the sale of nonmarijuana products. - 14 -
account with Wells Fargo.9 Mr. Duncan, Mr. Rozmarin, and Ms. Escalante each
were authorized signors on the Wells Fargo account. Wellness maintained bank
accounts with JP Morgan Chase and Wells Fargo.
Alternative and Wellness both used QuickBooks software to manage their
finances and shared the computer in which financial information was entered.10
Employees who were responsible for entering sales and expense information into
QuickBooks categorized certain entries as taxable or nontaxable and classified
certain products in a “hemp store” category. While the dispensary’s procedure
was to include marijuana products in the nontaxable sales category and
nonmarijuana products in the hemp store or taxable sales category, a change to its
bookkeeping procedure may have resulted in improper categorization. Sales
entries for marijuana and nonmarijuana products were combined into single entries
classified as “Donations” in QuickBooks; no distinction was made between the
two product categories on the dispensary’s financial records.
9 The Wells Fargo account was held in the name “Los Angeles Patients &.” 10 In 2010 the shared computer crashed, rendering inaccessible Alternative’s and Wellness’ QuickBooks data. Alternative and Wellness had several problems with the shared computer following the initial crash in 2010. Financial documents for Alternative and Wellness were reconstructed in preparation for respondent’s audit. - 15 -
III. Income Tax Returns
A. Alternative
Alternative filed Forms 1120, U.S. Corporation Income Tax Return, for the
2009 and 2010 taxable years. Alternative’s Forms 1120 were prepared by its
accountant, F. Michael Watson. Mr. Watson was referred to Mr. Duncan by an
individual who ran a medical marijuana dispensary in Los Angeles. Alternative
prepared financial statements for the taxable years at issue. Mr. Watson used only
Alternative’s financial statements to prepare the Forms 1120; Alternative did not
provide Mr. Watson with any other documents to complete its income tax returns.
Alternative’s 2009 Form 1120 lists “Medicine Sales” as its business
activity. Alternative reported $2,780,952 of gross receipts from the sale of
medical marijuana on its 2009 Form 1120. Alternative subtracted from gross
receipts $1,622,925 of COGS--an amount respondent allowed in its entirety.
Additionally, Alternative claimed deductions totaling $1,101,772 for 2009,
consisting of $700 of rent, $11,098 of taxes and licenses, $698 of depreciation,
$9,064 of advertising, and $1,080,212 of other deductions (including $896,975 for
contract services and $34,723 for outside services).
Alternative’s 2010 Form 1120 lists “Medicine Sales” as its business
activity. Alternative reported $2,803,521 of gross receipts from the sale of - 16 -
medical marijuana on its 2010 Form 1120. Alternative subtracted from gross
receipts $1,712,020 of COGS--an amount respondent allowed in its entirety.
Additionally, Alternative claimed deductions totaling $1,066,183 for 2010,
consisting of $2,816 of charitable contributions, $59 of advertising, and
$1,063,308 of other deductions (including $961,985 for contract services).
B. Wellness
Wellness filed Forms 1120S, U.S. Income Tax Return for an S Corporation,
for the 2009, 2010, 2011, and 2012 taxable years, listing “Management” as its
principal business activity. On its 2009 Form 1120S, Wellness reported gross
receipts of $922,936 and claimed deductions totaling $890,890.11 Wellness’
deductions consisted of $227,916 of compensation of officers, $318,534 of
salaries and wages, $64,713 of rent, $47,432 of taxes and licenses, $22,761 of
advertising, and $209,534 of other deductions.
On its 2010 Form 1120S, Wellness reported gross receipts of $961,985 and
claimed deductions totaling $911,791. Wellness’ deductions consisted of
$222,122 of compensation of officers, $343,552 of salaries and wages, $69,123 of
11 The parties did not explain why Alternative’s deductions for contract services and outside services did not equal Wellness’ gross receipts for 2009. - 17 -
rent, $48,322 of taxes and licenses, $15,422 of advertising, and $213,250 of other
deductions.
On its 2011 Form 1120S, Wellness reported $582,655 of gross receipts and
claimed deductions totaling $757,092. Wellness’ deductions consisted of
$222,122 of compensation of officers, $274,711 of salaries and wages, $1,583 of
repairs and maintenance, $95,025 of rent, $5,494 of taxes and licenses, $2,221 of
depreciation, $12,589 of advertising, and $143,347 of other deductions.
Finally, on its 2012 Form 1120S, Wellness reported $1,127,170 of gross
receipts and claimed deductions totaling $1,116,701. Wellness’ deductions
consisted of $524,727 of salaries and wages, $2,420 of repairs and maintenance,
$94,430 of rent, $209,128 of taxes and licenses, $15,882 of advertising, and
$270,114 of other deductions.
C. Donald Duncan
Mr. Duncan filed Forms 1040, U.S. Individual Income Tax Return, for the
2009, 2010, 2011, and 2012 taxable years. Mr. Duncan attached Schedules E,
Supplemental Income and Loss, to his Forms 1040 for the 2009 and 2010 taxable
years. Mr. Duncan reported $8,349 of nonpassive income related to his interest in
Wellness on his 2009 Schedule E. Additionally, Mr. Duncan reported $31,529 of
nonpassive income related to his interest in Wellness on his 2010 Schedule E. Mr. - 18 -
Duncan did not report Schedule E income or losses on either his 2011 or his 2012
Form 1040.
D. Jeremy Kwit
Mr. Kwit filed Forms 1040 for the 2011 and 2012 taxable years.12 Mr. Kwit
did not report any income or loss with respect to his interest in Wellness on his
2011 Form 1040. Mr. Kwit attached a Schedule E to his 2012 Form 1040,
reporting $1,739 of nonpassive income related to his interest in Wellness.
E. Grant Rozmarin
Mr. Rozmarin did not file Forms 1040 before the notices of deficiency were
issued to him for the 2011 and 2012 taxable years.
OPINION
I. Burden of Proof
The taxpayer generally has the burden of proving that the Commissioner’s
determinations in a notice of deficiency are incorrect. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). The burden of proof may shift from the
taxpayer to the Commissioner in certain circumstances under section 7491(a).
12 Mr. Kwit’s 2012 Form 1040 was filed after the notice of deficiency was issued for the 2012 taxable year. - 19 -
Petitioners have not claimed or shown that they meet the requirements of section
7491(a) to shift the burden of proof to respondent as to any relevant factual issue.
II. Deductions--Alternative
Deductions are a matter of legislative grace, and a taxpayer must prove its
entitlement to deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers
must maintain sufficient records to substantiate any deductions claimed. Sec.
6001.
Section 162(a) generally permits a taxpayer to deduct ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any
trade or business. Section 261, however, provides that “[i]n computing taxable
income, no deduction shall in any case be allowed in respect of the items specified
in this part.” “[T]his part” includes section 280E, Expenditures in Connection
With the Illegal Sale of Drugs. See Californians Helping to Alleviate Medical
Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173, 180 (2007). Section
280E provides:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) - 20 -
which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
Section 280E, therefore, bars the deduction of expenses by (1) a trade or business
that is (2) trafficking in (3) a controlled substance. See Canna Care, Inc. v.
Commissioner, T.C. Memo. 2015-206, at *8, aff’d, 694 F. App’x 570 (9th Cir.
2017). We address the existence of these elements in reverse order.
A. Controlled Substance
Petitioners acknowledge that marijuana is a controlled substance within the
meaning of schedules I and II of the Controlled Substances Act. See Controlled
Substances Act, Pub. L. No. 91-513, sec. 202, 84 Stat. at 1249 (1970) (codified as
amended at 21 U.S.C. sec. 812 (2012)). Marijuana is a schedule I controlled
substance in the context of section 280E even when the marijuana is medical
marijuana recommended by a physician. See, e.g., United States v. Oakland
Cannabis Buyers’ Coop., 532 U.S. 483 (2001); Olive v. Commissioner, 139 T.C.
19 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015); CHAMP, 128 T.C. at 181; Sundel
v. Commissioner, T.C. Memo. 1998-78, aff’d without published opinion, 201 F.3d
428 (1st Cir. 1999). We, therefore, find that the controlled substance element of
section 280E is satisfied. - 21 -
B. Trafficking
Section 280E does not define “trafficking” in controlled substances. In
CHAMP, 128 T.C. at 182, we defined “trafficking” as the act of engaging in a
commercial activity--that is, to buy and sell regularly. In Olive v. Commissioner,
139 T.C. at 38, we held that “dispensing * * * medical marijuana pursuant to * * *
[California law] was ‘trafficking’ within the meaning of section 280E.” In the
Controlled Substances Act, “[t]he term ‘dispense’ means to deliver a controlled
substance to an ultimate user”. 21 U.S.C. sec. 802(10); see id. sec. 841(a)(1)
(prohibiting the manufacture, distribution, dispensation, or possession of
marijuana).
Section 7208, which criminalizes certain offenses relating to stamps, is the
only section in the Internal Revenue Code that explicitly defines the term
“trafficking”. Section 7208(4)(B) defines “trafficking” as “[k]nowingly or
willfully buy[ing], sell[ing], offer[ing] for sale, or giv[ing] away * * * washed or
restored stamp[s] to any person for use”. While the Internal Revenue Code is
silent with respect to trafficking in controlled substances, congressional findings
and declarations on controlled substances, see 21 U.S.C. sec. 801(2), describe it as
“[t]he illegal importation, manufacture, distribution, and possession and improper
use of controlled substances”. Further, the Federal statute criminalizing - 22 -
trafficking in counterfeit goods or services provides that “the term ‘traffic’ means
to transport, transfer, or otherwise dispose of, to another, for purposes of
commercial advantage or private financial gain, or to make, import, export, obtain
control of, or possess, with intent to so transport, transfer, or otherwise dispose
of”. 18 U.S.C. sec. 2320(f)(5) (2012).
Petitioners do not dispute that Alternative was selling marijuana. While
petitioners acknowledge that marijuana is a controlled substance, they claim that
section 280E does not preclude dispensaries operating legally under State law
from deducting expenses related to the sale of medical marijuana. Petitioners
assert that section 280E should not apply because Alternative’s activities did not
“consist of” drug trafficking. Petitioners first argue that, under a plain reading of
the statute, “Alternative’s varied commercial activities place it squarely outside the
reach of [section] 280E.” Petitioners assert that because Alternative’s activities
did not consist solely of trafficking in medical marijuana, its expenses should be
deductible. Petitioners further argue that under a “purpose-based judicial
interpretation”, section 280E does not apply to Alternative because Congress
never intended that State-legal marijuana dispensaries be barred from deducting
business expenses. - 23 -
We have held previously that section 280E applies to medical marijuana
dispensaries even though they are operating in compliance with the laws of their
jurisdictions. See Patients Mutual Assistance Collective Corp. v. Commissioner
(Patients Mutual), 151 T.C. ___ (Nov. 29, 2018); Olive v. Commissioner, 139 T.C.
at 38; CHAMP, 128 T.C. at 182-183; Canna Care, Inc. v. Commissioner, T.C.
Memo. 2015-206. Further, in Olive v. Commissioner, 139 T.C. at 38, we
explicitly rejected the same arguments the taxpayers made in that case with respect
to the “consists of” language in section 280E:13
Petitioner argues that he may deduct the Vapor Room’s expenses notwithstanding section 280E because, he claims, the Vapor Room’s business did not consist of the illegal trafficking in a controlled substance. He argues that the illegal trafficking in controlled substances is the only activity covered by section 280E. We disagree that section 280E is that narrow and does not apply here. We therefore reject petitioner’s contention that section 280E does not apply here because the Vapor Room was a legitimate operation under California law. We have previously held that a California medical marijuana dispensary’s dispensing of medical marijuana pursuant to the CCUA was “trafficking” within the meaning of section 280E. That holding applies here with full force. [Citations omitted]
Our decision was affirmed by the Court of Appeals for the Ninth Circuit, to which
an appeal of these cases would lie. See Golsen v. Commissioner, 54 T.C. 742
(1970), aff’d, 445 F.2d 985 (10th Cir. 1971). The Court of Appeals concluded that
13 The taxpayer in Olive was represented by the same counsel representing petitioners in the present case. - 24 -
the taxpayer’s only “business” was selling medical marijuana because the
caregiving services were not a separate business. Olive v. Commissioner, 792
F.3d at 1149-1150. In response to the taxpayer’s arguments related to
congressional intent and public policy, the court concluded that “[i]f Congress
now thinks that the policy embodied in * * * [section] 280E is unwise as applied
to medical marijuana sold in conformance with state law, it can change the statute.
We may not.” Id. at 1150. Petitioners fail to distinguish these cases from Olive.
We, therefore, find that Alternative was engaged in “trafficking” in a
controlled substance within the meaning of section 280E.
C. Trade or Business
Petitioners do not dispute that Alternative is in the trade or business of
selling marijuana but argue that Alternative also operates a separate trade or
business consisting of the sale of nonmarijuana items. Petitioners assert that
Alternative is entitled to allocate its expenses between its “trafficking” and “non-
trafficking” businesses.
For an activity to qualify as a trade or business for purposes of the Internal
Revenue Code, “the taxpayer must be involved in the activity with continuity and
regularity and * * * the taxpayer’s primary purpose for engaging in the activity
must be for income or profit.” Commissioner v. Groetzinger, 480 U.S. 23, 35 - 25 -
(1987). A single taxpayer can have more than one trade or business, and multiple
activities may nevertheless constitute a single trade or business. Patients Mutual,
151 T.C. at ___ (slip op. at 37). Compare CHAMP, 128 T.C. at 183 (holding that
the taxpayer--which operated a community center for members with debilitating
diseases and charged a membership fee that covered only a fixed amount of
marijuana--was engaged in two separate trades or businesses and, therefore, was
entitled to an allocation of expenses), with Olive v. Commissioner, 139 T.C. at 39-
42 (holding that the taxpayer--which operated a community-center whose sole
source of revenue was from the sale of marijuana--had a single trade or business
and was precluded from deducting expenses pursuant to section 280E), and Canna
Care v. Commissioner, at *12-*13 (holding that--where the taxpayer was in the
business of distributing medical marijuana and its only other source of income was
its sale of books, T-shirts, and other nonmarijuana items--the sale of nonmarijuana
items “was an activity incident to” the taxpayer’s sole business of selling
marijuana and the taxpayer was precluded from deducting expenses pursuant to
section 280E). Further, the activities of separate entities can be treated as a single
trade or business if they are part of a “unified business enterprise” with a single
profit motive. Patients Mutual, 151 T.C. at ___ (slip op. at 37) (quoting Morton v.
United States, 98 Fed. Cl. 596, 600 (2011)). - 26 -
Petitioners direct us to two methods by which we can allocate expenses
between trafficking and nontrafficking activities: the percentage of employee time
dedicated to each activity and the percentage of floor space devoted to each
activity. Petitioners cite the trial testimony of Mr. Duncan and Ms. de la Rionda to
support their proposed allocation methods.
The percentages Mr. Duncan assigned at trial to marijuana and
nonmarijuana activities seemed improvised, but the import of his testimony and
that of Ms. de la Rionda is that Alternative’s primary activity was operating a
marijuana dispensary and the nonmarijuana activities were only ancillary--not
occupying much time or space. Their allocation of floor space and employee
activities both show that the receipt and sale of marijuana was the dominant
activity and that the sale of nonmarijuana products had “a close and inseparable
organizational and economic relationship” with--and was “incident to”--
Alternative’s primary business of selling marijuana. Patients Mutual, 151 T.C. at
___ (slip op. at 41-42) (quoting Olive v. Commissioner, 139 T.C. at 41).
We, therefore, hold that pursuant to section 280E Alternative is not entitled
to its claimed deductions for the taxable years at issue. - 27 -
III. Deductions--Wellness
We next must determine whether Mr. Duncan, Mr. Kwit, and Mr. Rozmarin
had unreported income with respect to their ownership interests in Wellness.
Section 1366(a)(1) provides that shareholders of an S corporation shall take
into account their pro rata shares of the S corporation’s income, loss, deductions,
and credits for the S corporation’s taxable year ending with or in the shareholder’s
taxable year. See CNT Inv’rs, LLC v. Commissioner, 144 T.C. 161, 178 n.23
(2015). An S corporation’s shareholders must take into account the S
corporation’s income regardless of whether any income is distributed. See Enis v.
Commissioner, T.C. Memo. 2017-222, at *15; Dunne v. Commissioner, T.C.
Memo. 2008-63, at *20; Chen v. Commissioner, T.C. Memo. 2006-160, at *14.
Therefore, as shareholders of Wellness--an S corporation during the taxable years
at issue--Mr. Duncan, Mr. Kwit, and Mr. Rozmarin each must include his pro rata
shares of Wellness’ income, loss, deductions, and credits on their income tax
returns.
Petitioners argue that in computing Mr. Duncan, Mr. Kwit, and Mr.
Rozmarin’s pro rata shares of Wellness’ income, respondent wrongly applied
section 280E to disallow Wellness’ claimed deductions. Specifically, petitioners
argue that because Wellness is a management company that does not engage in the - 28 -
sale and purchase of marijuana, section 280E does not apply. Petitioners cite
Davis v. Commissioner, 29 T.C. 878 (1958), and Roselle v. Commissioner, T.C.
Memo. 1981-394, to support their argument that a management services company
can engage in a separate line of business from the entity it manages.
Because Alternative and Wellness are legally separate entities, we must
analyze whether Wellness’ own business activities also constituted “trafficking in
controlled substances” as contemplated by section 280E. Petitioners argue that, as
a management services company, Wellness did not itself engage in the purchase
and sale of marijuana. But the only difference between what Alternative did and
what Wellness did (since Alternative acted only through Wellness) is that
Alternative had title to the marijuana and Wellness did not. Wellness employees
were directly involved in the provision of medical marijuana to the patient-
members of Alternative’s dispensary. While Wellness and Alternative were
legally separate, Wellness employees were engaged in the purchase and sale of
marijuana (albeit on behalf of Alternative); that was Wellness’ primary business.
We do not read the term “trafficking” to require Wellness to have had title to the
marijuana its employees were purchasing and selling. Neither that section nor the
nontax statute on trafficking limits application to sales on one’s own behalf rather - 29 -
than on behalf of another. Without clear authority, we will not read such a
limitation into these provisions.
We, therefore, hold that Wellness was engaged in the business of
“trafficking in controlled substances” during the taxable years at issue. And, to
the extent Wellness engaged in nontrafficking activities, the record before us does
not allow us to allocate expenses between marijuana-related and non-marijuana-
related activities.
Petitioners also argue that applying section 280E to both Alternative and
Wellness is inequitable because deductions for the same activities would be
disallowed twice. These tax consequences are a direct result of the organizational
structure petitioners employed, and petitioners have identified no legal basis for
remedy.
We, therefore, hold that Mr. Duncan, Mr. Kwit, and Mr. Rozmarin each
have additional taxable income from Wellness resulting from the denial of
deductions pursuant to section 280E.
IV. Cost of Goods Sold
Next, we must determine whether Alternative is entitled to a COGS amount
greater than respondent allowed for the taxable years at issue. - 30 -
A taxpayer engaged in manufacturing or merchandising can subtract COGS
from gross receipts to arrive at gross income. See secs. 1.61-3(a), 1.162-1(a),
Income Tax Regs.; see also Feinberg v. Commissioner, T.C. Memo. 2017-211, at
*10; Rodriguez v. Commissioner, T.C. Memo. 2009-22, 2009 WL 211430, at *3.
COGS is not a deduction but an offset to gross receipts for the purpose of
calculating gross income. See Feinberg v. Commissioner, at *11; Kazhukauskas
v. Commissioner, T.C. Memo. 2012-191, 2012 WL 2848694, at *9. A taxpayer is
required to maintain sufficient reliable records to allow the Commissioner to
verify the taxpayer’s income and expenditures. See sec. 6001; Olive v.
Commissioner, 139 T.C. at 33. COGS is generally determined under section 471
and the accompanying regulations. See secs. 1.471-3, 1.471-11, Income Tax
Regs. Producers must include in COGS both the direct and indirect costs of
creating their inventory. See secs. 1.471-3(c), 1.471-11, Income Tax Regs.
Section 471 and its regulations also direct taxpayers to section 263A for additional
rules. That section instructs both producers and resellers to include “indirect”
inventory costs in COGS. Sec. 263A(a)(2)(B), (b); sec. 1.263A-1(a)(3), (c)(1), (e),
Income Tax Regs. It also broadens the definition of indirect costs for both types
of taxpayers. Compare sec. 1.263A-1(e)(3), Income Tax Regs., with sec. 1.471-
11, Income Tax Regs. - 31 -
Petitioners first argue that, under section 263A, Alternative is entitled to
include both direct and indirect costs of its inventory in computing COGS.
Petitioners do not specify what additional expenses should be allowed beyond the
COGS offsets that respondent already allowed; rather they ask the Court to
consider Mr. Duncan’s testimony regarding the square footage of the dispensary
and a general overhead estimate as well as Ms. de la Rionda’s estimates regarding
employee time and related costs.
Section 263A puts into COGS only expenses otherwise deductible. See
Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, sec.
1008(b)(1), 102 Stat. at 3437 (“Any cost which (but for this subsection) could not
be taken into account in computing taxable income for any taxable year shall not
be treated as a cost described in this paragraph.”). Here, the expenses petitioners
have reported are not deductible. Petitioners are correct that Congress cannot take
away COGS, but that is not what section 263A does. It adds otherwise deductible
expenses to COGS. Because by operation of section 280E these indirect expenses
are not deductible, they cannot be added to COGS. Patients Mutual, 151 T.C. at
___ (slip op. at 19).
Petitioners further argue that Alternative is a “producer” for purposes of
sections 263A and 471 and is therefore entitled to include its “production” costs in - 32 -
inventory. We find that Alternative is not a “producer” for purposes of section
263A or 471. Under section 263A and its accompanying regulations, “[t]he term
‘produce’ includes construct, build, install, manufacture, develop, * * * improve”,
“create, raise, or grow.” Sec. 263A(g)(1); sec. 1.263A-2(a)(1), Income Tax Regs.
Under the section 471 regulations, “[c]osts are considered to be production costs
to the extent that they are incident to and necessary for production or
manufacturing operations or processes.” Sec. 1.471-11(b)(1), Income Tax Regs.
Petitioners have not shown that Alternative was a “producer” of the
marijuana products it purchased from its patient-members. Certain of
Alternative’s product offerings required some additional preparation and
maintenance. But we are unable to conclude that the dispensary grew, created, or
improved its marijuana products to the extent required by section 263A or 471
when the only evidence before us is that the dispensary inspected, packaged,
trimmed, dried, and maintained the stock. Patients Mutual, 151 T.C. at ___ (slip
op. at 60-62). Further, even were we to allow Alternative to include such costs,
petitioners have not offered a reasonable basis upon which to compute the
additional amounts of COGS.
We also reject Alternative’s argument that, under Suzy’s Zoo v.
Commissioner, 114 T.C. 1 (2000), aff’d, 273 F.3d 875 (9th Cir. 2001), it was a - 33 -
“producer” as it was the owner of the marijuana produced by its patient-members.
A taxpayer is considered a “producer” if it is an owner of the property produced
under Federal income tax principles. Sec. 1.263A-2(a)(1)(ii)(A), Income Tax
Regs. An ownership determination is made on the basis of “all of the facts and
circumstances, including the various benefits and burdens of ownership vested
with the taxpayer.” Id. Mr. Duncan testified that the dispensary had oral
agreements with its patient-members to grow the marijuana and create marijuana
products. But no other evidence supports petitioners’ claim that Alternative
owned the marijuana products produced by its patient-members until Alternative
paid them for their products. Further, even if patient-members had to sell to
Alternative, employees had complete discretion over whether to purchase the
marijuana products from the patient-members and compensated the patient-
members only if their marijuana was purchased. See Patients Mutual, 151 T.C. at
___ (slip op. at 62).
Petitioners have not established that Alternative’s relationship with its
patient-members was the type of contract-manufacturing arrangement the Court of
Appeals recognized in Suzy’s Zoo v. Commissioner, 273 F.3d at 877. We
conclude instead that Alternative was a reseller of the marijuana products it
purchased. - 34 -
We, therefore, hold that petitioners are limited to the COGS respondent has
already allowed for the taxable years at issue.
V. Section 6662(a) Penalty14
Finally, we must determine whether Alternative is liable for the section
6662(a) accuracy-related penalty for the 2009 and 2010 taxable years. Section
6662(a) and (b)(1) and (2) imposes a penalty equal to 20% of the portion of an
underpayment of tax required to be shown on the return that is attributable to
“negligence or disregard of rules or regulations” and/or a “substantial
understatement of income tax.” Negligence includes “any failure to make a
reasonable attempt to comply with the provisions of this title”. Sec. 6662(c). We
have defined negligence as the failure to exercise due care or the failure to do what
a reasonable person would do under the circumstances. See Allen v.
Commissioner, 92 T.C. 1, 12 (1989), aff’d, 925 F.2d 348 (9th Cir. 1991); Neely v.
Commissioner, 85 T.C. 934, 947 (1985). With respect to corporations, an
understatement of income tax is “substantial” if it exceeds the greater of 10% of
14 As we have stated above, Mr. Duncan, Mr. Kwit, and Mr. Rozmarin have conceded their liability for additions to tax to the extent we find that underpayments exist for the relevant taxable years. As we have determined that petitioners underreported their income with respect to their ownership interests in Wellness, Mr. Duncan, Mr. Kwit, and Mr. Rozmarin are liable for these additions to tax. - 35 -
the tax required to be shown on the return or $10,000 (or if it exceeds
$10,000,000). Sec. 6662(d)(1).
An understatement may be reduced if the taxpayer had substantial authority
for its return position. Sec. 6662(d)(2)(B); see Campbell v. Commissioner, 134
T.C. 20, 30 (2010), aff’d, 658 F.3d 1255 (11th Cir. 2011); sec. 1.6662-4(a),
Income Tax Regs. “Substantial authority is an objective standard based on an
analysis of the law and its application to the relevant facts.” See Campbell v.
Commissioner, 134 T.C. at 30 (citing Myers v. Commissioner, T.C. Memo. 1994-
529). And substantial authority exists only if the weight of the authorities
supporting the return position is substantial in relation to the weight of authorities
supporting contrary treatment. See id. (citing O’Malley v. Commissioner, T.C.
Memo. 2007-79).
An understatement also may be reduced if the taxpayer adequately disclosed
the position and had a reasonable basis for the position. Sec. 6662(d)(2)(B); see
Campbell v. Commissioner, 134 T.C. at 30; sec. 1.6662-4(a), Income Tax Regs.
Disclosure generally must be made on Form 8275, Disclosure Statement, unless
otherwise permitted by an applicable revenue procedure. Sec. 1.6662-4(f), Income
Tax Regs.; see Campbell v. Commissioner, 134 T.C. at 31. And reasonable basis
is a relatively high standard of reporting; taxpayers must have a position that is - 36 -
more than merely arguable. Sec. 1.6662-3(b)(3), Income Tax Regs.; see Campbell
v. Commissioner, 134 T.C. at 31.
Petitioners did not argue that Alternative had substantial authority for its
position or that they disclosed the section 280E issue and had a reasonable basis.
Respondent, therefore, asserts that petitioners waived this argument. We agree
and hold that Alternative had substantial understatements of income tax for the
years at issue.15
A taxpayer may avoid a section 6662(a) penalty if it can show reasonable
cause for the resulting underpayment and that it acted in good faith. Sec. 6664(c).
The decision as to whether a taxpayer acted with reasonable cause and in good
faith is made on a case-by-case basis, taking into account all pertinent facts and
circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs. Generally, the most
15 The burden of production as to the penalty remains on Alternative because sec. 7491(c) does not apply to corporations. See NT, Inc. v. Commissioner, 126 T.C. 191, 195 (2006). In addition, in Dynamo Holdings Ltd. P’ship v. Commissioner, 150 T.C. ___, ___ (slip op. at 13) (May 7, 2018), we held that the Commissioner does not have the burden of production as to supervisory approval under sec. 6751(b) for a penalty determined against a corporation in a notice of deficiency. Respondent has filed a motion to reopen the record and admit evidence pertaining to his compliance with sec. 6751(b)(1) here. As we held in Dynamo that the Commissioner has no burden of production with respect to sec. 6751(b), and Alternative did not argue that respondent failed to comply with that provision, we will deny as moot respondent’s motion to reopen the record. - 37 -
important factor is the extent of the taxpayer’s efforts to assess the proper tax
liability. Id.; see Halby v. Commissioner, T.C. Memo. 2009-204. Reliance on
professional advice may constitute reasonable cause and good faith if the taxpayer
proves, by a preponderance of the evidence, that it “meets each requirement of the
following three-prong test: (1) [t]he advisor was a competent professional who
had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and
accurate information to the advisor, and (3) the taxpayer actually relied in good
faith on the adviser’s judgment.” Neonatology Assocs., P.A. v. Commissioner,
115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); see Hudson v.
Commissioner, T.C. Memo. 2017-221.
Petitioners argue that, given the unsettled caselaw and confusion
surrounding section 280E (in their view) at the time the tax returns were prepared
and filed, it would be unfair to impose an accuracy-related penalty. Petitioners
note that during the years at issue, the only relevant case was CHAMP, and that
the Court in CHAMP allowed the taxpayer to deduct a large percentage of its
expenses despite its provision of medical marijuana. As we outlined above, the
factual circumstances that enabled the Court in CHAMP to allocate expenses
between the taxpayer’s businesses are absent from the case before us. The only
directly relevant authority available was directly against petitioners’ tax treatment. - 38 -
Alternative failed to state anywhere on its returns that it was involved in the
distribution of marijuana or that section 280E was at issue in any way. Alternative
stated on its return only that its business activity was “Medicine Sales”. And
Alternative offered insufficient evidence that it sought advice regarding proper tax
treatment for its transactions. While Alternative hired an accountant believed to
have experience with marijuana dispensaries, Alternative provided no evidence
that it relied on the accountant for advice on whether section 280E applied.
Indeed, the record shows that Alternative only provided its accountant financial
statements to prepare its returns. And merely hiring a professional to prepare an
income tax return--without giving him necessary information or relying on his
advice--does not absolve a taxpayer from liability of a penalty. See, e.g., Povolny
Grp., Inc. v. Commissioner, T.C. Memo. 2018-37, at *27-*28; Bronson v.
Commissioner, T.C. Memo. 2012-17, 2012 WL 129803, at *12-*13, aff’d, 591 F.
App’x 625 (9th Cir. 2015).
We, therefore, hold that Alternative is liable for the section 6662(a)
accuracy-related penalty for the taxable years at issue.
We have considered all of the arguments made by the parties and, to the
extent they are not addressed above, we find them to be moot, irrelevant, or
without merit. - 39 -
To reflect the foregoing,
An appropriate order will be issued,
and decisions will be entered under Rule
155.