Freeman Law’s “Tax Court Brief” covers all of the Tax Court’s substantive opinions, providing a weekly summary of its decisions in clear, concise prose.
Tax litigation: The week of February 28, 2022 to March 4, 2022
- Corning Place Ohio, LLC v. Comm’r, TC Memo. 2022-12 | February 28, 2022| Lauber, J. | Dekt. No. 12428-20
- Clary Hood, Inc. v. Comm’r, TC Memo. 2022-15 | March 2, 2022 | Greaves, J. | Dekt. No. 3362-19
- Lewis v. Comm’r, 158 TC No. 3 | March 1, 2022 | Pugh, J. | Dekt. No. 12930-18
Lord v. Comm’r, TC Memo. 2022-14 | March 4, 2022 | Kerrigan, J. | Dekt. No. 19224-18
Short summary: In 2012, Mr. Lord held interests in a limited liability company and an S corporation, both of which were formed in the state of Colorado and both licensed by that state to grow, process and distribute medical marijuana. The companies did not have audited financial statements for 2012 and were not otherwise required to maintain books and records or financial reports in accordance with US generally accepted accounting principles (“GAAP”). The companies calculated the depreciation included in their cost of goods sold (“COGS”) for the year using the accelerated cost recovery method in section 168(a), and they claimed additional depreciation under of section 168(k). The companies used methods under Section 168(a) and (k) that were not in accordance with GAAP.
Mr. and Mrs. Lord (“Claimants”) timely filed a joint Form 1040 for 2012. In a Notice of Deficiency for that year, the Commissioner determined adjustments to capital cost allowances that the companies had claimed. The adjustments reflected the Commissioner’s position that Section 263A should not have been invoked for the calculation of inventory and the determination of COGS.
- The text flush with section 263A(a)(2), which provides that costs which could not be taken into account in the calculation of taxable income could not be included in inventory costs, does not apply only to personal costs?
- Does the denial of accelerated depreciation and bonus create an unconstitutional tax on gross receipts rather than gross income?
- Is Section 280E unconstitutional because Congress did not describe it as an excise tax?
- Is Section 280E unconstitutional under the Fifth Amendment?
- Was the Commissioner’s decision to change the method of accounting for the inventories of the petitioners’ businesses arbitrary and capricious and without solid basis in fact or law?
- No, the full text of Section 263A(a)(2) does not only apply to personal expenses, but also includes business expenses. The ordinary meaning of the word “expenses” is not limited to personal expenses.
- No, the denial of accelerated depreciation and premium does not create an unconstitutional tax on gross receipts. Depreciation is an indirect cost of production and businesses are not permitted by constitution or law to deduct depreciation from production assets.
- No, any failure by Congress to describe Section 280E as an excise tax does not render that section unconstitutional, because the terms Congress uses to describe the abuses have no bearing on whether the taxes themselves are constitutional.
- No, Section 280E does not violate the Fifth Amendment because the illegality of an activity does not prevent its taxation.
- No, the Commissioner’s decision to change the method of accounting for inventories of the Applicants’ businesses was neither arbitrary nor capricious and without solid basis in fact or law. The plaintiffs specified that the companies’ method of accounting for inventory was not in accordance with GAAP and provided no evidence that this method was in accordance with the best method of accounting for their trade or business. Further, the petitioners could not rely on an amortization method described in Section 168 because Section 280E made such a method unavailable.
Main points of law
- The Commissioner’s determinations in a deficiency notice are generally presumed to be correct, and the taxpayer bears the burden of proving that these determinations are wrong. Tax Court Rule 142(a)(1); Welch versus Helvering290 US 111, 115 (1933).
- Under section 162(a), a taxpayer may generally deduct from gross income ordinary and necessary expenses paid or incurred during the tax year in the course of carrying on a trade or business. IRC § 162(a).
- However, Article 261 provides that “[i]In computing taxable income, no deduction is permitted in respect of items specified in this Part”—including Section 280E. To see Californians Helping Relieve Med. Probs., Inc. v. Comm’r128 TC 173, 180 (2007) (hereinafter, “CHAMPION”).
- Section 280E prohibits taxpayers from deducting expenses related to a business that involves trafficking in controlled substances. To see Olive c. Comm’r139 CT 19, 29 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015). Section 280E only applies to business expense deductions and does not prevent businesses from accounting for their COGS. CHAMPION128 TC to 178 n.4.
- Medical marijuana is a controlled substance. at 180-181; see also Gonzales v. Raich545 US 1 (2005); United States vs. Oakland Cannabis Buyers’ Coop.532 US 483 (2001).
- Although the distribution of medical marijuana is legal in Colorado, it is illegal under federal law, and Congress has defined illegality under federal law as one of the triggers for enforcement. section 280E. View Olive139 CT at 39.
- COGS is not a deduction under section 162(a), but is subtracted from gross receipts to determine a taxpayer’s gross income. See Max Sobel Wholesale Liquors c. Comm’r69 TC 477 (1977), aff’d, 630 F.2d 670 (9th Cir. 1980); Treasures. Reg. § 1.162-1(a).
- COGS is the cost of acquiring inventory, including by production. Mut patients. Assistance Collective Corp. vs. Com’r, 151 CT 176, 205 (2018), aff’d995 F.3d 671 (9th Cir. 2021); Reading vs. Comm’r70 TC 730, 733 (1978), aff’d, 614 F.2d 159 (8th Cir. 1980). COGS is generally determined under Section 471 and its regulations, and producers are required to include in COGS the direct and indirect costs of creating their inventory. To see Reg. §§ 1.471-3(c), 1.471-11.
- Section 471 and its accompanying regulations direct taxpayers to Section 263A for additional rules. Section 263A requires producers and dealers to include “indirect” inventory costs in the cost of their inventory. See § 263A(a)(2)(B), (b); Treasures. Reg. § 1.263A-1(a)(3), (c)(1), (e). Indirect costs are broadly defined as all costs other than direct material costs and direct labor costs (for producers) and acquisition costs (for dealers). Treasures. Reg. § 1.263A-1(e)(3). Depreciation of production assets is an indirect cost. To see Reg. § 1.471-11(c)(2).
- However, the flush text of section 263A(a)(2) provides: that “[a]any cost which (but for this subsection) could not be taken into account in computing taxable income for a taxation year will not be treated as a cost described in this paragraph. »
- The deductions disallowed by Section 280E are costs prohibited by the outcropping text of Section 263A(a)(2). Mut patients.151 TC at 209–10.
- Since section 263A(2)(a) does not define “cost”, the word has its ordinary meaning: “the amount or equivalent paid or charged for something”. Cost, Webster’s New Collegiate Dictionary 255 (1980).
- Gross revenue is generally gross receipts less COGS. Reg. § 1.61-3(a). Other deductions from gross receipts are permitted at the discretion of Congress. Helvering c. Indep. Life Ins. Co.292 US 371, 381 (1934).
- The terms Congress uses to describe the abuses have no bearing on whether the taxes themselves are constitutional. See Nat’l Fed’n of Indep. Bus. v.Sebelius, 567 US 519, 564–65 (2012).
- “The illegality of an activity does not prevent its taxation.” Alpenglow Botanicals, LLC we894 F.3d 1187, 1197 (10th Cir. 2018) (citing Marchetti v USA390 US 39, 44 (1968)).
- A taxpayer who challenges the Commissioner’s decision to change an accounting policy must show that the decision was “arbitrary and capricious and without solid basis in fact or law”. Ford Motor Co. v. Comm’r102 TC 87, 92 (1994), aff’d71 F.3d 209 (6th Cir. 1995).
- Section 471 requires that a method of accounting for inventory: (1) conform as closely as possible to the best accounting practices of the trade or enterprise and (2) clearly reflect revenue. Treasures. Reg. § 1.471-2. “Best Accounting Practices” is synonymous with GAAP, and GAAP methods satisfy the first prong of Section 471. Thor Power Tool Co. v. Comm’r, 439 U.S. 522, 532 (1979). Generally, an accounting policy will be considered to clearly reflect income if it has been applied consistently and is in accordance with GAAP. Reg. § 1.446-1(a)(2)
- The Commissioner can change a taxpayer’s accounting method if it does not clearly reflect income. RC § 446(b).
- If a taxpayer consistently applies a method of accounting that is explicitly provided to him by the Internal Revenue Code or the Treasury Regulations, the Commissioner cannot conclude that the method does not clearly reflect income and thereby change the taxpayer’s method of accounting. Orange & Rockland Utils., Inc. v. Comm’r86 TC 199, 215 (1986).
- Capital cost allowances are not available to taxpayers to whom Section 280E applies. San Jose Wellness vs. Comm’r, 156 CT 62, 67-68 (2021); Cal. Small bus. Assistants Inc. c. Comm’r153 CT 65, 73 (2019).
- Lack of congressional action, changes in public opinion, and the legalization of marijuana do not change the applicability of Section 280E. olive792 F.3d at 1150.
Knowledge: This case illustrates the ongoing difficulties that state-sanctioned marijuana businesses face in achieving a level playing field with other types of businesses under federal income tax, as well as the continued resistance of the Tax Court to entertain the purposes of running around Section 280E in the absence of legislation by Congress.
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