On March 1, 2022, the Tax Court issued a Memorandum Opinion in the case of Lord v. Commissioner (T.C. Memo. 2022-14). The primary issue presented in Lord was whether the tax depreciation methods for inventory production assets can be used under either section 263A or section 471 when section 280E is applied.
Holding: In a battle of Lord versus the IRS, one would think the almighty would prevail. Turns out, not so.
Background to Lord v. Commissioner
In 2012, the only year at issue, the petitioners (Colorado residents, which becomes important in a moment) owned two businesses—Beyond Broadway, LLC (Broadway), which had nothing to do with Broadway, and Artistant Dispensary Center, Inc. (Artistant). In 2012 the State of Colorado licensed the businesses to cultivate, process, and distribute medical marijuana and medical marijuana products. The Lords were quick to jump on the patchouli-scented bandwagon.
Both businesses produced medical marijuana products for sale to patients and other licensees. Broadway was formed under Colorado state law as a limited liability company and in 2012 was treated as a partnership for tax purposes. On its 2012 Form 1065, U.S. Return of Partnership Income, Broadway reported gross receipts of $9.7 million. After agreed adjustments, Broadway’s costs of goods sold (COGS) for 2012 was $5.9 million.
I picked the wrong #*&^@$! profession. I mean, let’s just look at the objective facts:
I love gardening.
- I love baking (brownies, not the other kind of baking).
- I have a quality control department the pedigree and experience in the area I would put up against the Grateful Dead themselves, to wit, a certain editor’s father, a self-described “pharmaceutical rep” in the late 60s and early 70s, who once won a game of invisible chess with his best friend, Sweet Willie, who, when he found himself in checkmate, exclaimed: “Shit, Boomer, I did not see that coming.” (Hand to God—for once in the history of Briefly Taxing, I am not even making this up.)
Artistant was incorporated under Colorado state law and in 2012 was treated as an S corporation for tax purposes. On its 2012 Form 1120S, U.S. Income Tax Return for an S Corporation, Artistant reported gross receipts of $1.1 million. After agreed adjustments, Artistant’s COGS was $1.1 million. The petitioner-husband acquired a 90% ownership interest in Artistant on July 31, 2012.
The businesses computed their depreciation included in COGS for 2012 using the accelerated cost recovery method detailed in IRC § 168(a); they also claimed bonus depreciation for 2012 pursuant to IRC § 168(k). The businesses used methods pursuant to IRC § 168(a) and (k) that did not conform with GAAP, but the recovery periods that they used did conform with GAAP. The parties agree that depreciation related to production assets is includible in inventory costs.
In the notice issued to the petitioners in July 2018, the IRS determined adjustments to the depreciation deductions claimed by the businesses for 2012. The IRS adjusted Broadway’s and Artistant’s depreciation by $66,000 and ($720), respectively. The IRS’s adjustments reflect the IRS’s position that IRC § 263A should not be relied upon for the calculation of inventory and determination of COGS. The petitioners’ income attributable to the businesses was likewise adjusted by $33,007 and ($270), reflecting the petitioner husband’s ownership interests in Broadway and Artistant, respectively.
The Intersection of Deductions and Drugs – IRC § 280E
Other than high-test coffee and low-grade, gray-market Adderall, I am not aware of any intersection between the IRS and any illicit substance. Dope, smack, 8-balls, and speed have more one-dimensional definitions to Settlement Officer Reggie Dunderhead (or Karen the Asshat).
Generally, IRC § 162(a) allows a taxpayer to deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business from the individual’s gross income. IRC § 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,” which includes IRC § 280E.
IRC § 280E precludes taxpayers from deducting any expense related to a business that consists of trafficking in a controlled substance. IRC § 280E disallows deductions only for business expenses and does not preclude the businesses from taking into account their COGS. We discussed the effect of IRC § 280E in this article, and again for good measure in this one, too.
The Tax Court has previously held that medical marijuana is a controlled substance. The dispensing of medical marijuana, while legal in Colorado, is illegal under federal law. By passing (and not yet repealing) IRC § 280E Congress established that illegality under federal law precludes a taxpayer from deducting expenses incurred in acquiring such income (such as by operating a medical marijuana dispensary business)—even if the business is legal under state law.
Costs of Goods Sold (COGS)
COGS is not a deduction within the meaning of IRC § 162(a); instead, COGS is subtracted from a taxpayer’s gross receipts in determining the taxpayer’s gross income. COGS is the cost of acquiring inventory, through either production or purchase. COGS is generally determined under IRC § 471 and its accompanying regulations. Producers are required to include in COGS both the direct and indirect costs of creating their inventory.
IRC § 471 and its accompanying regulations direct taxpayers to IRC § 263A for additional rules, which section instructs both producers and resellers to include “indirect” inventory costs in the cost of their inventory. Indirect costs are defined broadly as all costs other than direct material costs and direct labor costs (for producers) and acquisition costs (for resellers). Depreciation of production assets is an indirect cost.
The flush text of IRC § 263A(a)(2) provides that “[a]ny 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.” Deductions disallowed by IRC § 280E are costs subject to the prohibition of IRC § 263A(a)(2). The petitioners argue that the holding in Patients Mutual was overbroad. Citing legislative history, the petitioners argued that the word “cost” in the flush text of IRC § 263A(a)(2) is limited to personal, rather than business, costs. The Tax Court disagreed.
In so finding, the Tax Court observed that IRC § 263A(2)(a) does not define “cost;” therefore, the word is given its ordinary meaning: “the amount or equivalent paid or charged for something.” Nothing in the text of IRC § 263A suggests that Congress intended to restrict the prohibition of IRC § 263A(2)(a) to any personal expenses. The petitioners do not offer any evidence demonstrating a clear intent on the part of Congress to enforce IRC § 263A(2)(a) contrary to the plain text of the statute.
Had Congress intended to exclude business expenses from this restriction it could have; it did not. The statute as to this point is unambiguous; therefore, the inquiry is complete. The petitioners are therefore not able to rely on IRC § 263A to calculate inventory costs.
The petitioners next argued that the businesses are constitutionally entitled to accelerated and bonus depreciation because, as they claim, enforcement of the IRS’s adjustments would result in an impermissible tax on gross receipts, rather than gross income.
N.B.: Counsel for the petitioners reached out to your fearless editor to correct a comment that we made (and which we pulled directly from the opinion), incorrectly asserting that the petitioners argued that it would be unconstitutional not to be able to calculate their businesses’ inventories pursuant to IRC § 263A. Apparently, the Tax Court (like your fearless editor) failed to “read” the briefs submitted by the petitioners, who did not, technically, raise an argument of unconstitutionality on Fifth Amendment grounds. Without digging too much further into the briefs, I will take petitioner’s counsel’s word on the matter…in which case, I am going to have to assume some degree of contact high on the part of Judge Kerrigan. Thank you to Jennifer Benda for this clarification.
Not unsurprisingly, the Tax Court was “not persuaded,” observing that, in general, gross income is gross receipts less COGS, which is, in turn, calculated by using either IRC § 263A or IRC § 471. By using IRC § 471 to calculate inventory, the businesses are able to deduct their direct inventory costs. Other deductions from gross receipts are permitted at Congress’ discretion. Depreciation, however, is “an indirect cost of production,” and the businesses are not entitled by statute—and certainly not the Constitution—to deduct depreciation of production assets.
The petitioners also contended that IRC § 280E is unconstitutional. The petitioners argue that IRC § 280E cannot be upheld because Congress did not describe it as an excise tax. Once again, the Tax Court disagreed. The terms that Congress uses to describe exactions have no bearing on whether the taxes themselves are constitutional.
They further argue that IRC § 280E is unconstitutional on Fifth Amendment grounds. Once again, the Tax Court disagreed. The Tenth Circuit has stated that the unlawfulness of an activity does not prevent its taxation, lest we forget the undoing of Al Capone:
On October 17, 1931, Al Capone—the most notorious mobster in American history—was convicted of tax evasion (1925, 1926, and 1927) and failing to file his tax returns (1928 and 1929), and he was sentenced to 11 years in prison. During the trial Capone repeatedly contended (boasted) that the IRS couldn’t “collect legal taxes from illegal money.” Apparently, a jury of his peers disagreed, though he was convicted on only a handful of the numerous counts of malfeasance for which he stood accused. Capone appealed the Northern District of Illinois’ verdict to the Seventh Circuit, which issued a stern opinion affirming Capone’s conviction and sentencing. The Supreme Court denied certiorari.
For a fascinating look into the IRS’s investigation and prosecution of organized crime in the 1920s and 1930s, look no further than Guy Helvering’s (the IRS Commissioner at the time) “Narrative Briefly Descriptive of the Period 1919 to 1936” regarding the “Intelligence Unit of the Bureau of Internal Revenue,” the precursor to the IRS’s Criminal Investigation division. At the time the Intelligence Unit was led by Elmer Lincoln Irey, whose story is absolutely fascinating.
Conclusion with a Brief Note on Depreciation in IRC § 280E Cases
In the absence of new legislation from Congress, the legislative intent of IRC § 280E remains unchanged. The Tax Court observed that shifts in public sentiment and legalization of marijuana do not change the “purpose or applicability” of IRC § 280E, as the prohibitions of IRC § 280E apply in full force to state-sanctioned medical marijuana businesses.
Businesses that traffic in controlled substances are denied deductions, including deductions under IRC § 167. By the same logic, the associated IRC § 168 deprecation method is likewise disallowed to taxpayers affected by IRC § 280E. While the businesses’ accounting method is explicitly provided by the Code, it is not available to them because of IRC § 280E, and the IRS may determine that it does not clearly reflect income.
The IRS giveth, and the IRS taketh away. So sayeth, the Lord v. Commissioner.
(T.C. Memo. 2022-14) Lord v. Commissioner
- But not Willie Nelson. That dude is next level. If he were Buddhist, he would have reached pot enlightenment 25 years ago. ↑
- See Californians Helping to Alleviate Med. Probs., Inc. v. Commissioner (CHAMP), 128 T.C. 173, 180 (2007). ↑
- See Olive v. Commissioner, 139 T.C. 19, 29 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015). ↑
- See CHAMP, 128 T.C. at 178 n.4. ↑
- Id. at 180-81; see also Gonzales v. Raich, 545 U.S. 1 (2005); United States v. Oakland Cannabis Buyers’ Coop., 532 U.S. 483 (2001). ↑
- See Olive, 139 T.C. at 39. ↑
- Id. ↑
- See Max Sobel Wholesale Liquors v. Commissioner, 69 T.C. 477 (1977), aff’d, 630 F.2d 670 (9th Cir. 1980); Treas. Reg. § 1.162-1(a). ↑
- Patients Mut. Assistance Collective Corp. v. Commissioner, 151 T.C. 176, 205 (2018), aff’d, 995 F.3d 671 (9th Cir. 2021); Reading v. Commissioner, 70 T.C. 730, 733 (1978), aff’d, 614 F.2d 159 (8th Cir. 1980). ↑
- See Treas. Reg. §§ 1.471-3, 1.471-11. ↑
- See Treas. Reg. §§ 1.471-3(c), 1.471-11. ↑
- See § 263A(a)(2)(B), (b); Treas. Reg. § 1.263A-1(a)(3), (c)(1), (e). ↑
- Treas. Reg. § 1.263A-1(e)(3). ↑
- See Treas. Reg. § 1.471-11(c)(2). ↑
- Patients Mut., 151 T.C. at 209-10. ↑
- Cost, Webster’s New Collegiate Dictionary 255 (1980). ↑
- See Conn. Nat’l Bank v. Germain, 503 U.S. 249, 253–54 (1992) (Supreme Court stating that it has “stated time and again that courts must presume that a legislature says in a statute what it means and means in a statute what it says there”). ↑
- Id. at 254 (citing Rubin v. United States, 449 U.S. 424, 430 (1981)). ↑
- Treas. Reg. § 1.61-3(a). ↑
- See Patients Mut., 151 T.C. at 208-09. ↑
- Helvering v. Indep. Life Ins. Co., 292 U.S. 371, 381 (1934). ↑
- See Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519, 564-65 (2012). ↑
- Alpenglow Botanicals, LLC v. United States, 894 F.3d 1187, 1197 (10th Cir. 2018) (quoting Marchetti v. United States, 390 U.S. 39, 44 (1968)). ↑
- Capone v. United States, 56 F.2d 927 (7th Cir. 1932). ↑
- Olive, 792 F.3d at 1150. ↑
- See N. Cal. Small Bus. Assistants, 153 T.C. at 74 (finding that IRC § 280E applies to a “medical marijuana dispensary legally operated under California State law”). ↑
- Id. at 73. ↑