On March 29, 2021, the Tax Court issued a Memorandum Opinion in the case of Purple Heart Patient Center Inc. v. Commissioner (T.C. Memo. 2021-38). The primary issues presented in Purple Heart Patient Center Inc. v. Commissioner were whether the petitioner (1) was entitled to offset its gross receipts with any cost of goods sold (COGS), (2) underreported its gross income, and (3) is liable for the accuracy-related penalty pursuant to IRC § 6662(a).
Background to Purple Heart Patient Center Inc. v. Commissioner
Purple Heart is a California nonprofit mutual benefit corporation with members, rather than shareholders, which is treated as a C corporation for Federal tax purposes. Keith Stephenson organized Purple Heart in 2006 and obtained a license from the City of Oakland to operate a medical cannabis retail dispensary under California law. During the years in issue, he served as Purple Heart’s sole director and received wages that he reported on Forms W-2, Wage and Tax Statement. Aside from operating Purple Heart Mr. Stephenson also has served as a member of several cannabis-related committees and taught as an adjunct professor at Oaksterdam University, the first cannabis-focused school in America.
Medical cannabis accounted for most of Purple Heart’s sales during the years in issue, but it also sold non-cannabis items. Non-cannabis items accounted for approximately 3% of Purple Heart’s gross receipts for each year in issue. Purple Heart also offered free services as part of its medical cannabis dispensary business. Purple Heart’s complimentary services did not include counseling by any licensed medical professionals or therapists.
Paranoia Strikes Deep
Purple Heart purchased all of its inventory with cash, and its members purchased cannabis with cash; they could not use checks or credit cards. It did not deposit all of its cash from its sales into bank accounts. Purple Heart did not preserve the general ledger, Z-tapes, or any other source documents for any of the years in issue. Mr. Stephenson shredded the Z-tapes after Purple Heart paid its California State sales and use taxes each quarter and the general ledger and source documents after it submitted its Federal tax return each year. Mr. Stephenson understood that he risked criminal prosecution and asset forfeiture even without those records, but he feared that the records might be used in any prosecution and result in a lengthy mandatory minimum sentence. Purple Heart used a CPA to prepare its Forms 1120, though it chose not to provide him with any source documents for its sales or purchases…because he could have been The Man, man.
In 2010, Purple Heart reported $4.4 million in gross receipts, $2.6 million of COGS, for a gross profit of $1.8 million. It offset this gross profit with deductions totaling $1.6 million. Purple Heart’s 2010 Form 1120 did not list a business activity. However, it did include a disclosure statement that although IRC § 280E may apply to the “trafficking” portion of its business, they also provided health counseling services. It attributed the $1.6 million to “health counseling services.” Purple Heart’s 2011 and 2012 Forms 1120 listed “Alternative Health Services” as its business activity and included the same disclosure statement. These returns also attributed a substantial amount of its income to “health counseling services.”
Having no books or records to provide, the IRS performed a bank deposits and cash expenditures analysis. Because Purple Heart did not deposit all of its cash into bank accounts, the examining agent performed the cash expenditures part of his analysis by adding the purchases Purple Heart reported on each of its Forms 1120 for the years in issue for computing COGS to its net deposits to determine yearly gross receipts.
Completely harshing Purple Heart’s buzz, the IRS disallowed all amounts that Purple Heart claimed as COGS and business expense deductions for the years in issue. The notice of deficiency states that Purple Heart could not offset any of these COGS or deduct any of these expenses from its income because it failed to substantiate them. The notice further explains that IRC § 280E disallowed all deductions or credits paid or incurred during the taxable year in operating a medical cannabis dispensary. It also states that it disallowed a portion of Purple Heart’s COGS because of the change to Purple Heart’s ending inventory. Finally, the IRS determined negligence and/or a substantial understatement of income tax penalty for each year in issue.
Purple Heart’s “Expert”
Purple Heart offered Anthony Barr as an expert in tax and accounting matters relating to cannabis dispensaries to assist the Court in applying the Cohan rule to determine Purple Heart’s COGS, citing in support Olive v. Commissioner, 139 T.C. 19, 34-35 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015). See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930) (holding that the Court may estimate the amount of deductible expenses if there is a reasonable basis for making an estimate). Mr. Barr explained that his opinion is based on his accounting firm’s “historical knowledge of medical cannabis dispensaries” under California law, as well as the sheer number of cannabis-related returns prepared by his firm each year.
They did not, however, prepare or audit Purple Heart’s returns for the years at issue. Neither did he review the underlying books and record due to the fact that such books and records were used as rolling papers (just guessing here). He did not take any steps to verify that the COGS reported on the returns reflected the COGS to which the taxpayers were entitled. Rather he relied on the numbers reported on the returns.
The “Rules” of Evidence
Tax Court proceedings are conducted in accordance with the Federal Rules of Evidence (FRE). See IRC § 7453; Tax Court Rule 143(a). FRE 702 and FRE 703 govern testimony by expert witnesses. FRE 702 provides that a witness who is “qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion” if his testimony will help the trier of fact and the following conditions are met: (1) the testimony is based on sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the expert has reliably applied the principles and methods to the facts of the case.
In a Tax Court proceeding, a party who calls an expert witness must cause that witness to prepare a written report, which is served on the opposing party and lodged with the Court before trial. See Tax Court Rule 143(g)(1). If the expert is qualified, his report is “received in evidence as the direct testimony of the expert witness.” Tax Court Rule 143(g)(2). Because the written report serves as the direct testimony of the expert witness, the report must comply with the requirements for expert testimony set forth in FRE 702.
Testimony based on scientific, technical, or other specialized knowledge is subject to the Court’s gatekeeping function, which forecloses expert testimony that does not “rest on a reliable foundation” or is not “relevant to the task at hand.” Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579, 597 (1993); see Kumho Tire Co. v. Carmichael, 526 U.S. 137, 149 (1999) (extending the principles of Daubert to all expert testimony). While an expert can be qualified on the basis of his experience, he cannot cite his experience as the sole basis for his opinion. He must show his work, that is, the data he considered and the methodology he applied to produce his results. See Feinberg v. Commissioner, T.C. Memo. 2017-211, *9 (excluding appraisal testimony where expert did not provide sufficient data to show that “the opinions expressed are based on anything other than his own conjecture”), aff’d, 916 F.3d 1330 (10th Cir. 2019); Giles v. Commissioner, T.C. Memo. 2006-15, *14 (rejecting appraisal testimony where expert failed to explain the nature of her methodology and the reasons for her conclusions).
In Feinberg, the Tax Court previously excluded the expert report of an accountant that the taxpayer offered to establish the amount of COGS for a cannabis dispensary on the basis that the report was not based on personal knowledge of the dispensary’s business and lacked any substantiation of the dispensary’s expenses. Most damning to Purple Heart, however, was the finding that a “reconstructed income tax return based on industry averages does not take the place of substantiation and does not help determine a fact in issue.” Feinberg, T.C. Memo. 2017-211, at *9; accord Skolnick v. Commissioner, T.C. Memo. 2019-64, at *13 (horse appraiser with no appreciable “methodology” to his evaluation). Without a showing of the data he considered, the methodology he applied, and the manner in which he applied his methodology, the Tax Court has previously found that it has “no means of examining whether the report rests on a reliable foundation and is relevant to the task at hand,” as required by Daubert, 509 U.S. at 597.
Not a Perfect Argument, But It’s All They’ve Got
The IRS argued that Mr. Barr’s report fails to satisfy the requirements set forth in Tax Court Rule 143(g), primarily because his report does not provide the underlying factual support for his conclusions as required by Tax Court Rule 143(g)(1)(B). The IRS also argued that the report is not based on sufficient facts and data, as required by FRE 702(b), and is not a product of reliable principles and methods, as required by FRE 702(c). Purple Heart counters that the report is necessary because respondent has unreasonably disallowed all of its COGS and Mr. Barr’s report and testimony will be helpful to the Court in estimating the COGS under the Cohan rule as was done in Olive.
A Not So Unsurprising Result
The Tax Court was not moved by Mr. Barr’s report, insofar as it “failed” to “satisfy” the Federal “rules” of evidence, because it is not based in (nor does it cite) “facts” or “data.” Thus, the Tax Court declines Mr. Barr’s invitation to accept the COGS reported on the “99 returns” prepared for other cannabis dispensaries as a barometer for Purple Heart’s COGS in the case at hand.
Even Weed Has COGS
COGS for a taxable year equals the sum of beginning inventory and purchases (and other acquisition or production costs) during the taxable year less ending inventory. See Huffman v. Commissioner, 126 T.C. 322, 324 (2006), aff’d, 518 F.3d 357 (6th Cir. 2008)); see also Alterman v. Commissioner, T.C. Memo. 2018-83, *33 (holding that taxpayers’ method of computing COGS was improper when it considered only purchase and production costs and did not consider beginning and ending inventory).
All businesses, including cannabis dispensaries, may offset their gross receipts with COGS to compute gross income. See, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Olive, 139 T.C. at 20, n.2; Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173, 178, n.4 (2007); see also Treas. Reg. § 1.61-3(a). As the Tax Court and other courts have held, IRC § 280E disallows only deductions for a business’ expenses and does not preclude COGS. See CHAMP, 128 T.C. at 178, n.4; see also Doyle v. Mitchell Bros. Co., 247 U.S. 179, 185 (1918) (holding that Congress may tax a reseller only on its gross income, not its gross receipts).
COGS is not a deduction within the meaning of IRC § 162(a) but is subtracted from gross receipts to determine a taxpayer’s gross income. Metra Chem Corp. v. Commissioner, 88 T.C. 654, 661 (1987); Treas. Reg. § 1.61-3(a); Treas. Reg. § 1.162-1(a); see also Max Sobel Wholesale Liquors v. Commissioner, 69 T.C. 477, 485 (1977), aff’d, 630 F.2d 670 (9th Cir. 1980). It is “the costs of acquiring inventory, through either purchase or production”, which are generally determined under IRC § 471 and the accompanying regulations. Patients Mut. Assistance Collective Corp. v. Commissioner, 151 T.C. 176, 205 (2018) (citing Reading v. Commissioner, 70 T.C. 730, 733 (1978), aff’d, 614 F.2d 159 (8th Cir. 1980)); Treas. Reg. § 1.471-1; Treas. Reg. § 1.471-3(a), (b).
Even COGS Need Records
A taxpayer is required to maintain sufficient reliable records to substantiate its COGS. See IRC § 6001; Newman v. Commissioner, T.C. Memo. 2000-345, *2; Treas. Reg. § 1.6001-1(a); see also King v. Commissioner, T.C. Memo. 1994-318, *2 (“[A]ny amount allowed as cost of goods sold must be substantiated.”), aff’d without published opinion, 69 F.3d 544 (9th Cir. 1995). Previously, the Tax Court has disallowed all or part of COGS claimed for a tax year when the taxpayer failed to maintain these types of records. See, e.g., Factor v. Commissioner, 281 F.2d 100, 108, 122 (9th Cir. 1960), aff’g T.C. Memo. 1958-94; Chico v. Commissioner, T.C. Memo. 2019-123, at *25; Jabari v. Commissioner, T.C. Memo. 2017-238, *10 (holding that owners of a medical cannabis dispensary were not entitled to COGS greater than the Commissioner allowed because they had failed to document the dispensary’s “gross sales or to substantiate any expenses or costs relating to any gross sales”).
Applying the Cohan Rule
Under the Cohan rule, however, if a taxpayer is able to demonstrate that he paid or incurred an expense but cannot substantiate the precise amount, the Tax Court can estimate the amount of the expense while “bearing heavily upon” upon the taxpayer “whose inexactitude is of his own making.” Cohan, 39 F.2d at 543-544; see also Goldsmith v. Commissioner, 31 T.C. 56, 62 (1958) (applying the Cohan rule to COGS). For the Court to estimate the amount of an expense, there must be some basis upon which an estimate can be made. Norgaard v. Commissioner, 939 F.2d 874, 879 (9th Cir. 1991), aff’g in part, rev’g in part T.C. Memo. 1989-390; Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). Otherwise an allowance would amount to “unguided largesse.” Norgaard v. Commissioner, 939 F.2d at 879 (quoting Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957)).
Returns Not Evidence
Tax returns by themselves are not evidence to substantiate an amount claimed; they are merely a statement of the taxpayer’s claim. Roberts v. Commissioner, 62 T.C. 834, 837 (1974). The Tax Court has previously declined to estimate COGS when it had “little more than a taxpayer’s self-serving declarations.” See Pratt v. Commissioner, T.C. Memo. 2002-279, *5; Snyder v. Commissioner, T.C. Memo. 2001-255, *9 (holding that the taxpayers failed to prove that they were entitled to any COGS because they provided “no basis other than the self-serving figures on the taxpayer-owned business tax returns); Makspringer v. Commissioner, T.C. Memo. 1994-468, *2.
Tax Court Can Make an Educated Guess
On the other hand, if no other documentation is available the Tax Court may, but is not obligated to, accept credible testimony to estimate part of a taxpayer’s claimed expenses. See, e.g., Arizaga v. Commissioner, T.C. Memo. 2016-57, at *6-*7 (holding that a taxpayer who provided no documentation at trial was entitled to offset receipts with a portion of claimed COGS on the bases of the Tax Court’s “careful review of the entire record and [its] evaluation of petitioner’s credibility”); see also Watson v. Commissioner, T.C. Memo. 1988-29, *19. Further, the Tax Court previously has estimated COGS under Cohan relying primarily on a taxpayer’s credible testimony. See, e.g., Arizaga, T.C. Memo. 2016-57, at *6-*7; Riordan v. Commissioner, T.C. Memo. 1978-194; see also Cheyne v. Commissioner, T.C. Memo. 1977-361, *61.
A COGS-Related Bone is Thrown…
Having extended a potential lifeline, the Tax Court summarily yanks it back from Purple Heart, finding that neither Mr. Stephenson nor his “expert” provided testimony precise enough to substantiate the amounts of COGS Purple Heart claimed on its tax returns, but that Mr. Stephenson’s testimony was credible enough to estimate part of Purple Heart’s claimed COGS under Cohan.
…And Then Yanked Back (for 2010)
Nevertheless, because Mr. Stephenson destroyed all other documents the Tax Court could use to determine Purple Heart’s net sales or inventory, it is impossible for us to estimate any COGS reliably for 2010 under Cohan. See Petzoldt v. Commissioner, 92 T.C. 661, 698 (1989) (holding that the Tax Court “would distort income if [it] allowed the taxpayer an expense for cost of goods sold” without the information to determine the taxpayer’s net sales or inventory); Olagunju v. Commissioner, T.C. Memo. 2012-119, *12; see also Burnet v. Houston, 283 U.S. 223, 228 (1931). Against this backdrop, the Tax Court sustained the IRS’s disallowance of all of Purple Heart’s claimed COGS for 2010.
Unlike on its 2010 return, Purple Heart disclosed on its 2011 return that it had corrected its balance sheet amounts from previous years and its ending inventory for 2011 matched its beginning inventory for 2012. The IRS did not challenge Purple Heart’s correction or its updated inventory numbers. Therefore, the Tax Court held that the 2011 return does not prevent it from being able to estimate COGS under Cohan. As with the 2011 Form 1120, the beginning and ending inventory figures Purple Heart claimed on its 2012 Form 1120 are evident from the return itself, and IRS did not challenge the figures.
Taxpayers are responsible for maintaining adequate books and records sufficient to establish their income. See IRC § 6001; DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992). When a taxpayer fails to maintain adequate books and records, the IRS is authorized to compute the taxpayer’s income by any method that, in the IRS’s opinion, clearly reflects income. IRC § 446(b); see also Choi v. Commissioner, T.C. Memo. 2002-183, aff’d 379 F.3d 638, 639 (9th Cir. 2004); Petzoldt, 92 T.C. at 693; Treas. Reg. § 1.446-1(b)(1).
The IRS may use indirect methods to reconstruct income. Holland v. United States, 348 U.S. 121 (1954); Choi, 379 F.3d at 640. It is given latitude to determine which method of reconstruction to apply when a taxpayer fails to maintain records; the reconstruction need only be reasonable in the light of all surrounding circumstances and on the basis of “some substantive evidence.” See Hardy v. Commissioner, 181 F.3d 1002, 1004-1005 (9th Cir. 1999), aff’g T.C. Memo. 1997-97; Petzoldt, 92 T.C. at 687; Giddio v. Commissioner, 54 T.C. 1530, 1533 (1970). Courts have long sanctioned the use of the bank deposits and cash expenditures method. See Choi, 379 F.3d at 639-640; Nicholas v. Commissioner, 70 T.C. 1057, 1065 (1978); Kudo v. Commissioner, T.C. Memo. 1998-404, *12, aff’d, 11 F. App’x 864 (9th Cir. 2001).
The Bank Deposits / Cash Expenditures Method of Reconstruction
The bank deposits method assumes that all money a taxpayer deposited in its bank account during a given period is income, absent an explanation of a nontaxable source for the deposit. DiLeo, 96 T.C. at 868; see also Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000), aff’g T.C. Memo. 1998-121. The IRS is not even required to show a likely source of income when using the bank deposits method for computing unreported income. Clayton v. Commissioner, 102 T.C. 632, 645 (1994). The cash expenditures method assumes that the amount by which a taxpayer’s expenditures during a taxable year exceed his reported income has taxable origins absent some explanation by the taxpayer. Petzoldt, 92 T.C. at 694.
When the IRS uses the bank deposits and cash expenditures method, it “assumes a special responsibility to be thorough and particular” in its investigation and presentation. See Pawar v. Commissioner, T.C. Memo. 2013-257, *11-*12. The IRS must eliminate any nonincome items of which it has knowledge, such as gifts, loans, and transfers between the taxpayer’s various bank accounts. DiLeo, 96 T.C. at 868; see also Bacon v. Commissioner, T.C. Memo. 2000-257, *4, aff’d without published opinion, 275 F.3d 33 (3d Cir. 2001). The IRS must also make a further adjustment for the taxpayer’s ascertainable business expenses, deductions, and exemptions. Kling v. Commissioner, T.C. Memo. 2001-78, *9. This adjustment includes accounting for a taxpayer’s beginning and ending inventory. See, e.g., Goldberg v. Commissioner, T.C. Memo. 1958-187; see also Petzoldt, 92 T.C. at 694-695.
Looking Behind Notice of Deficiency
The Tax Court is not generally inclined to look behind the notice of deficiency to examine the basis for the IRS’s determination. Jackson v. Commissioner, 73 T.C. 394, 400 (1979); Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 327 (1974). The Tax Court has applied a limited exception to this general rule in cases involving unreported income where the Commissioner fails to introduce any substantive evidence but rests on the presumption of correctness afforded the notice of deficiency and the taxpayer challenges the notice on the grounds that it was arbitrary and excessive. See Helvering v. Taylor, 293 U.S. 507 (1935).
The IRS must introduce some substantive evidence linking the taxpayer to an alleged income-producing activity or demonstrate that the taxpayer actually received unreported income before the presumption of correctness attaches to the deficiency determination. Rapp v. Commissioner, 774 F.2d 932, 935 (9th Cir. 1985); Edwards v. Commissioner, 680 F.2d 1268, 1270 (9th Cir. 1982); see also Portillo v. Commissioner, 932 F.2d 1128, 1133 (5th Cir. 1991). The requisite evidentiary foundation is minimal and need not include direct evidence. See Rapp v. Commissioner, 774 F.2d at 935; Weimerskirch v. Commissioner, 596 F.2d 358, 360-362 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). If the IRS carries its initial burden, the taxpayer has the burden to rebut the presumption by establishing by a preponderance of the evidence that the deficiency determination is arbitrary or erroneous. Rapp, 774 F.2d at 935.
With respect to Purple Heart’s income, the Tax Court found that it was not “necessarily inconsistent” to rely on a document prepared by a taxpayer to determine the amounts of its gross receipts and refuse to rely on it to determine the amount of its COGS. See Olive, 139 T.C. at 34. Further, statements that a taxpayer makes on its signed tax return are considered binding admissions unless there is “cogent evidence” that indicates such statements are wrong.” Kornhauser v. Commissioner, T.C. Memo. 2013-230, *5, aff’d, 632 F. App’x 421 (9th Cir. 2016).
As such, the Tax Court found that Purple Heart’s 2011 and 2012 returns provided the necessary evidentiary foundation for respondent’s determination of Purple Heart’s cash expenditures and income for 2011 and 2012. Nonetheless, Purple Heart failed to prove any error as to respondent’s unreported income determinations for 2011 and 2012. Thus, the determinations for these years (and for 2010) were sustained.
Destroying Records is Negligent
This one should not come as too much of a shock, but the Tax Court found that Mr. Stephenson’s destruction of the records was negligent. As such, Purple Heart could not avoid the accuracy-related penalty. See Olive, 139 T.C. at 44-45; see also Treas. Reg. § 1.6662-4(e)(2)(iii) (stating that adequate disclosure will not have an effect where the item or position on the return is not properly substantiated, or the taxpayer failed to keep adequate books and records).
Mr. Stephenson’s intentional destruction of all business records would not have prevented the Federal Government from connecting him to Purple Heart’s illegal activities, and the Tax Court found, therefore, that such destruction amounted to a “conscious disregard of rules or regulations.” See Olive, 139 T.C. at 44; see also McCoy v. Commissioner, 76 T.C. 1027, 1029 (1981) (holding that “remote or speculative possibilities of prosecution” were not sufficient to justify a taxpayer’s disregard of rules and regulations), aff’d, 696 F.2d 1234 (9th Cir. 1983).
Bad Mr. Stephenson.
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