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Richmond Patients Group v. Commissioner (T.C. Memo. 2020-52)

On May 4, 2020, the Tax Court issued a Memorandum Opinion in the case of Richmond Patients Group v. Commissioner (T.C. Memo. 2020-52). The issues before the court in Richmond Patients Group were (1) whether the petitioner is entitled to additional costs of goods sold or deductions for business expenses; (2) whether the petitioner was a reseller or a producer of marijuana pursuant to IRC § 471 during the years in issue; (3) whether the petitioner is allowed to change its accounting method pursuant to IRC § 446 for tax year 2015; and (4) whether the petitioner is liable for accuracy-related penalties pursuant to IRC § 6662(a).

Background

The petitioner was a members-only medical marijuana dispensary. It offered no other services, therapeutic or otherwise, just the reefer. When the petitioner purchased bulk marijuana, it paid the seller a 25% to 50% down payment when the “product” was delivered and paid the remainder when the product “passed testing.”*

*Author’s Note: I’m no expert here, but this seems like a highly unscientific method with potential risk for the petitioner if the product “passed testing” with flying colors (literally, colors flying all around). The petitioner’s bargaining position (now supine) may have been compromised, and the generosity that abounded could have led to some inflated sales transactions to the benefit of the sellers (assuming they did not partake in the “testing” process, as well). Well, it appears that I was not the only one with such concerns, because the petitioner sent their “products” of to a third-party “lab,” which had the kushiest job in all of stonerdom. They were actually paid to test the “product” and determine if it was fit for the general public. If it was consumable, then it was passed on for sale. If, after a test (read: toke) or two, the schnozzberries tasted like schnozzberries, and the testers could smell the color purple, then it was not released for public consumption. For the good of the order, of course.

The petitioner used QuickBooks and provided them to the petitioner’s accountant, who used them to prepare the petitioner’s returns. In 2009, the petitioner reported gross receipts of $5m and costs of goods sold (COGS) of $3.2m. The petitioner claimed business expense deductions of $1.7m. In February 2016, the petitioner was notified that it’s 2014 return was being examined, which was, of course, a total downer.

In March 2016, the petitioner filed its 2015 return. The petitioner reported gross receipts of $6.2m and COGS of $6m. The petitioner claimed business expense deductions of $44,000, and reported other costs of $1.4m, which included $1.35m for labor. Along with their 2015 Form 1120, the petitioner submitted a Form 3115 (Application for Change in Accounting Method), which changed its accounting method from period costs to inventoriable costs, referred to as “indirect COGS.”

Unfortunately, the petitioner forgot about the notice of examination it had received during an independent “testing” session of a new line of edibles, which had the supreme advantage of being edibles, themselves. Thus, when the Form 3115 asked the petitioner whether it was under examination for any years, the petitioner checked the “No way, man, we’re cool” box.

In November 2016, the petitioner submitted a Form 1120X (Amended U.S. Corporation Income Tax Return) for 2014, which moved most of the deductions for business expenses to COGS. On the same day, the petitioner also submitted a 2015 Form 1120X, proposing changes that would reduce its tax liability by $10,000. The petitioner resubmitted the Form 3115 with the 2015 1040X, again asserting that they were not under exam.

Killing their buzz once more, in February 2017, the IRS mailed a Form 950 (30-day letter) and the examination report, which included accuracy-related penalties pursuant to IRC § 6662(a), which penalties had been approved properly pursuant to IRC § 6751(b)(1). A year later, the IRS issued a notice of deficiency, which made adjustments to COGS and disallowed a number of business expense deductions pursuant to IRC § 280E (Expenditures in Connection with the Sale of Illegal Drugs). Petitioner collectively were lit up by the accusations, but they managed to get their wits about them long enough to timely file a petition for redetermination.

These are Deductions; These are Deductions on Drugs

Generally, a taxpayer may deduct from its gross income ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. IRC § 162(a). However, there is an insidious little carve-out to this general rule contained in IRC § 261, which notes that in computing taxable income, no deduction shall in any case be allowed in respect of the items specified in Subchapter B, Part IX (Items Not Deductible), which, to every head shop’s chagrin, includes IRC § 280E. See Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173, 180 (2007).

IRC § 280E precludes taxpayers from deducting any expense related to a business that consists of trafficking in a controlled substance. See Olive v. Commissioner, 139 T.C. 19, 29 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015). The Tax Court has previously held that medical marijuana is a controlled substance. Id. at 180-181; see also Gonzales v. Raich, 545 U.S. 1 (2005); United States v. Oakland Cannabis Buyers’ Coop., 532 U.S. 483 (2001). The dispensing of medical marijuana, while legal in California, is illegal under Federal law. See Olive, 139 T.C. at 39.

Illegality under federal law is apparently one of Congress’ “buttons,” and IRC § 280E confirms that no matter how much the kids (states) want to rebel, this is the Uncle Sam’s house, and you are going to play by his rules (as far as income taxes go, at least). No matter how much individual states have tried to remind Uncle Sam that he was younger and fun once, neither Congress nor the courts have budged on this issue. Id.

The Tax Court’s hands were tied, and it found that pursuant to IRC § 280E, the IRS properly disallowed the petitioner’s deductions for business expenses. The disallowed deductions included rents, compensation of officers, salaries and wages, repairs and maintenance, taxes and licenses, charitable contributions, depreciation, pension and profit-sharing plans, employee benefit programs, and other expenses.

However, a glimmer of light shines through the purple haze, as IRC § 280E disallows deductions only for business expenses and does not preclude Richmond from taking into account its COGS. See CHAMP, 128 T.C. at 178, n.4.

As the Tax Court gave the petitioner the real bummer of a holding, somewhere Tommy Chong was dolefully singing the first lines of his most iconic song, “Up in smoke, that’s where my money goes…”

Lay off Petitioner’s COGS, Man

As the Tax Court noted, however, IRC § 280E operates only to disallow otherwise appropriate deductions, such as those for the expenses of a business. It does not preclude taxpayers from taking into account COGS. See CHAMP, 128 T.C. at 178, n.4. Although COGS is not technically a deduction within the meaning of IRC § 162(a), COGS is subtracted from gross receipts in determining a taxpayer’s gross income. 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).

COGS is the cost of acquiring inventory, through either production or purchase. Patients Mut. Assistance Collective Corp. v. Commissioner (Patients Mut.), 151 T.C. 176, 205 (2018); Reading v. Commissioner, 70 T.C. 730, 733 (1978), aff’d, 614 F.2d 159 (8th Cir. 1980). COGS is generally determined under IRC § 471 and its accompanying regulations, Treas. Reg. § 1.471-3 and Treas. Reg. § 1.471-11.

Additional rules related to calculate COGS are contained in IRC § 263A, which generally permits both producers and resellers to include “indirect” inventory costs in COGS. See IRC § 263A(a)(2)(B), (b); Treas. Reg. § 1.263A-1(a)(3); Treas. Reg. § 1.263A-1(c)(1); Treas. Reg. § 1.263A-1(e). Indirect costs are defined broadly as all costs other than direct material costs and direct labor costs (for producers) and acquisition costs (for resellers). Treas. Reg. § 1.263A-1(e)(3).

There is, however, one critical exception to IRC § 263A’s inclusion of “indirect” inventory costs in computing COGS. Only expenses that are otherwise deductible under the Code may be included in COGS pursuant to IRC § 263A. See Sec. 263A(a)(2). Thus, because IRC § 280E prohibits doobie-related expense deductions otherwise available to businesses under IRC § 162(a), the petitioner may not include “indirect” inventory costs into COGS. See Patients Mut., 151 T.C. at 209.

The petitioner contends that it was a producer for purposes of IRC § 263A and IRC § 471 and should be entitled to deduct the indirect inventory costs of labor under Treas. Reg. § 1.471-3(c). The Tax Court describes the steps that the petitioner took from point of purchase to point of sale and concluded that such activities were those of a reseller and not a producer. See Alt. Health Care Advocates v. Commissioner, 151 T.C. 225, 243 (2018); Patients Mut., 151 T.C. at 213, n.26. Because the petitioner was a reseller for purposes of IRC § 471, the petitioner was not allowed to offset its gross income through exclusion of additional indirect costs.

Change of Accounting Method

Pursuant to IRC § 446(a), taxable income must be computed under the method of accounting usually used by the taxpayer to computes its income in keeping its books. A method of accounting is only acceptable if, in the opinion of the IRS, it “clearly reflects” income. IRC § 446(b); Treas. Reg. § 1.446-1(a)(2). In general, a taxpayer wishing to change its method of accounting must obtain the IRS’s prior approval. IRC § 446(e); Treas. Reg. § 1.446-1(e)(2)(i).

The IRS has wide discretion in deciding whether to consent to a change of accounting method. Brown v. Helvering, 291 U.S. 193, 204 (1934). The IRS even has authority to permit a retroactive change in the method of computing taxable income, even when the computation of income under the old method has already been made. See Barber v. Commissioner, 64 T.C. 314, 319 (1975).

The petitioner’s 2015 Form 1120X included a Form 3115, which requested the IRS’s consent to change the petitioner’s method of accounting from “period costs” to “inventoriable costs,” which is a method permitted to a producer the COGS regulations contained in Treas. Reg. § 1.471-3(c). Since its inception Richmond had used the period cost, or “first in, first out (FIFO)” method of accounting for resellers pursuant to Treas. Reg. § 1.471-3(b).

The Tax Court sustained the IRS’s rejection of the change of accounting methods on two grounds. First, the Tax Court had already determined that the petitioner was a reseller and not a producer. Because the petitioner was not a producer, using the “producer” method would not clearly reflect income. Second, the method must be consistent from year to year, unless the IRS – in its complete discretion – authorizes a change. Huntington Sec. Corp. v. Busey, 112 F.2d 368, 370 (6th Cir. 1940).

If there is a change in business that would justify the change, the Tax Court has some discretion to review the IRS’s rejection of the change, but in the present case, because the petitioner’s business kept on keeping on, meaning that it had not materially changed, the Tax Court was bound to the IRS’s decision to reject the change.

Original opinion: (T.C. Memo. 2020-52) Richmond Patients Group v. Commissioner

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