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San Jose Wellness v. Commissioner (156 T.C. No. 4)

On February 17, 2021, the Tax Court issued its opinion in San Jose Wellness v. Commissioner, 156 T.C. No. 4. The underlying issue presented in San Jose Wellness was whether the petitioner, a marijuana dispensary, was prohibited from claiming deductions for depreciation and charitable contributions under IRC § 280E.

Background

TrumpWeed San Jose WellnessThe petitioner operated a medical marijuana dispensary pursuant to California law from 2010 to 2015. It sold marijuana to individuals who held a valid doctor’s recommendation to use the drug. It also sold T-shirts, pipes, and batteries; and it offered acupuncture, chiropractic, and “holistic” services.  (One questions the illegality of this, as well, but here we are.)  The petitioner did not charge a separate fee for membership, acupuncture, chiropractic services, or any other services.

In each year at issue, the petitioner had gross receipts of $5 million to nearly $7 million, $3,000 to $430,000 of depreciation deductions, and small charitable contributions.  In 2015, the IRS issued the petitioner a notice of deficiency disallowing deductions and other costs totaling $2.3 million and $2.6 million for the 2010 and 2011 taxable years, respectively. Included in the disallowed amounts were the deductions for depreciation and charitable contributions. The notice determined deficiencies in SJW’s Federal income tax of $790,000 for 2010 and $820,000 for 2011.  The IRS later issued two additional notices of deficiency, first for 2012, and then for 2014 and 2015.  The third notice also determined that the petitioner was liable for accuracy-related penalties under IRC § 6662(a) for 2014 and 2015.

Legal Framework

Corporations are liable for tax under IRC § 11(a) on their taxable income, which is defined by IRC § 63(a) as gross income minus the deductions allowed under the Code. Included as deductions are depreciation deductions under IRC § 167(a)(1) and charitable contributions under IRC § 170(a)(1). However, deductions are subject to certain exceptions (contained in Part IX of Subchapter B of Chapter 1 of Subtitle A of the Code), including IRC § 280ESee N. Cal. Small Bus. Assistants Inc. v. Commissioner (“NCSBA”), 153 T.C. 65, 73 (2019); Patients Mut. Assistance Collective Corp. v. Commissioner (“Patients Mutual”), 151 T.C. 176, 190 (2018) (citing Olive v. Commissioner, 792 F.3d 1146, 1148 (9th Cir. 2015), aff’g 139 T.C. 19 (2012)).

IRC § 280E provides that 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, which are prohibited by Federal law or the law of any State in which such trade or business is conducted.  The text of the statute makes clear that a deduction will be disallowed if three conditions are satisfied.  First, the deduction is for an amount paid or incurred during the taxable year.  Second, such amount was paid or incurred in carrying on any trade or business.  Third, such trade or business (or the activities that comprise the trade or business) consisted of trafficking in certain defined controlled substances.

The NCSBA Decision

NCSBA—also a medical marijuana dispensary—sought to save from disallowance the deductions it claimed for taxes (under IRC § 164) and depreciation (under IRC § 167). In support of its position, NCSBA argued that “IRC § 280E limits only deductions under IRC § 162,” such that “deductions under IRC § 164 and IRC § 167 are allowed notwithstanding IRC § 280E.” NCSBA, 153 T.C. at 72. In an Opinion reviewed by the full Tax Court, it rejected the argument, stating in relevant part: NCSBA’s argument missed the first line of IRC § 280E that “[n]o deduction or credit shall be allowed.” The Tax Court held that Congress “could not have been clearer in drafting this section of the Code.” Id. at 73.

Similarly, IRC § 161 provides that deductions found in part VI of subchapter B of chapter 1 of the Code are allowed subject to the exceptions provided in part IX. Part VI provides a comprehensive list of allowable deductions for taxpayers. This list includes IRC § 162 and IRC § 165 deductions, which we have previously disallowed pursuant to IRC § 280E. See Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (“CHAMP”), 128 T.C. 173, 180-81 (2007) (disallowing IRC § 162 deductions under IRC § 280E); Beck v. Commissioner, T.C. Memo. 2015-149, at *18 (disallowing an IRC § 165 loss deduction under IRC § 280E). As relevant here, part VI also includes IRC § 164 and IRC § 167, two additional sections petitioner believes would allow it a deduction. Clearly, IRC § 164 and IRC § 167 are limited by the exceptions in part IX, including IRC § 280E. Thus, IRC § 280E precluded petitioner from taking any deductions under IRC § 164 and IRC § 167 that are tied to its medical marijuana dispensary.

AHCA and CHAMP Preclude Depreciation and Charitable Deductions

The result reached in NCSBA is consistent with the outcomes of other cases including CHAMP and Alt. Health Care Advocates v. Commissioner (“AHCA”), 151 T.C. 225, 240 (2018). In AHCA and CHAMP, the Tax Court denied deductions for depreciation, and in AHCA it denied a deduction for charitable contributions as well. See AHCA,151 T.C. 225; CHAMP 128 T.C. 173.

A (Purple) Haze of Arguments Regarding Depreciation

“But…like…man…depreciation is not…like…‘paid’ during the year, man.” Unfortunately for the stoners, the Supreme Court has held otherwise.  Under IRC § 7701(a)(25), the terms “paid or incurred” are construed according to the method of accounting of the taxpayer.  See also IRC § 446(a). The petitioner was an accrual method taxpayer under IRC § 446(c)(2).  Congress authorized the accrual method of accounting to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period. United States v. Anderson, 269 U.S. 422, 440 (1926); see also Trinity Indus., Inc. v. Commissioner, 132 T.C. 6, 14, 19 (2009).

The Supreme Court further, rather on the nose if you ask me, held that the cost of depreciation is “certainly presently incurred.” Commissioner v. Idaho Power Co., 418 U.S. 1, 10-11 (1974).  Unfortunately for the petitioner, the Tax Court likewise has characterized depreciation as being “incurred” in a given year or over multiple years.  See, e.g., Procacci v. Commissioner, 94 T.C. 397, 405 (1990) (stating that a partnership “incurred depreciation on the improvements” related to a golf course); Curphey v. Commissioner, 73 T.C. 766, 768 (1980) (stating that a doctor “incurred depreciation and paid other expenses” in connection with a home office); Producers Chem. Co. v. Commissioner, 50 T.C. 940, 959 (1968) (stating that the taxpayer “used machinery…and incurred depreciation on that machinery”). Judge Toro spends a few more pages beating the dead horse of an argument with very sound and cogent citations to “authority” and “reasoning,” but this is cold comfort to the petitioner.

But, Like, Charities, Man…

The petitioner next argues that even if the Tax Court disallows the depreciation deductions, it’s charitable contributions should be deductible, because they were not paid “in carrying on” a trade or business as required by IRC § 280E. The Tax Court begs to differ.

Relax San Jose WellnessIRC § 280E applies to disallow a deduction for “any amount paid or incurred…in carrying on any trade or business.” It just so happens that the petitioner was engaged in a trade or business when it made the relevant charitable contributions. The Tax Court found that the petitioner chose to contribute the amounts to charity, and it saw “no reason to conclude” that the contributions were somehow separate from or outside the scope of its business activities. See, e.g., A.P. Smith Mfg. Co. v. Barlow, 98 A.2d 581 (N.J. 1953).

The petitioner’s argument that its charitable contributions by definition are not “business expenditures” misses the mark for similar reasons. Failing to qualify as a business expenditure may well be fatal under IRC § 162, although the phrase does not appear in that section. The concept, however, has no relevance under IRC § 280E, which applies to “any amount paid or incurred…in carrying on any trade or business.”

Accuracy-Related Penalty: Way Harsh, but Appropriate

Section 6662 imposes a 20% penalty on the portion of an underpayment of tax attributable to any substantial understatement of income tax. IRC § 6662(a), (b)(2). For corporations, an understatement of income tax is substantial if it exceeds the lesser of $10 million or “10 percent of the tax required to be shown on the return for the taxable year (or, if greater, $10,000).” IRC § 6662(d)(1)(B). The petitioner did not dispute that the understatement was substantial within the meaning of the statute. Nevertheless, the petitioner argued that it had reasonable cause and acted in good faith with respect to the underpayment. See IRC § 6664(c)(1); Treas. Reg. § 1.6664-4(a).

Harsh San Jose Wellness

A taxpayer may demonstrate reasonable cause through good-faith reliance on the advice of an independent professional, such as a tax adviser, a lawyer, or an accountant. See Treas. Reg. § 1.6664-4(b); see also Woodsum v. Commissioner, 136 T.C. 585, 591 (2011). An honest and reasonable misunderstanding of fact or law may indicate reasonable cause and good faith. Treas. Reg. § 1.6664-4(b). And in the penalties context more generally, a wide range of potential authorities–e.g., statutory text, regulations, caselaw, legislative history, and IRS guidance–is relevant to evaluating a taxpayer’s position. Cf. Treas. Reg. § 1.6662-4(d)(3)(iii).

Unfortunately, the petitioner did not claim that it relied in good faith on the advice of an independent professional in deducting the amounts at issue. Instead, it contends that the law in this area was sufficiently unsettled as of June 2016, the date that it filed its federal income tax return for 2015, that the petitioner reasonably reported its expenses. The Tax Court was unpersuaded. This is so, in large part, because by June 2016, the U.S. Court of Appeals for the Ninth Circuit had affirmed our Court’s interpretation of the phrase “consists of” in Olive, 792 F.3d at 1149-1150, agreeing that IRC § 280E applied with equal force to the deductions of taxpayers that undertake certain ancillary nontrafficking activities related to their trafficking activities. Further, in each of the marijuana dispensary cases that the Tax Court had decided prior to June 2016, the Tax Court had never allowed any of the taxpayer’s claim deductions—except to the extent that those deductions were attributable to a separate trade or business of the taxpayer. See Olive, 139 T.C. 19; CHAMP, 128 T.C. 173; Canna Care, Inc. v. Commissioner, T.C. Memo. 2015-206, aff’d, 694 F. App’x 570 (9th Cir. 2017); Beck v. Commissioner, T.C. Memo. 2015-149.

(156 T.C. No. 4) San Jose Wellness v. Commissioner

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