Medical marijuana companies face a number of challenges. The Section 280E limitation on business deductions is one example. There have been a number of court cases that address this limitation. The Feinberg v. Commissioner, T.C. Memo. 2017-211, case addresses a medical marijuana company’s efforts to substantiate cost of goods sold in light of the Section 280E limitation. This is a significant issue with a lot of tax dollars at stake for medical marijuana companies.
The Facts & Procedural History
The taxpayers were shareholders in Total Health Concepts, LLC (“THC”), which was a Subchapter S corporation. THC was licensed to grow and sell medical marijuana in Colorado.
Unlike most businesses in this industry, it appears that THC was operated as a single business enterprise.
THC did not pay any wages to the shareholders. Rather, the shareholders reported all of the income as flow through income on their personal income tax returns.
The IRS audited THC shareholder’s returns and adjusted THC’s costs of goods sold (“COGS”) and business deductions resulting in significant tax deficiencies. The taxpayers brought suit in the U.S. Tax Court.
THC’s COGS and other deductions were at issue in the court case. COGS is an above-the-line deduction that reduces gross receipts when computing income taxes. The Section 280E limitation essentially disallows tax deductions and credits, but it does not apply to COGS.
The IRS allowed several below-the-line deductions as COGS and then disallowed the remaining below the line deductions under Section 280E.
The question before the court was how COGS are substantiated.
Substantiating Costs of Goods Sold
The taxpayers attempted to substantiate THC’s COGS by qualifying their accountant and tax return preparer as an expert on cost accounting for the medical marijuana industry.
The accountant computed COGS by determining the average wholesale purchase price for medical marijuana and C “assuming” that COGS equaled 55% of gross sale.
The court did not accept the accountant as an expert. It noted that there was not data supporting many of the accountant’s conclusions. The court also noted inconsistencies in the accountant’s the average wholesale purchase price for medical marijuana.
What Could the Shareholders Have Done Different?
As noted by the court, the accountant based his opinions largely on his experience preparing tax returns for other medical marijuana companies. It does not appear that the accountant referenced data from other companies, such as publicly traded companies that are in this industry or even other industries that comparisons could be made to.
It does not appear that the accountant complied data from other companies. This could have been as simple as obtaining surveys from other companies. The IRS has accepted this in other contexts. For example, the IRS has a practice of accepting very small samples of companies to value stock transfers between related parties.
It does not appear that the accountant analyzed the individual expenses incurred by THC in the current year or over other years. Even a cost-build-up or even a cost trend analysis might have helped.
Would the court have accepted any of these methods? It isn’t clear.
As noted by the amounts at issue in this case, this is a significant issue for medical marijuana companies. There is no clear guidance for making this type of determination. We aren’t likely to see guidance on this issue anytime soon. The Federal government has little incentive to issue such guidance. Not only is the politics associated with this issue complex, the lack of guidance is a windfall for the Federal government.