Taxing Lessons From Court Decisions

Decisions — Smoking the deductions

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We’re not lost. We just don’t know where we are.

Words that create a phantom distinction where no difference exists can make us laugh. Except of course when they involve tax law.

In T.C. Memo. 2017-211 (Feinberg), the taxpayer was an LLC licensed in the state of Colorado to grow and sell medical marijuana. The taxpayer filed federal business income tax returns for tax years 2009 through 2011.

Each year the taxpayer calculated total income by subtracting the cost of goods sold from gross receipts. The taxpayer also claimed deductions from total income for ordinary and necessary business expenses for salaries and wages, repairs and maintenance, rents, depreciation, advertising, and “other deductions.”

The IRS examined the returns, and reclassified certain expenses that the taxpayer had claimed as deductions, saying those expenses were actually cost of goods sold. The IRS disallowed deductions for all other business expenses not reclassified as cost of goods sold, saying that internal revenue code section 280E (expenditures in connection with the illegal sale of drugs) applied to the taxpayer.

The taxpayer offered no business records to support the deductions, relying instead on the report of a certified public accountant, whom they said was an expert in cost accounting, with an emphasis in the marijuana industry.

The tax court said the expert’s testimony was not helpful, and since the taxpayer offered no other support, the court sided with the IRS in allowing only the amount the IRS calculated as cost of goods sold and disallowing all other deductions.

 

GIVEN THAT EXPENSES RELATED TO THE ILLEGAL SALE OF DRUGS CANNOT BE DEDUCTED,
WHY DO YOU THINK THE TAX COURT ALLOWED THE TAXPAYER
TO CLAIM ANY AMOUNT AS COST OF GOODS SOLD?

For a full explanation, hover your mouse over the link

 

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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Cost of goods sold is an offset to income for the purpose of calculating gross income and is subtracted from gross income to arrive at taxable income. Cost of goods sold is determined under internal revenue code section 471 and the accompanying regulations.

Deductions are permitted under internal revenue code section 162(a), which permits a taxpayer to deduct ordinary and necessary expenses incurred during the taxable year in carrying on a trade or business.

Internal revenue code section 261 provides that “no deduction shall in any case be allowed in respect of items specified in this part.” “[I]tems in this part” refers to part IX of subchapter B of chapter 1, entitled “Items Not Deductible,” and this includes section 280E, “Expenditures in Connection With the Illegal Sale of Drugs.”

Technically speaking, cost of goods sold is not a “deduction,” and is not subject to the various limitations on deductions pertaining to internal revenue code section 162. The distinction between an “offset” and a “deduction” means that cost of goods sold falls outside the prohibition of internal revenue code section 280E.

Editorial Note: In this case, the tax court did not need to address whether internal revenue code section 280E applied because the taxpayer failed to substantiate any of the expenses the IRS disallowed as deductions. The taxpayer did not produce any business records or any other supporting documents.

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