156 T.C . No. 4

UNITED STATES TAX C OUR T

SAN JOSE W ELLNESS, Pe titione r v. C OM M ISSIONER OF INTER NAL REVENUE, R e sponde nt

Doc ke t Nos. 12313-15, 12353-15, File d Fe brua ry 17, 2021. 15714-18.
P ope ra te s a

m e dic a l c anna

bis dispe nsa

ry pursua nt to C a lifornia la w. P inc urre d c e rta in e xpe nse s in c onne c tion with its ope ra tions a n d de duc te d those e xpe nse s on its Fe de ra l inc om e ta x re turns for the ta xa ble y e ars 2010, 2011, 2012, 2014, a nd 2015. P’ s re turns inc l ude d de duc tions for depre c iation a nd c ha rita b l e c ontributions. R disa llowe d a ll of P’ s de duc tions pursua nt to I.R .C . se c . 280E for a ll the y e ars at

issue . R a lso de te rm ine d a c c ura c y -re late d pe na ltie s unde r I.R .C . se c . 6662 for the taxa ble y e ars 2014 a

nd 2015, but ha s sinc e c onc e de d the pe na l ty for the taxa

ble y e ar 2014. P pe titione d the C ourt se e king re vie w of R ’ s de te rm inations. P m a inta ins tha

t I.R .C . se c . 280E doe s not fore c lose its de duc tions for de pre c i ation a

nd c ha rita ble c ontributions be c a

use (1) de pre c iation is not “pa id or inc urre d during thetax a ble y e ar” and (2) P’ s c ha

rita ble c ontributions we

re n o t m a de “ in c arry i ng on” a tra d e or busine ss. In
Served 02/17/21- 2 -

a ddition, while

re c ogniz i ng tha

t the argum e nt is fore c lose d by our de c ision in Pa

tie nts M utua l Assista

nc e C o lle c tive C orp. v. C om m issione r, 151 T.C . 176, 190 (2018), to pre se rve its a ppe lla te rights, P a

rgue s tha t none of its e xpe nse s should bedisa llowe d by I.R .C . se c . 280E be c a

use its busine ss did not “ c onsist of”tra ffic k ing in c ontrolle d substa

nc e s. Fina lly , P a sse rts tha t it should not be subje c t to a

n a c c ura c y -re late d pe na lty for the unde rpay

m e nt for the ta xa ble y e ar 2015 be c a

use it a c te d with re a sona

ble c a use and in good fa ith pursua

nt to I.R .C
. se c . 6664(c )(1). R dispute s e a c h of P’ s c onte ntions. He ld: P’ s de d

u c tions for depre c iation we re prope rly disa llowe d be c a use de pre c iation is a

n am ount inc urre d during thetax a ble y e ar. He ld, furthe r, P’ s de d

uc tions for c h a

rita b le c o ntributions were prope rly disa llowe d be c a

use P m a de the c o ntributions in c arry ing on its tra de or busine s s. He ld, furthe r, unde r Pa tie nts M utua l, P’ s busine ss c onsiste d of tra ffic king in c ontrolle d substa nc e s. He ld, furthe r, P ha s not shown tha t it a c te d with re a sona

ble c a use and in good fa ith with re spe c t to the unde rpay m e n t for the ta xa ble y e ar 2015, a

nd the a c c ura c y -re late d pe na lty for tha t y e a r is susta ine d.

He nry G. Wykowski, Ka

the rine L. Alle n, a

nd Ja m e s B rooks M ann, for pe titione r. Nic hola s J. Singe r a

nd Julie Ann Fie lds, for re s ponde nt.- 3 - OPINION
TOR O, Judge : Se c t ion 280E 1 of the Inte rna l R e ve n ue C ode (the “ C ode ” ) provide s tha

t “ [n] o de duc tion * * * sha l l be a llowe d

for any am ount pa id or inc urre d during thetaxa

b le y e ar in c arry ing on a

ny tra de or busine s s if suc h tra de or busine ss (or the a c tivitie s whic h c om prise suc h tra de or busine ss) c onsists of tra ffic king in [c e rta in de fine d] c ontrolle d substa nc e s.” In the se de fic ie nc y c a se s,
we are a ske d to c onside r princ ipa lly whe the r the de duc tion for de pre c iation
a llowe d by

se c tion 167(a) an d the de duc tion for c ha rita ble c ontributions a

l lowe d by se c t ion 170(a ) fa ll within the broa d prohibition of se c tion 280E. W e c onc lude that the y do. Ac c ordingly , we hold tha t the de duc tions for depre c iation a nd
c ha rita ble c ontributions c la im e d by pe titione r, San Jose W e l lne ss (“ SJW ” ), for its ta xa ble y e ars 2010, 2011, 2012, 2014, a nd 2015 a re disa llowe d. 2 W e a lso hold tha t SJW is lia ble for an a c c ura c y -re late d pe na lty for 2015.

1 Unle ss othe rwise note d, a ll se c tion re fe re nc e s a re to the Inte rna l R e ve nue C ode in e ffe c t at a ll re le va nt tim e s, a

nd a ll R ule re fe re n c e s a

re to the Ta x C ourt R ule s of Pra c tic e a

nd Proc e dure . W e round a ll m one ta ry am ounts to the

ne are st dolla r. 2 In a ddition, while

re c ogniz ing tha

t the argum e n t is fore c lose d by our de c ision in Pa

tie nts M utua l Assista

nc e C o lle c tive C orp. v. C om m issione r (“ Pa tie n ts M utua l” ), 151 T.C
. 176, 190 (2018), to pre se rve its a ppe lla te rights, SJW argue s tha

t none of its e xpe nse s should bedisa llowe d by se c tion 280E be c a use its busine ss did not “ c onsist of”tra ffic k ing in c ontrolle d substa nc e s. Following Pa

tie nts M utua l , we re

je c t tha t a rgum e nt. Se e infra

Part III.- 4 - B a c kground The pa rtie s subm itte d the se c a se s fully stipula te d unde r R

ule 122. The fa c ts be low a re ba se d on the ple a dings a nd the pa rtie s’ stipula

tions of fa c ts (inc luding the e xhibits a

tta c he d the re to). The pa

rtie s’ stipula

t ions of fa c t s with a c c om

p any ing
e xhibits a re inc orporate d he re in by this re fe re nc e . SJW is a c orporation a

nd m a inta i ne d a

princ ipa l pla c e of busine s s in Sa n Jose , C a lifornia , whe n its pe titions we re file d. During thetaxa ble y e a rs e nde d Oc tobe r 31, 2010, 2011, 2012, 2014, a nd 2015, SJW

ope ra te d a

m e dic a l c anna

bis dispe nsa ry pursua nt to C a lifornia

la w. The dispe nsa

ry wa s lic e nse d by

the C ity of San Jose
. SJW sold c a nna b is to individua

ls who he ld a

va lid doc tor’ s re c om

m e ndation to use c anna

b is. SJW a lso sold nonc anna

bis ite m s , inc luding T-shirts, pipe s, a nd batte rie s. In a ddition, SJW offe re d a c upunc ture and c hiropra c t ic se rvic e s, a s we ll
a s othe r “ holistic ” se rvic e s . SJW did not c ha

rge a se pa ra te fe e for m e m

be rship,
a c upunc ture , c hiropra c tic se rvic e s, or a ny othe r se rvic e s. For e a c h of the taxa

ble y e ars at issue , SJW

use d the a c c rua l m e thod of
a c c ounting. For those

y e ars, SJW

ha d gross re c e ipts of $5,753,023, $6,283,393, $6,729,831, $4,997,684, a nd $5,476,844. SJW

file d its 2010 ta

x re turn on July 25, 2011, its 2011, 2012, a nd 2014 ta

x re turns on da

te s not e sta

blishe d by

the- 5 -

re c o rd, a nd its 2015 ta

x re turn on June15, 2016. In those re turns, SJW c la im e d de pre c iation de duc tions of $102,920, $24,250, $9,740, $2,958, a nd $434,253 3 and
c ha rita ble c ontribution de duc tions of $3,211, $0, $10, $1,035, a nd $125. 4 On Fe brua

ry 12, 2015, the

C om m issione r of Inte rna l R e ve n ue issue d to SJW
a notic e of de fic ie nc y

disa llowing de duc tions a nd othe r c osts tota ling $2,297,077
and $2,570,115 for the 2010 a nd 2011 ta

xa ble y e ars, re spe c tive l y . Inc l ude d in the disa llowe d am ounts we re the de duc tions for depre c iation a nd c ha rita b le
c ontributions. The

notic e de t e rm ine d

de fic ie nc ie s in SJW ’ s Fe de ra l inc om e tax of $786,498 for 2010 a

nd $818,024 for 2011. On the sa m e da y , the C om

m issione r issue d to SJW

a se c ond notic e of de fic ie nc y

disa llowing de duc tions a nd othe r c osts tota l ing $1,516,743 for the 2012 ta xa ble y e ar. Inc lude d in the disa llowe d am ount we re the de duc tions for

3 SJW ’ s re turn for the ta x a ble y e ar 2015 showe d

a de p re c iation de d

uc tion of $176,903 on Line 20 of Form 1120, U.S. C orporation Inc o m e Ta x R e turn. In a ddition, tha

t re turn re fle c t e d $257,350 of de pre c iation a s pa

rt of the am ount shown on Line

5 of Form 1125-A, C ost of Goods Sold, a s e xpla ine d in a supple m e nta l sc he dule e n title d “ TY 2014 Ite m iz e d Othe r C osts.”
4 Sc he dule M -1, R e c onc ilia tion of Inc om e (Loss) pe r B ooks W ith Inc om e pe r R e turn, of SJW ’ s re turn for the taxa ble y e ar 2015 a lso re fle c te d the following e xpe nse s re c orde d on the books but not de duc te d on the re t urn: (1) $85 for de pre c iation, (2) $842 for tra ve l a nd e nte rta inm e n t, a

nd (3) $807,142 for othe

r “ non-de d uc tible e xpe nse s.”- 6 -

de pre c iation a

nd c ha rita ble c ontributions. The

se c ond notic e de te rm ine d a de fic ie nc y

in SJW ’ s Fe de ra l inc om e tax of $515,693. On M ay 21, 2018, the

C om m issione r issue d to SJW

a third notic e of de fic ie nc y

disa llowing de duc tions totaling $2,870,073 a nd $2,649,775 for the

2014
and 2015 ta

xa ble y e ars, re spe c tive ly . Inc lude d in the disa llowe d am ounts we re the de duc tions for depre c iation a n d c ha rita b l e c ontributions. The

third notic e de te rm i ne d de fic ie nc i e s in SJW ’ s Fe de ra l inc om e ta x of $975,824 for 2014 a nd $907,116 for 2015. The notic e a lso de te rm i ne d tha t SJW wa s lia b l e for a c c ura c y re late d pe na ltie s unde r se c tion 6662 of $195,165 for 2014 a nd $181,423 for 2015. The C om m issione r e ve ntua lly

c onc e de d the pe na lty

de te rm i ne d for the taxa

ble y e ar 2014. SJW tim e ly file d pe titions with the C ourt se e king re de te rm ination of the de fic ie nc ie s a

nd pe na ltie s se t forth in theC o m m issione r’ s notic e s. W e
c onsolida te d the c a se s for disposition. As de sc ribe d furthe r be low, we will sustain the d e fic i e n c ie s a s we ll a s the pe na lty tha t re m a ins in dispute
. Disc ussion I. Applic a

ble Le ga l Fram e work The C ode im

p ose s a t a x “ on the taxa

ble inc om e of e ve ry

c orporation” for
e a c h taxa ble y e ar. Se c . 11(a ). As re le va nt he re , “ ta xa

ble inc om e ” is de fine d in- 7 -

se c t ion 63(a ) a s “ gross inc om e m inus the de duc t ions a llowe d by this c ha p te r.” 5 The C ode furthe r provide s tha t, “ [i] n c om

puting ta xa ble inc om e unde r se c tion 63, the re sha l l be a llowe d a s de duc tions theite m s spe c ifie d in this pa rt.” 6 Se c . 161. The re fe re nc e d “ pa

rt” inc l ude s se c tions 167 a n d 170. Se c t ion 167(a )(1) a llows “ a s
a de p re c iation de duc tion a

re a sona ble a llowa

nc e for the e xha

u stion, we ar and te ar (inc luding a

re a sona ble a llowa

nc e for obsole sc e nc e ) * * * of prope rty use d in a tra de or busine ss.” (Em

pha sis a dde d.) Sim ila

rly , se c tion 170(a)(1) a llows “ a s a de duc tion a

ny c ha rita ble c o ntribution * * * pa

y m e nt of whic h is m a de within the ta xa ble y e ar.” (Em

pha sis a dde d .) As the Supre m e C ourt ha s e xpla ine d, the “ de duc tions spe c i fie d in Pa rt VI of Subc ha pte r B of the Inc om e Ta x Subtitleof the C ode [whic h inc lude s se c tions 167
and 170] are ‘ subje c t

to the e xc e ptions provide d in pa rt IX.’ ” C om

m issione r v. Idah o Powe r C o., 418 U.S. 1, 17 (1974) (quoting se c tion 161). One of the se
e xc e ptions is se c tion 280E. Se e N. C a l. Sm a l l B us. Assista n ts Inc . v. C om m issione r (“NC SB A” ), 153 T.C . 65, 73 (2019); Pa tie nts M ut. Assista

nc e C olle c tive C orp. v. C om

m issione r (“ Pa t ie nts M utua l” ), 151 T.C . 176, 190 (2018)

5 The re fe re n c e to “ this c h a pte r” is to c h a

pte r 1, Norm a l Tax e s a

nd Surtaxe s, of subtitleA, Inc om e Ta xe s, of the C ode
.

6 The re fe re n c e to “ this pa rt” is to pa

rt VI of subc h a

pte r B of c ha

pte r 1 of subtitleA of the C ode
.- 8 -

(c iting Olive

v. C om m i ssione r, 792 F.3d 1146, 1148 (9th C ir. 2015), a ff’ g 139 T.C . 19 (2012)). Se c tion 280E provide s: No de duc tion or c re dit sha ll be a llowe d for a ny am o unt pa id or inc urre d during thetaxa

b le y e ar in c arry ing on a

ny tra de or busine s s if suc h tra de or busine ss (or the a c tivitie s whic h c o m prise suc h tra d e or busine ss) c onsists of tra ffic king in c ontrolle d substa n c e s (within the m e aning of sc he dule I and II of the C ontrolle d Substa nc e s Ac t) whic h is prohibite d by

Fe de ra l la

w or the la

w of a ny State in whic h suc h tra de or busine ss is c o nduc te d. As re le va nt for the s e c a se s, the te xt of the sta tute m a k e s c le ar that

a de duc tion will be disa llowe d if e a c h of the following c onditions is sa tisfie d: (1) the de duc t ion is for a n am ount pa id or inc urre d during thetaxa ble y e ar; (2) that a

m ount wa s pa id or inc urre d in c arry ing on a

ny tra de or busine ss;
and (3) that tra de or busine ss (or the a c tivitie s tha t c om prise the tra de or busine ss) c onsiste d of tra ffic k ing in c e rta in de fine d c ontrolle d substa n c e s. W e are c a lle d upon to de c ide whe the r c e rta in de pre c iation a nd c ha rita ble
c ontribution de duc tions c la i m e d by SJW m e e t e a c h of the sta tutory c onditions
sum m ariz e d a bove (and a

re the re fore disa llowe d unde r se c tion 280E). SJW- 9 -

m a inta ins tha

t its de duc tions do not m

e e t the c onditions. As we e xpla in be low, we disa gre e . II. Im port of Our De c ision in NC SB A B e fore turning to SJW ’ s a rgum e nts, we pa

use to c onside r the signific anc e of
our re c e nt de c ision in NC SB A a s it re late s to the s e c a se s. 7 The re , NC SB A--a lso a
m e dic a l m arijua

na dispe nsa ry --sought to sa

ve from disa llowa

nc e the de duc tions it
c la im e d for taxe s (unde r se c tion 164) a n d de pre c iat ion (unde r se c t ion 167). In support of its position, NC SB A a rgue d tha t “ se c tion 280E lim

its only de duc tions unde r se c tion 162,” suc h tha t “ de duc tions unde r se c tions 164 a n d 167 a re a llowe d notwithsta

nding se c tion 280E.”NC SB A, 153 T.C . at 72. In a n Opinion re vie we d by the full C ourt, we re

je c te d the argum e nt, sta

ting in re le va

nt pa rt: NC SB A’ s

“ argum e nt m isse s the first line of se c tion 280E: ‘ No de duc tion or c re d it sha ll be
a llowe d’ . (Em

p ha sis a dde d.) C ongre ss c ould not ha ve be e n c le are r in dra fting this
se c t ion of the C ode
. ” Id. at 73. W e found support for this c onc lusion in the C ode ’ s te xt a n d struc ture : The broa d e r statutory

sc he m e a lso supports our c onc lusion tha t se c tion 280E m e an s wha

t it sa y s--no de d

uc tions unde r any

se c tion sha ll be a llowe d for busine sse s tha t tra ffic in a

c ontrolle d substa

nc e .

7 The C ourt c onside rs it puz z ling tha t the C om m issione r’ s brie f in doc ke t No. 15714-18, whic h wa s file d a fte r the C ourt issue d its opinion in N. C a l. Sm a ll B us. Assista

nts Inc
. v. C om

m issione r (“NC SB A” ), 153 T.C . 65 (2019), fa ils to c ite , le t a lone disc u ss, NC SB A.- 10 -

Se c tion 261, in pa

rt IX of subc ha

pte r B of c h a

pte r 1 of the C o de , provide s tha

t “ no de duc tion sha ll in a

ny c a se be a llowe d in re spe c t of the ite m s spe c ifie d i n this pa rt.” Se c tion 280E is in pa rt IX. Sim ila rly , se c tion 161 provide s tha t de duc t ions found in pa

rt VI of subc ha pte r B of c ha

pte r 1 of the C o de are a llowe d “ s ubje c t to the e xc e ptions provide d

in pa rt IX” . Part VI provide s a c o m p re he nsive list of a llowa

ble de duc tions for ta

xpa y e rs. This list inc lude s se c tion 162 a

nd se c tion 165 de duc tions, whic h we have pre viously disa llowe d pursua

nt to se c tion 280E. Se e C HAM P, 128 T.C . at 180- 181 (disa llowing se c tion 162 de duc tions unde r se c tion 280E); B e c k v. C om m issione r, T.C
. M e m o. 2015-149, a t *18 (disa l lowing a se c tion 165 loss de d

uc t ion unde r se c t ion 280E). As re le va nt he re , pa

rt VI a l so inc lude s se c tions 164 a nd 167, two a dditiona l se c t ions pe titione r be lie ve s would a llow it a de duc tion. C le arly , se c tions 164 and 167 a re lim ite d by the e xc e ptions in pa rt IX, inc luding se c tion 280E. Thus, se c tion 280E pre c lude d pe titione r from ta king any de duc tions unde r se c tions 164 a nd 167 tha

t a re tie d to its m e d ic a l m arijua n a dispe n sa ry . Id. (e m pha sis a dde d). The re sult re a c he d in NC SB A is c onsiste nt with the outc om e s of othe r c a s e s. Se e , e .g., Alt. He a lth C are Advoc a te s v. C om m issione r (“ A HC A” ), 151 T.C . 225, 240 (2018); C a lifornia

ns He lping to Alleviate M e d. Proble m s, Inc . v. C om m issione r (“ C HAM P” ), 128 T.C . 173, 182 (2007). In AHC A a nd C HAM P, the C ourt de nie d de duc tions for dep re c iation, a nd in AHC A we de nie d a de duc tion for c h arita

ble c ontributions a s we ll. Se e AHC A,151 T.C . 225; C HAM P 128 T.C
. 173. In light of the

pa rtie s’ argum e nts in those

c a s e s, the C ourt did not se pa ra te ly
ana ly z e the a

p p lic a tion of se c t ion 280E to se c tions 167 a nd 170; inste a d, the C ourt- 11 -

de nie d a ll the de duc tions a t issue . The ultim a te re sults, howe ve r, we re the sam e a s the re sult in NC SB A. Give n the disc ussion in NC SB A, a nd the re s ults in AHC A a nd C HAM P, we
c ould e nd our a

na l y s is he re . Howe ve r, be c a use SJW ha s a dva nc e d m ore nua

nc e d te xtua l a rgum e nts tha

n those pre se nte d in NC SB A, AHC A, a n d C HAM P, we proc e e d to c o nside r SJW ’ s c onte ntions on the ir m e rits ra the r tha n sim ply re sting on our holdings in those

c a se s. As shown be low, SJW ’ s a rgum e n ts fa il to c arry

the da y . III. SJW ’ s Argum e nts A. SJW ’ s “ C o nsist Of” Argum e nt W e be gin by

a ddre ssing a

n a rgum e nt tha

t SJW offe rs sim

ply to pre s e rve its
a ppe lla te rights, re lat ing to the third of thesta tutory c onditions sum

m ariz e d a bove
. Se e supra Part I. SJW

m a inta ins tha

t, be c a use its tra de or busine ss inc l ude s m ore tha n the sa le of c anna

bis ite m s (for e xam

ple , SJW a lso se l ls T-shirts a

nd provide s
a c upunc ture se rvic e s), tha t tra de or busine ss doe s not “ c onsist of”(that is, doe s not
c om prise e x c lusive ly ) tra ffic king in c ontrolle d substa nc e s. The re fore , SJW
c onc lude s, the sta

tutory pre d ic a te is not sa

tisfie d a nd se c tion 280E doe s not a pply
. As SJW re c ogniz e s, howe ve r, we re je c te d the sa

m e argum e nt in Pa

tie nts M utua l, 151 T.C . at 196-197 (“ W e the re fore re a d se c tion 280E to de ny busine ss-e xpe nse- 12 -

de duc tions to a

ny tra de or busine ss tha

t involve s tra ffic king in c ontrolle d substa nc e s, e v e n if tha

t tra de or busine ss a lso e nga g e s in othe r a c tivitie s.” ). W e
se e n o re a son to depa

rt from tha t c onc lusion he re . 8 B
. SJW ’ s “ Pa id or Inc urre d During theTa xa ble Ye a r” Argum e n t W e turn ne x t to SJW ’ s a

rgum e nt tha

t the de pre c i a tion de duc tion unde r
se c t ion 167(a )(1) fa lls outside the sc o pe of se c tion 280E be c a use de pre c iat ion is not “pa id or inc urre d during thetaxa ble y e ar.” This c onte ntion re late s to the first of the sta tutory c onditions sum

m ariz e d a bove . Se e supra

Part I. SJW argue s tha

t the m e aning of se c tion 280E is una m biguous a nd tha t its
re a c h is limite d to “ de duc tions a nd c re dits for busine s s e xpe nditure s .” In SJW ’ s vie w , the busine ss e xpe nditure s c ove re d by se c t ion 280E inc l ude (but a re not lim ite d to) the e xpe n s e s de sc ribe d in se c t ion 162. B ut the y do not inc lude de pre c iation be c a

use de pre c iation is not de sc ribe d in se c tion 162 a nd is not a

n
am ount “ pa id or inc urre d d

uring the ta xa

ble y e ar.” W e ne e d

not a ddre s s whe the r (for purpose s of a

pply i ng se c t ion 280E) depre c i a tion m ight be de sc ribe d in
se c t ion 162 be c a

use , re ga rdle ss of the answe r to tha t que stion, we disa g re e with

8 SJW doe s not c ha lle n g e the c o nstitutiona lity of se c tion 280E, so we ne e d not a ddre ss tha

t que stion furthe r. Se e NC SB A , 153 T.C . at 68-72. B ut se e id. a t 77-90 (Gusta fson, J., c onc urring in pa rt a nd disse nting in pa

rt).- 13 -

SJW ’ s c onte ntion tha

t de pre c i ation is not “

pa i d or inc urre d during thetaxa ble y e ar.” SJW ’ s c onte ntion is fore c lose d by the C ode an d Supre m e C ourt pre c e de nt. Se c tion 7701(a

)(25) provide s tha

t , “ [w] h e n use d in this title , whe re not othe rwise distinc tly e xpre s se d or m anife stly inc o m patible with theinte nt the re of,”

“ [t] he te rm s ‘ pa id or inc urre d’ * * * sha ll be c onstrue d a c c o rding to the m e t hod of
a c c ounting upon the

ba sis of whic h * * * ta

xa ble inc o m e is c om

pute d unde r subtitleA.” Ge ne ra lly , “ [t] a xa ble inc om e sha ll be c om

pute d unde r the m e thod of
a c c ounting on the

ba sis of whic h the taxpa

y e r re gula rly c om pute s his inc o m e in ke e ping his books.”

Se c . 446(a ). During the ta xa ble y e ars at issue , SJW

use d the
a c c rua l m e t

hod of a c c ounting, a

pe rm issiblem e thod unde r se c tion 446. Se e
se c . 446(c )(2). As the Supre m e C ourt ha s obse rve d , C ongre ss a uthoriz e d the a c c rua l
m e thod of a c c ounting “ to e n a ble taxpa y e rs to ke e p the i r books a nd m ake the ir
re turns a c c ording to sc i e ntific a c c ounting princ i ple s , by c ha rging a ga inst inc om e
e arne d during thetaxa

ble pe riod, the e xpe nse s inc urre d in a nd prope rly

attributa ble to the proc e ss of e arning inc om e during tha t pe riod.” Unite d State s v. Ande rson, 269 U.S. 422, 440 (1926); se e a lso Trinity Indus., Inc . v. C o m

m issione r, 132 T.C
. 6, 14, 19 (2009). Se e ge ne ra lly B oris I. B ittke r & Lawre nc e Lokke n, Fe de ra l Ta xation of Inc om e , Esta te s & Gifts, pa

ra . 105.4 (W e s tla

w2020), FTXIEG- 14 -

(providing a

n ove rvie w of a c c rua l a c c ounting). The Supre m e C o urt e xpla ine d how the s e princ iple s a

p ply to de p re c iation in C om

m issione r v. Ida

ho Powe r C o., 418 U.S. at 16-19. In Ida ho Powe r, the C ourt c onside re d whe the r a

taxpa y e r that use d its own
e quipm e nt in thec onstruc tion of its own c a pita l fa c ilitie s wa s e ntitle d unde r
se c t ion 167(a ) to a

de pre c iat ion de duc tion for thec urre nt y e ar with re spe c t to the
use of tha t e quipm e n t, or whe the r the de d uc t ion wa s ba

rre d by se c tion 263(a)(1). 9 If the de duc tion wa s ba

rre d by se c tion 263(a)(1), the am o unt of the de duc tion would be c a

p ita l iz e d a

nd re c ove re d ove r the use ful life of the c o nstruc t e d fa c ilitie s. Foc using on the

c onc e pt of de pre c i a tion, theC ourt note d: Ove r a pe riod of tim e a

c a pita l a sse t is c onsum e d a

nd, c orre spondingly

ove r that pe riod, its the ore tic a l va lue an d utility are the re by re d uc e d . De pre c iation is a

n a c c ounting de vic e whic h re c ogniz e s tha

t the phy sic a l c onsum

ption of a c a p ita l a sse t is a true c ost, sinc e the a sse t is be ing de ple te d. As the proc e s s of c onsum p tion c ontinue s, a

nd de pre c iation is c l a im e d a nd a llowe d, the a sse t’ s a djuste d inc om e ta x ba sis is re duc e d to re fle c t the distribution of its c ost ove r the a c c ounting pe riods a ffe c te d. The C ourt sta te d in He rtz C orp. v. Unite d State s, 364 U.S. 122, 126 (1960): “ [T] h e purpose of de pre c i ation a c c o unting is to a lloc a te the e xpe nse of using a n a sse t to the va rious pe riods whic h a

re be ne fite d

by that a sse t.” Se e a lso

9 Se c t ion 263(a )(1) disa l lows a de duc tion for “ [a ] ny am ount pa id out for ne w buildings or for pe

rm an e nt im

prove m e nts or be tte rm e nts m a de to inc re a se the va lue of a ny prope rty

or e sta te
. ” The C ourt in Ida

ho Powe r inte rpre te d se c t ion 263(a )(1) of the 1954 C ode , but the te xt of tha t se c tion wa s ide ntic a l to the te xt of the c urre nt C ode . Se e C om m issione r v. Ida

ho Powe r C o., 418 U.S. 1, 3 n.2 (1974).- 15 -

Unite d State s v. Lude y , 274 U.S. 295, 300-301 (1927); M a s se y M otors, Inc . v. Unite d State s, 364 U.S. 92, 96 (1960); Fribourg Naviga tion C o. v. C om

m issione r, 383 U.S. 272, 276-277 (1966). W he n the a s se t is use d to furthe r the ta xpa y e r’ s da y -to-da y busine ss ope ra tions, thepe riods of be ne fit usua l ly c orre late with theproduc tion of inc om e . Thus, to the e xte nt tha t e quipm e n t is use d in suc h ope ra tions, a

c urre nt de pre c iation de duc t ion is a n a ppropria te offse t to gross inc o m e c urre ntly

produc e d. It is c l e ar, howe ve r, tha t diffe re nt princ iple s a

re im plic a te d whe n the c onsum p tion of thea s se t ta

ke s pla c e in the c onstruc tion of othe r a sse ts tha t, in thefuture , will produc e inc om e the m se lve s. In this la tte r situa tion, thec ost re pre se nte d by

de pre c iation doe s not c orre late with produc tion of c urre nt inc om e . R a the r, the c ost, a l though c e rta inly pre se ntly inc urre d, is re l a te d to the future an d is a ppropria te l y a lloc a te d a s pa

rt of the c ost of a c q

uiring a n inc om e -produc ing c a

pita l a s se t. [Fn. re f. om itte d.] C om m issione r v. Ida

ho Powe r C o., 418 U.S. a t 10-11 (e m

pha s is a dde d). Idaho Powe r le av e s no doubt tha t, a s a “ c ost * * * c e rta inly pre se ntly inc urre d,” id. a

t 11, de pre c iation c o nstitute s a n “ am ount pa id or inc urre d during the ta xa ble y e ar,” s e c . 280E. 1 0 Give n tha t c onc lusion, se c tion 280E a p plie s by its
e xpre s s te rm s to SJW ’ s c irc um sta nc e s.

1 0 W e ourse lve s ha

ve m ore tha

n onc e c h ara c te riz e d de pre c iation a s be ing
“ inc urre d” in a

give n y e a

r or ove r m

ultipley e ars. Se e , e .g., Proc a c c i v. C om m issione r, 94 T.C
. 397, 405 (1990) (sta ting tha t a pa rtne rship “ inc urre d de pre c iation on the

im prove m e n ts” re late d to a

golf c ourse ); C urphe y v. C om m issione r, 73 T.C
. 766, 768 (1980) (sta ting tha t a doc tor “ inc urre d de pre c iation a

nd pa id othe r e xpe nse s” in c onne c tion with a hom e offic e ); Produc e rs C he m . C o . v. C om m issione r, 50 T.C . 940, 959 (1968) (sta ting tha t the ta xpa y e r “ use d m a c h ine ry * * * a nd inc urre d

de pre c iation on tha

t m a c hine ry ” ).- 16 -

The pa rtie s a gre e tha

t se c tion 167(a)(1) provide s a “ de d uc tion.” Se e
se c . 167(a )(1) (a llowing “ a s a de pre c iation de duc tion a re a sona ble a llowa

nc e for the e xha ustion, we ar a

n d te ar” of c e rta in ite m s ). And, a s just discusse d, tha t de duc tion is for a

n “ am ount pa i d or inc urre d during thetaxa ble y e ar.” Se c . 280E. W ith re spe c t to the first sta tutory c ondition sum

m ariz e d a bove , the te xt of
se c t ion 280E re quire s no m ore . M o re ove r, SJW a gre e s tha

t the de pre c i a tion he re
wa s inc urre d “ in c arry ing on” a tra de or busine ss (sa

tisfy i ng the se c ond sta

t utory
c ondition), a

nd we h a ve a lre a d y e xpla ine d tha

t SJW ’ s tra de or busine ss “ c o nsist[s] of” tra ffic king in c o ntrolle d substa nc e s (satisfy ing the third sta tutory c o ndition). In vie wof the fore going, se c tion 280E disa llows SJW ’ s c la im e d de p re c iation de duc tions for a l l of the y e ars at issue
. 1 1

1 1 “ For those who c onside r le gisla tive history

re l e va nt,” W arge r v. Sha

ue rs, 574 U.S. 40, 48 (2014), we note tha t, in its re port on thebill proposing wha t be c am e se c tion 280E, the Se nate e xpla ine d the provision a s follows: “ All de duc tions a

nd c re dits for a

m ounts pa id or inc urre d in the ille ga l tra ffic k ing in drugs liste d in the C ontrolle d Substa nc e s Ac t a

re disa llowe d. To pre c lude possible c ha lle nge s on c onstitutiona l grounds, the

a djustm e nt to gross re c e ipts with re spe c t to e ffe c tive c o sts of goods sold is not a ffe c t e d by this provision of the

bill,” S. R e p t. No. 97-494 (Vol. 1), a t 309 (1982), 1982 U.S.C .C .A.N. 781, 1050. This sta te m e nt sugge sts tha

t C ongre ss inte nde d to de ny de duc tions a

nd c re dits to the e xte nt of its c onstitutiona l a uthority . M ore ove r, the Se n a te am e ndm e nt proposing to a d d wha

t would be c om e se c tion 280E wa s a dopte d in C o n fe re nc e , a nd the c onfe re nc e re port use d the sa m e e xpa nsive te x t to de s c ribe the e ffe c t of the ne w provision. H.R
. R e p t . No. 97-760, a t 597-598 (1982), 1982-2 C .B . 600, 661.- 17 -

This c onc l usion is e ntire ly c onsiste nt with other a

uthoritie s re l a te d to de pre c iation. For e xam

ple , se c tion 168 m ake s c le a r tha t the am ount of a llowa

ble de pre c iation is de te rm ine d for e a c h tax a ble y e a r a nd is the re fore a

de duc t ion for a

n ite m inc urre d during tha

t y e a r. Se e se c . 168(b)(1)(B ) (providing tha t the a pplic a ble de pre c iation m e thod switc he s for a pa rtic ula r ta xa ble y e a r a c c ording to the

am ount
a llowa ble in tha t y e ar unde r various m e t

hods). Sim i la

rly , if a taxpa y e r se lls
e quipm e nt use d in a

tra de or busine ss in them iddle of a y e ar, the taxpa

y e r is
a llowe d a de p re c iation de d

uc t ion for the portion of the y e ar in whic h the
e quipm e nt wa s use d. Se c . 1.167(a )-10(b), Inc om e Ta x R e gs. This rule a c c ounts for the fa c t tha

t , a s a taxpa y e r like SJW

use s de pre c ia

ble prope rty during the y e ar, the p rope rty

is “ c onsum e d” an d ordina rily its va lue and utility

are re duc e d. Thus, the t a xpa y e r inc urs the ty

pe of c ost e nvisione d by

the Supre m e C ourt in Ida ho Powe r for that pa

rt of the y e ar. 1 2 Our c onc lusion he re is a lso c onsiste nt with our de c ision in Fort Howa rd C orp. & Subs. v. C om

m issione r, 103 T.C . 345, 351 (1994), supple m e nte d by

107 T.C . 187 (1996). The re , we c onside re d se c tion 162(k)(1), whic h provide d tha t “ no

1 2 As the Supre m e C o urt re c ogniz e d in Ida ho Powe r, “ de p re c iation-- ina s m uc h a s it re pre se nts a

using up of c a

pita l--is a s m

uc h a n ‘ e xpe nditure ’ a s the using up of la

bor or othe r ite m s of dire c t c ost.” C om m issione r v. Ida

ho Powe r C o., 418 U.S. a

t 17 (quoting B rooks v. C om m issione r, 50 T.C . 927, 935 (1968), re v’ d, 424 F.2d 116 (5th C ir. 1970)).- 18 -

de duc tion othe rwise a l lowa ble sha ll be a llowe d unde r this c ha pte r for any

am ount pa id or inc urre d by a c o rporation in c onne c tion with the re d e m ption of its stock.” (Em pha s is a dde d.) W e we re a ske d in Fort Howa rd C orp. & Subs. v. C om m issione r, 103 T.C . at 367, to de c ide whe the r “ am ortiz a tion c o nstitute [s] an
am ount pa i d or inc urre d,” and we “ answe r[e d] this que stion in the a ffirm a tive .” Our a na ly sis re lie d on Ida

ho Powe r, noting tha

t, “ [f] or tax purpose s , am ortiz a tion
se rve s a purpose sim ila

r, if not ide ntic a l, to depre c i a tion.” Id. at 368 (c i ting Ark.- Okla . Ga s C o. v. C om

m i ssione r, 201 F.2d 98, 102 (8th C ir. 1953), re v’ g 17 T.C
. 1208 (1952), a

nd B la c k’ s La

w Dic tiona

ry 76, 397 (5th e d. 1979) (de fining of

“ am ortiz a tion” and “ d e pre c iation” )). 1 3 Like the de pre c iation he re , the re fore , the

1 3 In re a c hing our c onc lusion weobse rve d: W e note , a s did the Supre m e C ourt, se e C om m issione r v. Ida

ho Powe r C o., 418 U.S. 1, 16 n.11 (1974), tha t de pre c iation ha s be e n he ld not to be an e xpe nditure or pa

ym e nt for purpose s of a

c ha rita b le c ontribution de duc tion unde r se c . 170, se e Orr v. Unite d State s, 343 F.2d 553 (5th C ir. 1965), or for purpose s of a m e dic a l e xpe nse de duc tion unde r se c . 213, se e Gordon v. C om m issione r, 37 T.C . 986 (1962). In distinguishing those

de c isions, the

Supre m e C ourt sta

t e d: Se c tion 263 is c onc e rne d, howe ve r, with the c a pita l nature of an e xpe nditure and not with its tim ing, a s are the phra s e s “ p aym e nt * * * within the taxa ble y e ar” or “ pa id during the ta xa

ble y e ar,” re s pe c tive ly

use d in §§ 170 a nd 213. Thetre a tm e nt of de p re c iation unde r those se c tions ha s no re le va nc e to the issue of c a pita liz ation he re . * * * (c ontinue d...)- 19 -

am ortiz a tion a

t issue in Fort Howa

rd wa s a n “ am o unt pa id or inc urre d” by the ta xpa y e r. 1 4 C
. SJW ’ s “ In C a

rry ing On” Argum e nt SJW ne x t argue s tha

t, e ve n if we disa llow its de pre c i a tion de duc tions, its
c ha rita ble c ontributions should be de duc tible in light of the se c o nd sta

tutory
c ondition de sc ribe d a

bove . Spe c ific a lly , SJW c onte nds tha t its c ha rita ble
c ontributions we

re n o t pa id “ in c arry ing on” a tra d e or busine ss a s re q uire d by
se c t ion 280E. W e disa gre e . As re le va nt he re , se c tion 280E a

pplie s to disa llow a

de duc tion for “ any
am ount pa i d or inc urre d * * * in c arry ing on a ny tra de or busine ss.” (Em

pha sis

1 3 (...c ontinue d ) Fort Howa

rd C orp. & Subs v. C om

m issione r, 103 T.C . 345, 368 n.36 (1994), supple m e nte d by

107 T.C
. 187 (1996). Thesa m e ra t iona le a

pplie s to our a

na ly sis he re . 1 4 Afte r we issue d

our de c ision in Fort Howa rd, C ongre ss a

m e nde d se c t ion 162(k) to a d d a

n e xc e ption to the

ge ne ra l rule . Se e Sm a ll B usine ss Job Prote c tion Ac t

of 1996, Pub. L. No. 104-188, se c . 1704(p)(2), 110 Sta t. at 1886 (a m e nding se c . 162(k)(2) to a dd se c . 162(k)(2)(A)(ii)). Unde r that e xc e ption, “ the e xpe nse d isa llowa

nc e rule of se c tion 162(k) doe s not a pply to a ny ‘ d e d uc tion for am ounts whic h a

re prope rly

a lloc a ble to indebte dne ss a

nd a m ortiz e d ove r the te rm of suc h inde bte dne ss.’ ” Fort Howa rd C o rp. & Subs. v. C om

m issione r, 107 T.C
. at 188. C o ngre ss’ s a c tion c onfirm s tha t our inte rpre tation of thephra se “ am ount pa id or inc urre d” wa s c orre c t . In a m e nding se c t ion 162(k), C ongre ss le ft the ge ne ra l rule unc ha

nge d an d a dde d inste a d a

n e xc e ption for a

c e rta in fa c t

patte rn, c onfirm i ng tha

t, but for the e xc e ption, thege ne ra l rule would a pply to the am ounts a t issue
.- 20 -

a dde d.) SJW

is a c orporation tha

t wa s e nga ge d in a

tra de or busine ss whe n it m a de the re le va nt c ha rita ble c ontributions. C a l ifornia State la w spe c ific a lly

a uthoriz e s a
c orporation to m ake c ha

rita ble c ontributions, C a l. C orp. C ode se c . 207(e ) (W e st 2020), a nd c ourts ha

ve long pe rm itte d c orporations to de c ide whe the r a c h a rita ble gift is c onsiste nt with the ir fina nc ia l a nd ope ra tiona l goa ls, se e , e .g., A.P. Sm ith M fg. C o. v. B arlow, 98 A.2d 581 (N.J. 1953) (c olle c ting a uthoritie s). SJW

c hose to c o ntribute the am ounts a t issue he re , a

nd we se e no re a son to c onc lude tha t this
a c tion wa s som e how se pa ra te from , or outsidethe sc ope of, its busine ss a c tivitie s. M any c ourts ha ve a c k nowle dge d the pote ntia l be n e fits to a c orporat ion of m aking a
c ha rita ble gift, a nd the re is no indic a tion tha t we should que stion SJW ’ s
m otiva t ions in m ak ing the se c ontributions. Se e , e .g., Unite d State s v. Transa m e ric a C o rp., 392 F.2d 522, 524 (9th C ir. 1968) (“ [A] n a bsolute
re quire m e nt of de ta c he d

an d disinte re ste d ge ne rosity or la c k of a

ny busine ss purpose would te nd to re nde r ultra vire s substa

ntia lly a ll c ha rita ble c ontributions
and thus to frustra

t e the c ongre ssiona l inte nt tha t c orporations should e

n joy suc h de duc tions.” ); Gre e ne C t

y . Nat’ l Fa

rm Loa n Ass’ n v. Fe d. La

nd B ank of Louisville , 57 F. Supp. 783, 789 (W .D. Ky . 1944) (“ [I] t is * * * we ll e sta blishe d that c orporations a

re pe rm itte d to m ake substa ntia l c ontributions whic

h ha ve the outwa rd form of gifts whe re the a c tivity be i ng prom ote d by the so-c a lle d gift te nds- 21 -

re a s ona bly to prom ote the goodwill of the busine ss of the c ontributing
c orporation.” ), a ff’ d, 152 F.2d 215 (6th C ir. 1945). In our view, SJW c ontribute d the a m ounts a t issue “ in c a

rry ing on” its tra de or busine ss. In re sponse , SJW ’ s prim ary argum e nt se e m s to be that a m o unts pa i d “ in
c arry ing on” a

tra de or busine ss fa ll into a na rrowe r c a te gory tha

n am ounts pa id “ in
c onne c tion with”a

tra de or busine ss, a

nd tha t the form e r c a te gory

doe s not
e nc om pa ss its c ha

rita ble c o ntributions. In support of this vie w, SJW c om pa re s the te xt of se c tion 280E with tha t of se c tion 162(a). The latte r provide s a de duc tion for “ ordina

ry and ne c e ssa

ry e xpe nse s pa id or inc urre d during thetaxa ble y e ar in
c arry ing on a

ny tra de or busine ss.” (Em

pha sis a d de d
. ) SJW

c onte nds tha

t the phra se “ in c arry ing on” signific antly lim its the unive rse of e xpe nditure s to whic h
se c t ion 162 a

pplie s a nd tha t a sim ila r an a ly sis of se c tion 280E c onfirm s tha t the
se c t ion doe s not a

pply to SJW ’ s c ha

rita ble c ontributions. W e find this a rgum e nt unpe rsua sive
. SJW is c orre c t tha

t c o urts ha

ve c o nstrue d se c tion 162(a) a s ina pplic a b le to
c e rta in c a te gorie s of e xpe n diture s--for e xam ple , distributions of profits, loa ns, a nd
c a pita l e xpe nditure s . B ut c ourts ty pic a lly do not ground the se e xc lusions in the phra se “ in c arry ing on.” R a the r, the y re ly on othe r re quire m e nts of se c tion 162(a),
suc h a s the c ondition tha

t a n e xpe nditure m

ust be an “ e xpe nse ” tha

t is both- 22 -

“ ordina ry ” and “ ne c e ssa

ry .” Se c tion 280E, which a pplie s to “ any

am ount pa id or inc urre d,” ha s no a

na l o gous re quire m e nts. As a n e xam ple , SJW c ite s B urne tt v. C om

m issione r, 356 F.2d 755 (5th C ir. 1966), re m an ding 42 T.C . 9 (1964), for the proposition tha t “ the phra se ‘ c arry ing on’ distinguishe s c a

pita l outla

y s , distributions of profits, a nd loa ns from e xpe nse s .” In B urne tt, the U.S. C ourt of Appe a ls for the Fifth C irc uit c onside re d whe the r
a dva nc e s pa id by

an attorne y

to c lie nts he de e m e d

like ly to pre va il we re de d

uc tible busine ss e xpe nse s unde r se c tion 162. Id. Noting the a ttorne y ’ s c are ful ve tting proc e s s a nd the high pe rc e nta ge of e xpe nditure s tha t he ultim a te ly

re c oupe d, the Fifth C i rc uit c onc lude d tha t the a dva nc e s we re virtua lly

c e rta in to be re pa id a

nd the re fore should not be

de duc tible . Id. at 759-760. B ut the c ourt did not re ly on the p hra se “ in c arry ing on” in re a c hing its c onc lusion--the re wa s no que stion tha t the a dva nc e s we re pa id in c arry ing on theattorne y ’ s busine ss of re pre s e nting
c lie nts. R a the r, the c ourt c onc l ude d tha t the a dva nc e s ope ra te d a s loa

ns a nd the re fore did not qualify a s “ e xpe nse s” within the m e aning of se c tion 162. Id. W hile undoubte dly c o rre c t, the ana ly sis a n d c onc lusion in B urne tt ha ve no be aring on the tre a tm e nt of SJW ’ s c ha rita ble c ontributions. 1 5

1 5 The c ourt in B urne tt sta

te d in dic ta

tha t “ [t] o be de d

uc tible unde r [s] e c tion 162(a), an e xpe nditure m ust c onstitute

an e xpe nse of c a

rry ing on a

tra de or busine ss, a s distinguishe d from som e othe r ty

pe of e xpe nditure m a de in

(c ontinue d...)- 23 -

One c a se c ite d

by SJW doe s a ddre ss the m e aning of thephra se “ in c arry ing on.” In Snow v. C om

m issione r, 416 U.S. 500 (1974), the Supre m e C ourt
c onside re d the ta xpa

y e r’ s de duc tion of re se arc h a nd de ve lopm e nt e xpe nditure s unde r se c tion 174. Tha

t provision a llows a

de duc tion for c e rta i n e xpe nditure s pa id or inc urre d “ in c onne c tion with”a tra de or busine ss during the taxa ble y e a r. Se c . 174(a )(1). The C ourt c onc lude d tha t the taxpa

y e r wa s e ntitle d to the de duc tion e ve n though the e xpe nditure s we re inc urre d during thesta rtup pha se of the t a xpa y e r’ s busine ss, be fore it ha d re porte d a ny sa le s. Snow v. C om

m issione r, 416 U.S. a

t 501-502. TheC ourt note d tha t se c tion 162(a) is unhe lpful in a n a ly z ing
se c t ion 174(a )(1) be c a

use the form e r “ is m ore na rrowly writte n” tha

n se c tion 174. Id. at 503. In pa

rtic ula r, the C o urt found tha

t C ongre ss ha d use d the phra se “ in
c onne c tion with”in se c tion 174 to a llow ta xpa y e rs de ve loping ne w produc ts

1 5 (...c ontinue d ) c onne c tion with the

taxpa y e r’ s busine ss.” B urne tt v. C om m issione r, 356 F.2d 755, 759 (5th C i r. 1966), re m a n ding 42 T.C . 9 (1964). W hile SJW argue s tha

t the c ritic a l distinc t ion in this sta te m e nt is be twe e n “ in c arry ing on” and “ in c onne c tion with,” the ana ly s is in B urne tt turns on the distinc tion be twe e n a

n “ e xpe nse ” and
“ som e othe r ty

p e of e xpe nditure ” (i.e ., a loa n ). Id. at 759-760. The

c a se s c ite d in support of thequote d te xt sim ila rly turn on them e aning of “ ordina ry and ne c e ssa

ry e xpe nse ” ra the r tha

n the phra se “ in c arry ing on.” Se e W e lc h v. He lve ring, 290 U.S. 111 (1933) (c a

pita l outla

y s a re not busine ss e xpe nse s ); Swe d Distrib. C o. v. C om m issione r, 323 F.2d 480 (5th C ir. 1963) (distributions of profits a re not busine ss e xpe nse s), a ff’ g T.C . M e m o . 1962-41; Le vy v. C om m issione r, 212 F.2d 552 (5th C i r. 1954) (e xpe n d iture s for whic h the re is a n unc onditiona l right of re im burse m e nt a

re not busine ss e xpe nse s).- 24 -

without e sta

blishe d re s e arc h

de pa rtm e n ts to qua l ify for the de duc tion. Id. The C ourt im p lic itly re c ogniz e d tha

t no de duc t ion is a

va ila b le unde r se c t ion 162(a ) for
c osts inc urre d be fore the c om m e nc e m e nt of busine s s, at le a st in pa rt be c a use of the
re quire m e nt unde r se c t ion 162(a ) that e xpe nse s be inc urre d “ in c arry ing on” a tra de or busine ss. Othe r c a se s ha ve re a c he d

sim ila r c o nc lusions. Se e , e . g., Frank v. C om m issione r, 20 T.C
. 511, 513-514 (1953). W e a gre e that, a s the C ourt note d in Snow, thete xt of se c tion 162(a)--a nd spe c ific a lly

the phra se “ in c arry ing on” --is na rrow in the se nse tha

t it a pplie s only to e xpe nse s inc urre d while c onduc ting a tra de or busine ss, a

nd not to e xpe nse s inc urre d be fore a

busine ss c om

m e nc e s or a fte r its c onc lusion. B ut a ga in, tha t distinc tion ha s no be aring on there sults in the se c a s e s, whe re SJW c onc e de s tha

t the c ha rita b le c ontributions we

re m a de while it c o nduc te d its busine ss. SJW ’ s a rgum e nt tha

t its c ha rita ble c ontributions by

de finition a

re not

“ busine ss e xpe nditure s” m isse s the m ark for sim ila r re a sons. Fa i ling to qualify a s
a busine ss e xpe nditure m a y we ll be fa ta l unde r se c tion 162, a lthough the phra se doe s not a ppe ar in tha

t se c tion. Thec onc e pt, howe ve r, ha s no re le va nc e unde r
se c t ion 280E, whic h

a pplie s to “ any

am ount pa id or inc urre d * * * in c arry i ng on
any tra de or busine ss.” (Em

pha sis a d de d.) The fa c t tha t the two provisions sha

re- 25 -

one phra se (“ in c arry ing on” ) doe s not im port the othe r re quire m e nts of se c tion 162 into se c tion 280E. Fina lly , SJW

argue s tha

t se c tion 280E should not a pply to c ha rita b le
c ontributions a s a

m a tte r of polic y , be c a

use to de c i de othe rwise c ould produc e unfavora ble outc om e s for taxpa

y e rs who c ontribute c a

p ita l prope rty

or inve ntory

to
c ha ritie s. B ut the se argum e nts a re be side the point. W

he n it e na c te d se c tion 170, C ongre ss wa s fre e to provide a de duc tion to ta

xpa y e rs who m e t c e rta i n c rite ria , a nd whe n it subse que ntly e na c te d se c tion 280E, C ongre ss wa s e qua lly fre e to disa llow the d e duc tion (or othe r sim ila r be ne fits) ba s e d on ne wc rite ria
. The re quire m e nts of se c tion 280E a

re c le ar, an d the hy

pothe tic a ls posite d by

SJW are not re le v ant to the s e c a se s. B a se d on the fore going, we c onc lude se c tion 280E a pplie s to SJW ’ s
c ha rita ble c ontributions for the

y e ars a t issue , a nd thus tha

t the c orre sponding de duc tions a

re disa llowe d.- 26 -

IV. Ac c ura c y -R e late d Pe n a lty Se c tion 6662 im

p ose s a 20% pe na lty

on the portion of a

n unde rpaym e nt of ta x attributa

ble to a ny substa ntia l unde rstate m e n t of inc om e tax. Se c . 6662(a ), (b)(2). For c o rporations, a n unde rstate m e nt of inc om e tax is substa n tia l if it
e xc e e ds the le sse r of $10 m illion or “ 10 pe rc e nt of the ta x re quire d to be shown on the re turn for the tax a

ble y e ar (or, if gre a te r, $10,000).” Se c . 6662(d)(1)(B ). The re is no dispute that SJW ’ s unde rstate m e nt of inc om e tax for the taxa ble y e ar 2015 wa s substa

ntia l within the

m e aning of thesta

tute
. 1 6 Ne v e rthe le ss, SJW
c an avoid the pe na lty

the C om m issione r de te rm i ne d if SJW a c te d with re a sona

ble
c a use and in good fa ith with re spe c t to the unde rpay m e n t. Se e se c . 6664(c )(1); se c . 1.6664-4(a ), Inc o m e Ta x R e g s. SJW ha s the burde n of proving tha t its a c tions
satisfie d this sta

nda rd. Se e R ule 142(a ); Higbe e v. C om m i ssione r, 116 T.C . 438, 449 (2001); se e a lso NT, Inc . v. C om m issione r, 126 T.C . 191, 195 (2006) (holding that the rule s unde r se c tion 7491(c ) do not a pply to pe na ltie s a sse rte d a ga i nst
c orporations). To de c ide whe the r a

taxpa y e r a c te d with re a sona

b le c a u se and in good fa ith,
we c onside r a ll re l e va

nt fa c t s a n d c irc um sta

nc e s , suc h a s the “ ta xpa

y e r’ s e ffort to

1 6 The tota l tax re quire d to be shown on SJW ’ s re turn for 2015 wa s $972,718, a s re fle c te d in the notic e tha t we susta in. SJW ’ s re turn, a s file d, re porte d tax of $65,602. Thediffe re nc e be twe e n the two a m ounts ($907,116) e xc e e ds 10% of the ta x tha t wa s re q uire d to be shown on SJW ’ s re turn.- 27 -

a sse ss the taxpa

y e r’ s prope r ta x lia

bility ” and its “ e xpe rie n c e , knowle d ge , an d
e duc a tion.” Se c . 1.6664-4(b)(1), Inc om e Ta x R e gs.; se e a lso Arm strong v. C om m issione r, 139 T.C . 468, 478 (2012), a ff’ d , 745 F.3d 890 (8th C i r. 2014). A ta xpa y e r m ay de m onstra

t e re a sona ble c a use through good-fa i th re lia nc e on the
a dvic e of a

n inde pe nde nt profe s siona l, suc h a s a tax a dvise r, a

la wy e r, or a

n
a c c ounta nt. Se e se c . 1.6664-4(b), Inc om e Ta x R e gs.; se e a l so W oodsum v. C om m issione r, 136 T.C . 585, 591 (2011). An hone st a nd re a sona

ble
m isunde rsta

nding of fa c t or la

w m ay indic a te re a sona

ble c a use and good fa ith. Se c . 1.6664-4(b), Inc o m e Ta x R e gs.; se e a lso Higbe e v. C om m issione r, 116 T.C
. a t 449. And in the

pe na l tie s c onte x t m ore ge ne ra lly , a wide range of pote ntia l
a uthoritie s--e .g., sta

tutory te xt, re gula

tions, c a s e la

w, le gisla tive history , a

nd IR S guida n c e --is re le va

nt to e va luating a

taxpa y e r’ s position. C f. se c . 1.6662- 4(d)(3)(iii), Inc om e Ta x R e gs. The re c ord offe rs littlee vide nc e tha t SJW a c te d re a sona

bly and in good fa ith with re spe c t to its 2015 unde rpa ym e n t. The pa

rtie s a g re e tha

t SJW followe d the substa ntia tion rule s tha

t a pplie d to its c la im e d de d

u c tions, a nd SJW ’ s 2015 ta

x
re turn sugge sts tha

t SJW inc urre d $807,142 of “

non-de duc tible e xpe nse s” for tha t y e ar, pe rha

ps in a c knowle dgm e nt of the C H AM P de c i sion. B ut SJW ha s not
argue d he re tha t it ha s anothe r tra de or busine ss se pa ra t e from its tra ffic king- 28 -

busine ss to whic h

c e rta in e xpe nse s should be a lloc at e d. Nor ha s SJW a dva n c e d
any othe r argum e nt to support such a bifurc a te d a

p proa c h to its e xpe nse s. Inde e d, the p artie s’ stipula

tion of fa c ts provide s no insight into the proc e s s SJW followe d in pre pa ring its re turn. 1 7 Furthe r, SJW

ha s not c la im e d tha

t it re lie d in good fa ith on thea dvic e of a n inde pe nde nt profe ssiona l in de duc ting theam ounts a t issue . Inste a d, SJW

c onte nds that the la w in this a

re a wa s suffic ie ntly unse ttle d a s of June 15, 2016--the date tha t SJW file d its Fe de ra l inc om e tax re turn for 2015--tha t SJW re a s ona

bly re p orte d its
e xpe nse s . W e are unpe rsua de d
. To be gin with, the

te xt of se c tion 280E swe e ps broa d l y to pre c lude a de duc tion for “ any

am ount pa id or inc urre d

during thetaxa

ble y e ar in c arry ing on
any tra de or busine ss * * * [tha t] c onsists of tra ffic king in c ontrolle d substa nc e s.” (Em pha s is a dde d.) B y June 15, 2016, the U.S. C ourt of Appe a ls for the Ninth C irc uit ha d a ffirm e d our C ourt’ s inte rpre tation of thephra se “ c o nsists of” in Olive v. C om m issione r, 792 F.3d a

t 1149-1150, ag re e ing tha t se c tion 280E a

pplie s with
e qua l forc e to the de duc tions of ta xpa y e rs tha t unde rtake c e rta in a

n c i lla rynontra ffic king a c tivitie s re l a te d to the ir tra ffic king a c tivitie s . M ore ove r, in e a c h of the

1 7 Although SJW

c la im s tha

t it volunta

rily tre a te d a portion of its e xpe nse s a s nonde duc tible , ne ithe r the re turn nor the re st of the re c ord e xpla ins how SJW re a c he d tha

t de c ision. And the

fa c t tha t SJW ’ s e xpe nse s we re a de quate l y substa ntia te d doe s not m e an SJW

a c te d re a s ona

bly whe n it de duc te d the m .- 29 -

four m arijua

na dispe n s ary

c a se s tha t our C ourt ha d de c ide d a s of June 2016, we disa llowe d a ll of the taxpa y e r’ s c la im e d de duc tions, e xc e pt to thee xte nt those de duc tions we re attributa

ble to a se pa ra te tra de or busine ss of the taxpa y e r. Se e Olive v. C om

m i ssione r, 139 T.C . 19; C HAM P v. C om m issione r, 128 T.C . 173; C anna C a re , Inc . v. C om

m issione r, T.C
. M e m o. 2015-206, a ff’ d , 694 F. App’ x 570 (9th C ir. 2017); B e c k v. C om m issione r, T.C . M e m o. 2015-149. Le gisla tive history
and IR S guida

nc e e x isting a

t the tim e re fle c te d sim ila rly e xpa nsive inte rpre tations of se c tion 280E. 1 8 Se e , e .g., S. R e pt. No. 97-494 (Vol. 1), a t 309 (1982), 1982 U.S.C .C .A.N. 781, 1050 (“ All de duc tions * * * for a m ounts pa id or inc urre d in the ille g a l tra ffic king in drugs liste d in the C ontrolle d Substa

nc e s Ac t a

re disa llowe d.” ); C h ie f C o unse l Adv. M e m . 201504011 (Ja n. 23, 2015) (“ [Se c tion 280E] re ve rse s the holding in * * * [Edm ondson v. C om

m issione r, T.C
. M e m o. 1981-623,] a s it re l ate s to de duc t ions othe r tha n the c ost of the c ontrolle d substa nc e s.” ). To sum m a riz e , at the tim e SJW

file d its 2015 re t

urn in 2016, the

te xt of
se c t ion 280E, a s we ll a s the re late d c a se la w, le gisla tive history , a

n d publishe d

1 8 The m ore re c e nt c a se s a nd guida n c e ava ila ble at the tim e SJW

file d its 2015 re turn distinguish the fa c ts he re from

those in Patie nts M utua l Assista nc e C olle c tive C orp. v. C om

m issione r, T.C . M e m o. 2018-208, whic h SJW c ite s in support of its position. Additiona lly , the taxpa

y e r in tha t c a se pre se nte d c re dible te stim ony tha t he a c tive ly

sought to c om

ply with C a lifornia

la w a nd this C ourt’ s c a se la w. Id. a t *7. SJW

m a ke s no suc h showing.- 30 -

guida n c e , indic a te d

tha t SJW ’ s c la im e d de duc t ions would be disa llowe d. SJW

ha s offe re d littlee vide nc e to sugge st tha t it c onside re d the s e a

uthoritie s--or took a

ny othe r a c tion--to de te rm ine its prope r ta x lia bility . On the se fa c ts, SJW ha s fa ile d to
e sta blish tha t it a c te d with re a sona

ble c a use and in good fa ith with re spe c t to the unde rpay m e nt a t issue
. W e the re fore susta in the pe na lty de te rm ine d

by the C om m issione r. To re fle c t the fore going, Appropria te de c isions will be e nte re d.