T.C. M em o . 2 0 1 8 -8 3

UNITED STATES TAX COURT

LAUREL ALTERM AN AND W ILLIAM A. GIBSON, Pet i t i o n ers v . COM M ISSIONER OF INTERNAL REVENUE, Res po n d en t

Do ck etNo . 1 3 6 66 -1 4
. Fi l edJ u n e 1 3 , 2 0 1 8
.

Hen ry G. Wyk o w s k i an dM at thew A. W i l l i am s , fo r p et it i o n ers . Cam ero n W . Carr, Kael yn J . Ro m ey , an dLu k e D. Ortn er, fo r res p o n d en t
.

M EM ORANDUM FINDINGS OF FACT AND OPINION
M ORRISON, J u d g e: Th e p et i t i o ners , Lau rel Al t erm an an dW i l l i am A. Gi b so n , fi l edjo in t i n co m e-t ax return s fo r 2 0 1 0 an d2 0 1 1 . OnM arch 1 3 , 2 0 1 4 , th e
res p o n d en t (h erei n aft er, t h e “ IRS”) i s su eda n o t i ce o f d efi ci en cy t o Al t erm an an d Gi b so n . Th e n o t i ce o f d efi ci en cy m ad e ad ju s t m en t s t o th e i n co m e o f a Co l o rad o
m ed i cal -m ari

ju an a b us i nes s, o wn edb y Al t erm an , i n co m e th atwas rep o rt edo n- 2
-

[* 2 ] Sch edu les C, “ Pro fi to r Lo s s Fro m Bu s i n es s ”, o f b o th retu rn s . Th e IRS d et erm i n edth e fo l l o w i n g i n co m e-t ax d efi ci en ci es an daccu racy -rel at edp en al t i es
u n d er s ect i o n 6 6 6 2 (a) fo r t ax y ears 2 0 1 0 an d2 0 1 1
. 1

Year Defi ci en cy Pen al ty s ec. 6 6 6 2 (a) 2 0 1 0 $ 1 5 7 ,8 2 1 $ 3 1 ,5 6 4 2 0 1 1 2 3 3 ,4 2 1 4 6 ,6 8 4 Al t erm an an d G ib s o n fi l eda p et i t i o n u n d er s ect i o n 6 2 1 3 (a) fo r red et erm i n at i o n o f th e d efi ci en ci es fo r b o th y ears . W e h av e ju ri sd i ct i o n u n der s ect i o n 6 2 1 4 (a). 2 Aft er t ak in g i n t o acco u n tco n ces s i o n s b y th e p art i es d es cri b edl at er i n th e o p i n i o n , h ere are t h e i s s u es rem ai n i n g fo r d eci s i o n: 1
. Wh atare t h e am o u n t s o f d edu ct i b l e b u s i n es s ex p en s es fo r Al term an ’ s
m ed i cal -m ari

ju an a b us i nes s fo r t ax y ears 2 0 1 0 an d2 0 1 1? W e h o ldth at p et i t i o n ers are n oten ti t l edt o an y b u s i n es s -ex pen s e d edu ct i o n s . See i n fra Part I.

1 Un l es s o th erwi s e i nd i cat ed , al l referen ces t o s ect i on s are t o t h e In t ern al Rev enu e Co de o f 1 98 6 , as am en d ed , an dal l referen ces t o Ru l es are t o th e Tax Co u rtRu l es o f Pract i ce an dPro cedu re. Al l d o l l ar am ou n t s are ro u nd edt o th e n eares td o l l ar.

2 Al t erm an an dGi bs o n res i dedi n Co l o rad o wh en th ey t i m el y fi ledth e p et i t i o n . Th erefo re, an y

ap peal o f o u r d eci s i o n i n th i s cas e wo ul dg o t o th e U.S. Co u rto f Ap p eal s fo r t h e Ten th Ci rcu i tu n l es s th e p art i es d es i gn at e t h e Co u rto f Ap p eal s fo r an o th er ci rcu i t . See s ec. 7 4 8 2 (b )(1 ) an d (2 ).- 3
-

[* 3 ] 2 . Are Al t erm an an dGi bs o n en t i t l ed t o co s t -o f-g o o ds -s o ldal l o wan ces fo r t h e
m ed i cal -m ari

ju an a b us i nes s i n ex ces s o f t h e am o u n t s co n ced edb y th e IRS i n i t s b ri efs fo r t ax y ears 2 0 10 an d2 0 11 ? Th e co n ced edam o u nt s are $ 4 5 2 ,2 9 2 fo r 2 0 1 0 an d$ 2 3 2 ,7 7 2 fo r 2 0 1 1 . W e h o l dth atth ey are
n o ten t i tl edt o ad d i t i o n al al l o wan ces . See i n fra Part II. 3
. Are Al t erm an an dGi bs o n l i ab l e fo r accu racy -rel at edp en al t i es u n d er s ect i o n 6 6 6 2 (a) fo r t ax y ears 2 0 1 0 an d2 0 11 ? W e h o l dth atth ey are l i ab l e. See i n fra Part III. FINDINGS OF FACT Th e p art i es s t i p u l at eds o m e fact s, an dtho s e fact s are i n co rp o rat edb y referen ce. At al l t i m es du ri n g 2 0 0 9 , 2 0 1 0 , an d2 0 1 1 Al t erm an an dGi b s o n were
m arri edan d res i d edi n Co l o rad o . Th ey fi l edjo i n tretu rn s fo r th es e y ears . Set t i ng Up Al term ed s, LLC Du ri n g th e y ears ati ss u e, i twas n o t i l l eg al u n d er Co l o rad o l aw fo r p eo p le t o
u s e m ari ju an a m ed ical l y

an dfo r a m ed i cal -m ari

ju an a b u s i n es s t o s el l m ari ju an a. See Co l o . Co n s t. art . XVIII, s ec. 1 4 . Ho wev er, b o th act i v i t ies were i l l eg al u n d er fed eral l aw. 3 In J ul y

2 0 0 9 , Al t erm an i n co rp o rat edAl t erm ed s , LLC. 4 Sh e was i t s

3 Un d er fed eral l aw, m ari

ju an a i s cl as s i fi edas a Sch edu l e I co n tro l l ed s ub s t an ce u n d er th e Co n tro l l edSub s t an ces Act . Pub
. L. No . 9 1 -5 1 3 , s ecs . 1 0 2 , (co n ti n u ed ...)- 4
-

[* 4 ] s o l e o wn er du ri n g 2 0 0 9 , 2 0 1 0 , an d 2 0 1 1 . Al term ed s, LLC, was a s ep arat e
en t i ty u n der Co l o rad o l aw. Fo r fed eral t ax p u rp os es , i t i s a d is reg ard eden t i ty , m ean i n g th ati t i s treat edas a s o l e p ro p ri et o rs h i p o f Al t erm an . See s ec. 3 0 1.7 7 0 1
- 2 (a), Pro ced . & Ad m in . Reg s . Op erat i o n o f t he M ed i cal -M ari ju an a Di s p en s ary Aro u n d Sep t em

b er 2 00 9 , Al t erm ed s, LLC, o p en eda ret ai l s t o re u n d er t h e b u s i n es s n am e “ Al term ed s”. W e refer t o thi s ret ai l s t o re as th e “ d i sp en s ary ”. Th e d i s p en s ary was i n Lo u i s v i l l e, Co l o rad o , wh i ch i s n ear Bo u l d er, Co l o rad o . Th e d i s p en s ary h adreg u l ar o p erat i ng h o u rs o f M on d ay th ro ug h Satu rd ay

fro m 1 1 a.m . t o 7 p .m ., an d o n Su n d ay fro m 1 2 p .m . t o 5 p .m . Th e d i sp en sarys o l ds m o k ab l e m ari ju an a, ei th er as p rero l l edm ari ju an a ci g aret tes (i .e., jo i n ts ) o r as dri edm ari ju an a b ud s . It al s o s o l dm ari ju an a i n ed i b l e fo rm , s u ch as b ro wn i es an dcak es , an do ral l y -co ns u m edt i n ctu res 5 . W e refer t o

3 (...co n t in u ed ) 2 0 2 , 4 0 1 , 8 4 St at . at1 2 42 , 1 2 4 7 , 1 2 6 0 (1 9 7 0) (co d i fi ed as am en d edat2 1 U.S.C. s ecs . 8 0 2, 8 1 2 , 8 4 1 (2 0 1 2 )).

4 Befo re s h e s tart edAl t erm ed s , LLC, Al t erm an wo rk edas a real es t at e ag en t
. Sh e co n t i n u edt o wo rkas a real es t at e ag en t ev en wh i l e o wn i n g an d wo rk i ng at Al t erm ed s , LLC.

5 A m ari ju an a t i n ctu re i s a l i qu i dco nt ai n i n g m ari ju an a an di s co ns u m ed o ral l y , fo r ex am

p l e, b y ad d i n g t i n ctu re d ro p s t o t ea.- 5
-

[* 5 ] Al t erm ed s , LLC’ s m erch an d i s e th atco nt ai ned m ari j u an a, i n an y o f t h e ty

p es
o f p ro du ct s m en t i on edab o v e, as i t s “ m ari j u an a m erch an di s e”. Du ri n g 2 0 1 0 an d2 0 1 1 , th e d i s p en s ary al s o s o l d p ro du ct s th atco n tai n edn o
m ari ju an a, s uch as p i p es , p ap ers , an do th er i t em s u s edt o co n s um e m ari ju an a. W e refer t o th i s t y

p e o f m erch an d i s e as th e “ n o n-m ari ju an a m erch an d i se”. In 2 0 0 9 , 2 0 1 0 , an d2 0 1 1 Al t erm ed s , LLC, acqu i redal l o f i t s n o n -m ari ju an a m erch an d i s e fro m th i rd -p art y

s el l ers . Al t erm ed s , LLC, d idn o t p ro v i d e an y s erv i ces . Al t erm an s h aredth e m an ag em en tres po n si b i l i t i es fo r t h e d i s p en s ary wi th h er s o n , J ackAl t erm an . J ackwo rk edatth e d i s p en s ary du ri n g th e y ears ati s s u e. It
was h e wh o u s u al l y

m ad e t he d eci s i on s co n cern i n g th e p u rch as e o f m ari ju an a an d
n o n -m ari ju an a m erch an di s e. 6 Al term an was res p on s ib l e fo r Al t erm ed s , LLC’ s
reco rd k eep i n g an dfi n an ces , s u ch as m ak i ng b an kd ep o s i t s, p ay i n g fo r
m erch an d i s e, an dp ay i n g ex p en s es .

6 J ackd i dn o two rkfo r Al t erm ed s , LLC, co nt i n u o u sl y du ri n g th e y ears at i s su e. Th e reco rdi s n o tcl ear wh en J ackwas n o two rk i n g fo r Al t erm ed s , LLC, an d wh o h an dl edm erch an d i s e p u rch as es duri n g h is ab s en ce.- 6
-

[* 6 ] Pu rch as es an d Pro du ct i o n o f M ari ju an a M erch an d i s e By

Al t erm ed s , LLC Du ri n g 2 0 0 9 , Al t erm ed s , LLC, d i dn o tg ro w o r p ro du ce an y o f i t s m ari

ju an a
m erch an d i s e. It b o u gh tal l o f i t s m ari ju an a m erch an d i se du ri n g thaty ear
ex cl u s i v el y

fro m th i rdp art i es . Du ri n g 2 0 1 0 , Al t erm ed s , LLC, co n t i n u edt o acq u i re m ari ju an a m erch an d i s e fro m th i rd -p art y

s el l ers . Effect i v e Sep t em

ber 2 0 1 0 , Co l o rad o req u i redm ed i cal -m ari ju an a b u si n es s es t o g ro w atl eas t7 0% o f th e m ari ju an a t h ey

s o l d . Co l o . Rev
. St at . s ec. 1 2 -4 3.3 -1 0 3 (b )(2 ) (2 0 10 ). An ti ci p at i ng th is 7 0 % requ i rem en t , Al t erm ed s , LLC, b eg anren t i n g a wareh o u s e i n J u n e 2 0 1 0 t o g ro w i t s o wnm ari ju an a. Th e wareh o us e, wh i ch was i n Bo u l d er, was referred t o as th e “ g ro w s it e”. Wh en Al t erm ed s , LLC, fi rs tren t edth e wareh o u se, t h e wareh o u s e n eed edm o d i fi cat i o n s b efo re i t co u l dp ro du ce m ari ju an a. Al t erm ed s , LLC, h i redM i ch ael Bo u gh t o n an d Ti ffan y W eav er i n J u n e 2 01 0 t o m ak e t h e n eces sarym o d ifi cat i o ns . Bo u g h t o n was a p ers o n wh o h adp rev i o u s l y s o l dm ari ju an a m erch an d i s e t o Al t erm ed s , LLC. In Sep tem b er 2 0 1 0 , Al term ed s, LLC, al s o h i redJ o s ep h In g o gl i a t o as s i s twi th th e g ro w s i t e. Th e o n l y em

p l o y ees wh o wo rk edatthe g ro w s i t e du ri n g 2 01 0 were Bo u g h t o n , W eav er, an d In g o g l i a.- 7
-

[* 7 ] Wh i l e t h e g ro w s i t e was b ei ng m o d i fi ed , Bo u gh t o n an dW eav er ag reedt o
s el l m ari ju an a m erch an d i s e t o Al t erm ed s , LLC, o n cred it , p u rs uan tt o an o ral ag reem en twi th Al t erm an . In2 0 1 0 , m ari ju an a was g ro wni n t en t s i n th e wareh o us e wh i l e t h e g ro w s i t e was b ei n g m o d i fi ed . Th e reco rdi s u n cl ear as t o wh et h er t h e m ari

ju an a g ro wni n th e t en ts i n 2 0 1 0 was o wn edb y Bo u gh t o n an d W eav er (wh o th en so l d i tt o Al t erm ed s , LLC, o n cred i t ) o r b y Al t erm ed s , LLC. It i s al s o u n cl ear wh et h er an y o f th e m ari

ju an a g ro wn i n th e t en t s du ri n g 2 0 1 0 was tran s ferred t o t h e d i s p en sary i n 2 01 0
. Du ri n g 2 0 1 0 , Al t erm ed s , LLC, m ad e p aym en t s t o Bo u g h t o n, W eav er, an d In g o gl i a. Th e p aym en t s t o In g o g l i a were t reat edas wag e p aym en t s b y Al term ed s , LLC. Th e p aym en t s t o Bo ug h t o n an dW eav er i n cl u d edp aym en t s treat edb y Al t erm ed s , LLC, fo r fed eral tax p u rp o s es as wag e p aym en t s an d i n cl u d ed p aym en t s n o ts o treat ed
. In 2 0 1 1 , Al t erm ed s , LLC, co nt i n uedt o p urch as e m ari ju an a m erch an d i s e fro m th i rd -p art y

s el l ers . Iti s u n cl ear wh et h er Al t erm ed s , LLC, p u rch as ed
m ari ju an a fro m

Bo u g h to n an dW eav er du ri n g 2 0 1 1 . Fro m J an u ary u n ti l M ay 2 0 1 1 , Al t erm ed s , LLC, m ad e p aym en t s t o Bo u gh t o n an dW eav er. Al l o f t h es e p aym en t s were t reat edas wag e p aym en t s fo r fed eral t ax p u rp o s es b y Al t erm ed s ,- 8
-

[* 8 ] LLC, al th o ug h the reco rdd o es n o t al l o w u s t o s ay h o w m u ch o f th e p aym en t s were act u al l y

fo r Bo ug h t o n ’ s an dW eav er’ s s erv i ces as em p l o y ees . Aro u n d M ay 2 0 1 1, the Co l o rad o M ed i cal M ari ju an a Bo ardcert i fi edth at Al t erm ed s , LLC’ s g ro w s it e m etth e s tru ctural an dm ech an ical req u i rem en t s fo r
m ari ju an a cu l ti v at i o n faci l i t i es . Al t erm ed s , LLC, fi redBo u g ht o n an dW eav er
aro u n dth e s am e t i m e. Bo u g ht o n an dW eav er cred ib l y t es t ifi edth atwh en th ey were fi red , Al t erm ed s , LLC, s t i l l o wedth em fo r m ari ju an a th atth ey h ads o l d Al t erm ed s , LLC, o n cred i t . Th e reco rdd o es n o t al l o wu s t o cal cu l at e t h e ex act
am ou n to wed . In go g l i a co n t in u edt o wo rkatth e g ro w s it e fo r s o m e t i m e aft er Ap ri l 2 0 11 b uten dedh i s em p l o ym en twi th Al t erm ed s , LLC, b efo re th e en do f 2 0 1 1 . Aft er In g o g l i a s t o p p edwo rk i n g fo r Al t erm ed s , LLC, i t i s u n cl ear wh i ch Al t erm ed s , LLC em

p l oy ees wo rk edatth e g ro w s i t e. Em p l o y ees o f Al t erm ed s , LLC In 2 0 1 0 an d2 0 1 1 , Al t erm ed s , LLC, em p l o y edBo u g h t o n, W eav er, In g o g l i a,
an d o thers . Th e fo l l o wi n g t ab l e s u m m ari zes th e Fo rm s W -2 , “ W ag e an d Tax St at em en t ”, i s su edb y

Al t erm ed s , LLC, fo r t h e y ears ati ss u e:- 9
- Em p l o y ee 20 1 1 20 1 2 J ackAl t erm an $1 0 ,8 0 0 $3 2 ,0 0 0 Ro b ertDes Pl ai n es 3 3 ,6 2 0 4 8 ,4 5 0 Sam u el Fel i ci an o 1 3 ,7 3 8 8 ,7 8 8 Nat han Leak e 1 5 ,2 0 4 2 6 ,1 0 0 No el l e Sh erm an 7 ,0 2 4 5 ,9 8 0 M i ch ael Bo ug h t o n 1 0 ,0 0 0 2 4 ,2 5 0 Ti ffan y W eav er 2 ,0 0 0 2 4 ,2 5 0 J o s ep h In g o g l i a 2 ,8 0 0 2 5 ,0 0 0 Ch adTerry 0 4 ,8 2 9 Ad am Lo cy 0 8 ,7 4 5 J es s ica Co l e 0 9 ,4 6 6 Lau rel Al term an 0 1 4 ,5 0 0 To t al 9 5 ,1 8 6 23 2 ,3 5 8

Th e reco rdco n fi rm s th atAl t erm ed s , LLC, m ad e p aym en t s i n t h es e am o un t s t o th es e p ers o n s . Th e reco rdd o es n o tal lo w u s t o s ay h o w m u ch o f t hes e p aym en t s
was actu al l y

fo r t h es e p ers o n s ’ s erv i ces as em p l o y ees . Th e o veral l am o un t s rep o rt edo n the Fo rm s W -2 as wag es equ al th e wag e d edu ct i o n s rep o rt ed o n Al t erm ed s , LLC’ s Sch edul es C: $ 9 5 , 1 8 6 i n 2 0 10 an d$ 2 32 ,3 5 8 i n 2 0 1 1
. So m e em p l o y ees wo rk edatth e d i s pen s ary , s o m e wo rk edat th e g ro w s i t e,
an d s om e wo rk ed at bo th . Em pl o y ees atth e d i s pen s ary s o l d m ari ju an a
m erch an d i s e an d n o n -m ari ju an a m erch an d is e. Acco rd in g t o Al t erm an , em p l o y ees atthe d i sp en s ary

al so en g ag edi n th e “ tri m m i n g” o f m ari

ju an a. “ Tri m

m i n g ” i s th e p ro ces s o f rem o v in g s t em s , s eed s , an dtwi g s fro m a m ari ju an a p l an t t o co n v ert [* 9 ]- 1 0 -

[* 1 0 ] m ari

ju an a t o fi n al , s al ab l e fo rm . Al t erm an es t i m at ed th ato f t h e t i m e s p en t b y an y p art i cu lar em

p l o y ee atth e d i s p en s ary , 4 0 % o f t hatt i m e was o ccup iedb y tri m m i n g . W e d o n o t b el iev e t hatem pl o y ees wo rk i n g atth e d i sp en s ary s p en t
s ub s t an t i al t i m e t ri m

m in g b ecau s e (1 ) n o ev i d en ce o th er t h an Al t erm an ’ s t es t i m o ny s up p o rt s the as s ert i o n th atem p l oy ees wo rk i n g at the d i s p en s ary tri m m edm ari ju an a an d(2 ) o th er wi tn es s es cred i b l y t es ti fi ed th atn o tri m

m in g t o o k p l ace at th e d i s p en s ary . Nei ther Al t erm ed s , LLC em p l o y ees n o r Al t erm an reco rd edth e h o u rs
wo rk edb y

p art i cu l ar em

p l o y ees atthe g ro w s i t e v ers us th e d i sp en s ary . Gi ven th e l acko f i n fo rm at i o n i n th e reco rd , we can n o td et erm i n e wh atp arto f t h e p aym en t s treat ed b y Al t erm ed s , LLC, as em

p l o y ee wag es was p ai d fo r wo rkp erfo rm edat th e g ro w s i t e v ers u s th e d i s p en s ary . Reco rd s o f Al t erm ed s , LLC Du ri n g ex am i n at i o n , Al t erm an p ro v i d edth e IRS wi th recei p t s that
co rro b o rat ed s om e o f the ex p en s es p ai db y Al term ed s, LLC, an d s om e o f t he p u rch as es o f m erch an d i se m ad e b y Al t erm ed s , LLC. 7 No n e o f t h es e recei p t s are i n th e reco rd
.

7 Th e reco rdd o es n o t rev eal wh et h er t h e recei p t s fo r p u rch as es o f m erch an d i s e g i v en b y

Al t erm an t o the IRS were recei p t s fo r n o n -m ari j u an a m erch an d i s e o r m ari

ju an a m erch an d i s e o r b o th.- 1 1 -

[* 1 1 ] Th e reco rdco n t ai ns Al t erm ed s , LLC’ s g en eral l ed g er fo r 2 01 0 an d 2 0 1 1
. W e fi rs td i s cu s s th e n o t at i o ns m ad e i n th e g en eral l ed g er fo r p u rch as es o f
m ari ju an a an dn o n -m ari

ju an a m erch an d i s e. W e refer t o th es e n o t at i o n s as

“p u rch as e n o tat i o n s”. Fo r each p u rch as e o f m erch an di s e, t h e g en eral l ed g er
reco rd ed(1 ) t h e d at e, (2 ) t h e d o l l ar am o u n t , an d (3 ) t h e m et h odo f p aym en t . Each p u rch as e o f m erch an di s e was g i v en o ne o f fo u r ty p es o f d es cri p t i o n s i n the g en eral l ed g er: (1 ) s m o k ab le, fo r m ari ju an a b u d s an dp re-ro l ledjo i n t s; (2 ) ed i b l e, fo r fo o d i t em s , t i n ctu res , an do th er i nfu s ed i t em s ; (3 ) n o n -m ari ju an a, fo r p ap ers an d o th er p arap h ern al i a; an d(4 ) a fo u rt h g ro upi n g m y s t eri o u s l y

l ab el ed“ M ed s -C” (h erei n aft er, t h e “ u n d efi n edm erch an d i s e”). Th e reco rdi s u n cl ear as t o wh et h er th e u n defi n edm erch an d i s e co n t ai n edm ari ju an a. So m et i m es th e i d en t i ty o f t h e
s el l er was n o t edi n t he p u rch as e n o t at i o n ; s o m et im es i twas n o t . Th e g en eral l ed g er ag g reg at edthe t o tal am ou n t s p ai dfo r m erch an d i s e p u rch as es i n a y ear i n each o f t h e fo u r d es cri p ti v e cat eg o ri es o f m erch an d i s e. Th e g en eral l ed g er al s o ag g reg at edthe t ot al am o u n t s p ai dfo r al l m erch an di s e p u rch as es i n a y ear. Th e g en eral l ed g er t rack edth e d is p en s ary ’ s d ai l y recei p t s i n t h e s am e fo u r
m erch an d i s e cat eg o ri es as th e p u rch as e n o t at i on s . Th e g en eral l ed g er d o es n o t refl ectth e d o l l ar am o u nto f each p art i cu l ar t ran s act i o n . Acco rd i n g t o th e g ro s s recei p t s i n th e 2 0 10 g en eral l ed g er, Al t erm ed s , LLC, d eri v ed8 6 .5 % o f i t s g ro s s- 1 2 -

[* 1 2 ] recei p ts fro m

s m o kab l e m ari

ju an a m erch an d i se, 8
. 6 % fro m ed i bl e m ari

ju an a
m erch an d i s e, 1 .4 % fro m

n o n -m ari ju an a m erch an d i s e, an d3 .6 % fro m th e
u n d efi n edm erch an d i s e. Fo r 2 0 1 1 , th e p ercen t ag es are 8 1 .7 % fro m s m ok ab l e
m ari ju an a m erch an d is e, 1 4
. 2 % fro m ed i bl e m ari

ju an a m erch an d i s e, 3
. 6 % fro m
n o n -m ari ju an a m erch an di s e, an d0 .6 % fro m th e u n d efi n edm erch an d i s e. W e n o wd i s cu s s th e n o t at i o ns m ad e i n th e g en eral l ed g er wi th res p ectt o
ex p en s es (as d i s ti n g u i sh edfro m th e p u rch as e o f m erch an d i s e). Fo r each p aym en t
o f an ex p en s e, t h e g en eral l ed g er s h o ws (1 ) t h e d at e, (2 ) th e d ol l ar am o u n t, (3 ) t h e ty p e o f ex p en s e (e.g ., u ti l it i es , ren t , et c.), (4 ) t h e p aym en t m et h o d(i .e., cas h , ch eck , cred i tcard , o r el ect ro n i c fu n d s tran s fer), an d(5 ) s o m et i m es , th e i d en t i ty o f th e p ay ee. Al t erm ed s , LLC, p ai di t s ex p en s es , an dp ai dfo r i t s m erch an d i s e, t h ro u g h
v ari o u s al t ern at i v e m et h o ds : (1 ) ch eck s fro m th ree ch eck i n g acco u nt s wri t t en d i rect l y t o v en do rs , (2 ) ch eck s fro m o ne o f t hree ch eck i n g acco un t s (i .e., th e d i s p en s ary acco un t , as d es cri b edb el o w) t o J ack , wh o th en p ai dcas h t o th e v en d or, (3 ) el ect ro n i c fu n d s tran sfers fro m th e t h ree ch eck i n g acco u nt s , (4 ) a Vi s a cred i t card , (5 ) cas h p ai do u to f t h e cas h reg i s ter at the d i s p en s ary , o r (6 ) cas h p ai dfro m
an u n kn o wn s o u rce. As d i s cu s s edab ov e, ch eck s were wri t t enfro m th ree ch eck in g acco u nt s .- 1 3 -

[* 1 3 ] Th e fi rs tch eck i n g acco u n twas o ft en u s edt o p ay th e ex p en s es o f t h e d i s p en s ary an dfo r m erch an d i se p u rch as es . W e refer t o th i s ch eck i n g acco u n tas th e d i s p en s ary

acco u nt . Ch eck s were wri t t en fro m th i s acco u ntdu ri n g b o th 2 0 1 0
an d 2 0 1 1 . Th e reco rdco n t ai n s ch eck -reg i st er en tri es fo r t h e ch eck s wri t t en du ri n g 2 0 1 0 . Th e reco rdco n t ai n s ch eck -reg i s t er en tri es fo r s o m e, b utn o t al l , o f t he ch eck s wri t t endu ri ng 2 01 1 . Th e i n fo rm at i o n i n each ch eck -reg i s t er en try i n cl u d ed th e d at e an d t h e am o u n t o f t h e ch eck . Fo r ch eck s wri t t en fo r m erch an d i s e p u rch as es , th e ch eck -reg i s t er en t ri es al s o s o m et i m es s h o wedth e p ay ees . Fo r ch eck s wri t t enfo r s m o k ab l e m ari j u an a, t h e ch eck -reg i s t er en tri es al s o s o m et i m es
s h o wedth e s trai n s an dwei g h t s o f m ari ju an a p u rch as ed . Fo r ch eck s wri t t enfo r ed i b l es an dn o n -m ari

ju an a m erch an d i se, t h e ch eck -reg i st er en tri es al s o s o m et i m es
s h o wedth e qu an ti t ies p u rch as ed . Fo r ch eck s wri t t en t o p ay ex p en s es (as d i s t i n gu i sh edfro m

th e p u rch as es o f m erch an d i s e), t he ch eck -reg i s t er en tri es al s o
s h o wedth e g en eral p u rp o s es o f t h e p aym en t s (e.g ., “ Co st co - s upp l ies ”), an d
s o m et i m es s h o wedth e p ay ees . Th e s eco n dch eck i n g acco u n twas o ft en u s edt o p ay th e co s ts o f t h e g ro w
s i te an d al s o fo r m erch an d i se p u rch as es . W e refer t o th i s s eco n d ch eck i n g acco u n t
as th e g ro w-s i te acco u n t . Al th o u g h ch eck s were wri t t en fro m thi s acco u n t i n 2 0 1 0
an d 2 0 1 1 , th ere i s n o ch eckreg i s t er i n t h e reco rdfo r t h i s acco u n t
.- 1 4 -

[* 1 4 ] Th e t h ird ch eck i n g acco u n twas fi rs t u s edi n Decem b er 2 0 1 1
. Itwas
s o m et i m es u s ed t o pay

ex p en s es an dal so fo r m erch an d i s e p u rch as es . No ch eck reg i s ter i s i n th e reco rdfo r t h i s acco u n t
. In b o th y ears ati s s u e, s o m e m erch an d i s e p u rch as es an dex p en s es were p ai d wi th el ect ro n i c fu n d s tran s fers , m ad e fro m al l th ree ch eck in g acco u n t s . Th e reco rdco n t ai ns b an k s s t at em en t s fo r al l th ree ch eck in g acco u n t s . Fo r th e d i s p en s ary

acco u nt , th e b an ks t at em en t s co v er J an u ary 2 0 1 0 t o Decem

b er 2 0 1 1 . Fo r t h e g ro w-s i t e acco u n t , the b an k s t at em en t s co v er t h e p eri o dfro m wh en th e acco u n twas o p en ed , J u n e 2 0 1 0 , u n t il Decem b er 2 0 1 1
. Fo r th e th i rd acco u n t , th e b an ks t at em en t s co v er Decem b er 2 0 1 1 , wh i ch i s wh en th e acco un twas fi rs t
u s ed
. Th e b an ks t at em en t s co nt ai n en tri es co rres p o n d in g t o al l ch eck s wri t t en fro m th e t h ree acco u n t s du ri n g 2 0 1 0 an d 2 01 1 . Th e b an ks t at em en ts co n t ai n
en tri es co rres p o n di n g t o al l el ect ro n ic fu nd s tran s fers fro m al l th ree acco u n t s du ri n g 2 0 1 0 an d2 0 1 1. Fo r el ect ro n i c fu n d s t ran s fers , th e b an ks t at em en t s s h o w th e d at e o f each tran s fer, th e am o un t o f t h e tran s fer, an dth e p ay ee. Th i s s eto f i n fo rm at i o n i s n o t
m o re d et ai l edth an th e co rres p on d i n g i n fo rm at io n i n th e g en eral l ed g er fo r t h e i d en t i cal el ect ro n ic fu n d s tran sfers . A nu m ber o f en tri es reco rd ed i n th e 2 0 1 1 g en eral l ed g er as p urch as es o f s m ok ab l e m ari ju an a m erch an d is e were p ai dwi t h- 1 5 -

[* 1 5 ] el ect ro n i c fu n d s tran s fers . Fo r s o m e o f t h es e en tri es , th e p ay ees were h o m e i m p ro v em en ts t o res , s u ch as Ho m e Dep o to r Lo we’ s . W e fi n d i t i m p ro b ab l e t h at th es e s t o res s o l ds m o k ab le m ari ju an a t o Al term ed s , LLC. In b o th y ears ati s s u e, s o m e m erch an d i s e p u rch as es were m ad e wi th cas h t ak en fro m

th e d i s p en s ary ’ s reg i s t er. Al t erm ed s , LLC, k ep ta d ai l y s al es reco rdfo r i t s d i s p en s ary . In ad d it i on t o reco rd i n g g ro ss recei p ts (o n a d ai l y b as i s ), th i s d ai l y
s al es reco rdn o t edth e am o u n t o f cas h t ak en fro m the reg i s t er fo r m erch an d i s e p u rch as es an dcl as s i fi edth e p u rch as ed m erch an d i s e i n t o o n e o f t h e fo u r
m erch an d i s e cat eg o ri es . Occas i o n al l y ad d i t i o n al d et ai ls co n cern i n g t h e p u rch as ed
m erch an d i s e were reco rd edo n th e d ai l y s al es reco rd
. 8 So m e ed i b l e m ari

ju an a m erch an d i s e was p u rch as ed duri n g 2 0 1 1 u s in g cas h
. Th e s ou rce o f t h e cas h i s u ncl ear. So m e m erch an d i s e was p u rch as eddu ri n g 2 0 1 0 b y J ack , u si n g cas h t h ath e acq u iredwh enAl t erm an wro t e a ch eckt o h i m . M erch an d i s e was p u rch as edi n th i s way wh en th e t h i rd -p art y

s el l er d i dn o twi s h t o recei v e a ch eck . Itap p ears

8 Th e ad di t i o n al i n fo rm at i o n fo r t hes e m erch an d is e p u rch as es was n o g reat er i n d et ai l th an wh atAl t erm an n o t edi n the m o s td et ai l edch eck -reg is ter en tri es fo r p u rch as es o f m erch an d i se (i .e., th o s e ch eck -reg i st er en tri es i n wh i ch Al t erm an n o t edth e s trai n s an d wei g h t s fo r s m o k ab l e m ari j u an a m erch an d i se, an dth e u n i t qu an ti t i es fo r ed ib l e m ari j u an a an dn o n -m ari

ju an a m erch an di s e).- 1 6 -

[* 1 6 ] th atth e ch eck s u s edi n s u ch an i n t erm ed i ary p u rch as e were d rawn fro m th e d i s p en s ary acco un tan dwere reco rd edi n th e ch eckreg i s t er. In 2 0 1 0 an d2 0 1 1 , Al t erm ed s , LLC, u s eda Vi s a cred itcard t o p ay s o m e o f i t s ex p en s es an d fo r m erch an d is e p u rch as es . Th e cred i tcard s tat em en t s (h erei n aft er, t h e “ Vi s a s tat em en t s ”) i n th e reco rdwere i n co m p l et e, as p ag es were
m i s s i n g fo r b o th y ears . Al t erm an wro t e o n the Vi s a s t at em en t s d es cri p t i o n s o f t h e cat eg o ri es o f s o m e o f t h e ex p en s es . Ei th er Al term an o r M arkPen d l et o n , Al t erm ed s , LLC’ s b o o kkeep er, wen tth ro u g h th e Vi s a s t at em en t s an dag g reg at ed cert ai n ex p en s es o r m erch an di s e p u rch as es i n t o s in g l e s u m s . Th es e s u m s were th en tran s ferred t o th e g en eral l ed g er. Th u s , fo r t h es e s u m s , th e g en eral l ed g er
en tri es are n o ts p eci fi c t o p art i cu l ar p aym en t s, b utrat h er a g ro up o f p aym en t s . Pen dl et o n u sedAl t erm an ’ s i ni t i al cat eg o ri zat i on s o f Vi s a card ch arg es wh enh e tran s ferred the am o u n t s t o th e ex p en s e o r m erch an di s e p u rch as e cat eg o ri es i n th e g en eral l ed g er. As d i s cu s s edab ov e, t h e d i s p en s ary u s edd ai l y

s al es reco rd s th attrack edi t s g ro s s recei p ts . Al t erm an g av e t h e d ai l y s al es reco rd s t o Pen dl et o n t o en t er i n t o th e g en eral l ed g er. Pen d l et on u sedth e d ai l y s al es reco rd s t o p rep are m o n th l y
s t at em en t s , b u t th es e m o n th l y s t at em en t s are n oti n t h e reco rd . To p rep are t h e g en eral l ed g er, Pen dl et o n rel iedo n d ocu m en t s th atAl t erm an p ro v i d edt o h i m ,- 1 7 -

[* 1 7 ] i n cl u d i n g d ai ly

s al es reco rd s, Vi s a s t at em en t s , an drecei p t s . (Iti s u n cl ear wh et h er Al t erm an p ro vi dedPen d l et o n wi th b an ks t at em en t s . Itap p ears th at Al t erm an d i dp ro vi d e Pen dl et o n wi th s o m e d ep o s its l i p s, i
. e., reco rd s g i v en t o Al t erm an b y

th e b an kwh enAl t erm an m ad e a p art i cu l ar d ep o s i t . Ho wev er, n o d ep os i t s s l i p s are i n th e reco rd
. ) Al t erm an h ers el f d i dn o tv eri fy wh et h er t h e g ro s s recei p t s i n th e g en eral l ed ger were co ns i s ten twi th th e am o u nt s s t at edi n th e d ai l y
s al es reco rd s . Tax Rep o rt i n g Th e i n co m e o f Al term ed s , LLC, was rep o rt edo n Sch edu l es C at t ach edt o Al t erm an an d G ib s o n ’ s 2 0 10 an d2 0 1 1 jo in tretu rn s . Fo r 2 0 1 0, the Sch edu l e C rep o rt ed g ro s s recei pt s o f $ 8 9 4 ,9 2 2
. Th e Sch edu l e C redu cedg ro s s recei p t s b y co s to f g oo d s s o l do f $ 46 4 ,1 1 9. Th e Sch edu l e C al so rep o rt edb u s i n es s -ex p en s e d edu ct io n s o f $ 38 5 ,4 8 9. Fo r 2 0 1 1, the Sch edu l e C rep o rt ed g ro s s recei pt s o f $ 6 5 7 ,1 2 6
. Th e Sch edu l e C redu cedg ro s s recei p t s b y co s to f g oo d s s o l do f $ 25 3 ,0 8 9. Th e Sch edu l e C al so rep o rt edb u s i n es s -ex p en s e d edu ct io n s o f $ 38 4 ,8 1 7. Th e Sch edu l es C rep o rt edth atco s to f g o o d s s o l dfo r each y ear at i s su e (an d 2 0 0 9 ) was co m

pu tedas fo l lo ws :- 1 8 - 2 0 0 9 2 0 1 0 2 01 1

In v en t o ry at b eg i nn i n g o f y ear 0 0 0 + Pu rch as es l es s co sto f i t em s wi th drawn fo r p ers o n al u s e $7 2 ,5 6 4 $ 47 6 ,3 9 8 $ 25 3 ,0 8 9
+ Co s t o f l ab or 0 0 0 + M at eri al s an d s up p l ies 0 0 0

! In v en t o ry

at en do f y ear 0 1 2 ,2 7 9 0

= Co s to f Go o d s So l d 7 2 ,5 6 4 46 4 ,1 1 9 25 3 ,0 8 9 Th e Sch edu l es C rep o rt edthatAl term ed s , LLC’ s i n co m e h adb een cal cu l at ed
u s i n g th e cas h m et h o do f acco u n t i n g . Fo r t h e 2 0 0 9 t ax y ear, t h e fi rs ty ear t h atAl t erm ed s , LLC, was i n b u s i n es s , Al t erm an an d G ib s o n ’ s t ax return was p rep aredb y Pen d l et o n . 9 Pen d l et o n al s o
s erv edas Al t erm ed s , LLC’ s b o o kk eep er du ri n g 2 0 0 9 . Pen d let o n h adb een p rep ari n g retu rn s fo r Al term anan dGi b s o n i n y ears b efo re 2 0 0 9
. Fo r t h e 2 0 1 0 t ax y ear, Al t erm an d eci dedi n s teadt o u s e t h e s erv i ces o f Co m i s k ey

& Co . (h erei n aft er, “ Co m i s k ey ”) t o p rep are t h e ret u rn . 1 0 Co m is k ey was
reco m m en d edt o Al t erm an b y

J i l l Lam ero u x , an o ther m ed i cal -m ari j u an a b u s i n es s
o wn er. Al t erm an rev i ewedth e 2 0 1 0 retu rn b efo re s i g n i n g i t
. [* 1 8 ]

9 Pen d l et o n at t ach eda s ep arat e Sch edu l e C fo r t ax y ear 2 0 0 9 t o rep o rtth e ex p en s es an d i n co m e o f Al t erm an ’ s real es t at e ag en tb us i n es s .

1 0 Co m i s k ey

at tach ed a s ep arat e Sch edu l e C fo r t ax y ear 2 0 1 0 t o rep o rtth e ex p en s es an d i n co m e o f Al t erm an ’ s real es t at e ag en tb us i n es s .- 1 9 -

[* 1 9 ] Fo r Co m i sk ey ’ s u s e i n p rep ari ng th e 2 0 1 0 retu rn , Al t erm an p ro v i d edth e fi rm wi th a p ro fi tan dl o s s s t at em en t an da b al an ce s heet fo r Al t erm ed s , LLC. 1 1 Sh e d idn o t p ro v i de Co m i s key wi th o th er reco rd s , s u ch as th e g en eral l ed g er o r recei p t s. Co m i s key

ap p aren tl y

u s edth e p ro fi tan dl o s s s t at em en t an d t h e b al an ce
s h eett o rep o rtth e v ari ou s i t em s o f co s to f g o o d s s o l d o n th e Sch edu l e C fo r 2 0 1 0
. 1 2 Inp art i cu l ar:
! $ 46 4 ,1 1 9 To tal Co s to f Go od s So ldfo r 2 0 1 0 . Itap pears th at Co m is k ey

tran s ferred th e p ro fi tan dl o s s s t at em en ten try “ To t al Co s t
o f Go o d s So l d ”, i n the am o u nto f $ 4 6 4 ,1 19 , t o th e 2 01 0 Sch edu l e C l i n e i t em fo r co s t o f g o o d s s o l d, i n t h e s am e am o u nt . Th e en try “ To t al Co s to f Go o d s So l d ” i n th e p ro fi tan dl o ss s t at em en t , i n t h e am o u n to f $ 46 4 ,1 1 9, was co m

p o s edo f fo u r s ub to t al s fo r each o f t h e fo u r
m erch an d i s e cat eg o ri es u s edi n th e p u rch as e n o t at i o n s i n the g en eral l ed ger. Th e reco rdd oes n o trev eal h o w th e p ro fi tan dl os s s t at em en t
co m p u t edth e s ub to t al s i n each o f t he fo u r m erch an di s e cat eg o ri es .

1 1 Th e reco rdd oes n o trev eal wh o p rep ared the p ro fi tan dl o ss s t at em en to r th e b al an ce s h eeto r wh ati n fo rm at i o n was u s edt o p rep are t h es e t wo d ocu m en t s .

1 2 Th e reco rdi n cl u d es the p ro fi tan d l o s s s t at em en tan d b al an ce s h eetfo r t ax y ear 2 0 1 0 . No s u ch do cu m en t s ap p ear i n t h e reco rdfo r t ax y ears 2 0 09 an d2 0 1 1 , an d we b el i ev e th ere were n o s u ch d o cu m en t s fo r th o s e y ears .- 2 0 -

[* 2 0 ] ! $ 0 Beg i nn i n g In ven t ory fo r 2 0 1 0 . It i s u n cl ear h o w Co m i s k ey d et erm i nedthe $ 0 v al u e rep o rt edo n th e 2 0 1 0 Sch edul e C fo r b eg i n n i n g i n v en t o ry . Th e b al an ce s h eetfo r 2 0 1 0 refl ect s o n l y o n e i n v en t o ry am o u n t , “ To t al In v en t ory ”, wh i ch i s p res u m ab l y th e en d i n g i n v en t o ry fo r 2 0 1 0 . (As ex pl ai nedb el o w, thi s am o u n twas co m p o s ed
o f s ub t o tal s .)
! $ 12 ,2 79 En d in g In v en t o ry fo r 2 0 1 0 . Itap p ears th atCo m i s k ey tran s ferred th e en try

i n th e b al an ce s h eet , “ To t al In v en t o ry ”, i n th e
am o u n to f $ 1 2 ,2 7 9 , t o th e 2 0 1 0 Sch edu le C l i n e i tem fo r i n v en t o ry

at th e en d o f t h e y ear, i n th e s am e am o u n t
. Th e en try “ To t al In v en t o ry ” i n th e b al an ce s h eet , i n th e am ou n to f $ 1 2 ,2 7 9 , was co m p o sedo f th ree s ubt o t al s fo r s m o k ab le m ari ju an a ($ 9 ,5 9 2 ), ed i b l e m ari ju an a ($ 1 ,2 7 5 ), an dn o n -m ari

ju an a m erch an d i s e ($ 1 ,4 1 2 ). Itfu rt h er ap p ears th atth e b al an ce s h eeten try o f $ 1 2 ,2 7 9 fo r “ To t al In v en t o ry ”
co rres p o n d s t o th e s am e n am eden try , wi th th e s am e d o l l ar am o u n t , i n th e 2 0 1 0 g en eral l ed g er (t o wh i ch Co m i s k ey d i dn o th av e acces s ). Th e 2 0 1 0 g en eral l ed g er en try “ To t al In v en t o ry ” was m ad e up o f fi v e
s ub t o t al s : s m o k ab l e m ari j u an a o f $ 9 , 5 9 2; ed i b l e m ari j u an a o f $ 1 ,2 7 5 ;
n on -m ari ju an a m erch an d i se o f $ 1 ,4 12 ; u nd efi n ed m erch an d i s e o f $ 0 ;- 2 1 - an dan o th er cat eg o ry , “ In v en t ory - Oth er”, o f $ 0 . W e are u n ab l e t o trace t h e d o cu m en t ary

s o u rce fo r t he $ 1 2 ,2 7 9 am o u n t , o r i t s s ub t o t al s , fo u n di n b o th th e g en eral l ed ger an dth e b al an ce s heet . Itap p ears th at th es e am o u n ts u l t i m at el y cam e fro m

an y earen d i n v en t o ry

d o n e b y Al t erm an , wh o t es t i fi edth ats h e g en eral ly p erfo rm eda p h y s ical i n v en t o ry atth e en do f each y ear an dd o cu m en t edh er i n v en t o ry co u n t
o n p ap er. 1 3 Th e reco rdd o es n o t rev eal wh eth er Al t erm an as s i g n ed
co s t val u es t o t h e u n i tqu an t it i es i n t h e p h y si cal i n v en t o ry ; ev en i f s h e d id s o, the reco rdd o es n o tg i v e u s an y i n fo rm at i o n ab o u t th e co s ts h e
as s ig n edt o an y

p art i cu l ar u n i t i n i n v en to ry o r h o w s h e as si gn edco st t o an y p art i cu l ar u n i tfo r an y u n ito f p u rch as ed m ari

ju an a an dn o n m ari ju an a m erch an d i s e o r s el f-g ro wnm ari ju an a m erch an d is e. In d eed th e reco rdd o es n o th av e an y p h y s i cal i n v en t o ry

th atAl t erm an
co m m it t edt o p ap er.
! $ 47 6 ,3 9 8 Pu rch as e Co s t s fo r 2 0 1 0 . Th e reco rdi s u n cl ear as t o h o w th e $ 4 7 6 ,3 9 8 am o u n to n th e 2 01 0 Sch edu le C fo r p u rch as e co s t s o f [* 2 1 ]

1 3 A p h y s i cal i n v en to ry i s a l is to f t he t y p es o f p ro duct s o n h an dan du n i t qu an ti t i es o f each ty

p e o f p ro du ctata g i v en t i m e.- 2 2 - m erch an d i s e was co m

p u t ed
. 1 4 W e n o t e th atth e ag g reg at eds u m o f

“ To t al In v en t o ry ” ($ 1 2 ,2 79 ) fro m the b al an ce s h eetan d “ To t al Co s t
o f Go o d s So l d ” ($ 4 6 4 ,1 1 9 ) fro m th e p ro fi t an d l o s s s t at em en t equ al s th e d o l l ar am o u n t fo r p u rch as e co st s o f m erch an d i s e o n t h e 2 0 1 0 Sch edu l e C ($ 4 7 6 ,3 9 8 ). Fo r t h e 2 0 1 1 retu rn , Al t erm an d eci d ed t o h av e Pen d l et o n p rep are t h e retu rn i n s t eado f Co m i s k ey . 1 5 Al t erm an ’ s d eci s i o n t o g o b ackt o Pen d l et o n was
m o ti v at edb y

the fact th atCo m i s k ey

h adch arg edAl t erm an s i g n i fi can tl y m o re fo r p rep ari n g th e 2 0 1 0 retu rn th an Pen d l et o n h ad ch arg edfo r t h e 2 0 0 9 return . Al s o Pen dl et o n t o l dAl t erm an h e h adex p eri en ce p rep ari n g return s fo r o th er m ed i cal

m ari ju an a b u s i n es s es . Aft er Pen d let o n p rep aredthe 2 0 1 1 retu rn , Al t erm an
rev i ewedi t . Duri n g 2 0 1 1 , Pen d l et o n co n ti n u edt o wo rkas Al t erm ed s , LLC’ s b o o kk eep er (as he h addu ri n g 2 0 1 0 , ev en th o ug h h e h adn o tp rep aredth e 2 0 1 0 retu rn ). As p arto f h is b o o kk eep i n g du t i es fo r 2 0 1 1, h e co n ti n u edt o p rep are
m o nt h l y s t at em en t s fro m

d o cu m en t at i o n Al term an p ro v i d edt o h i m . He al s o [* 2 2 ]

1 4 Th e 2 01 0 g en eral l ed ger co nt ai n s a l i n e i t em (“ To t al Co sto f Go o d s So l d ”) th atap p ears an al og ou s t o th e t ax -ret u rn l i n e i t em u n d er wh i ch th e $ 4 7 6 ,3 9 8 am ou n tap p ears . Ho w ev er, t he g en eral -l ed g er i t em i s a d ifferen tam o u n t , $ 4 7 3 ,4 8 5
.

1 5 Pen d l et o n at t ach eda s ep arat e Sch edu l e C fo r t ax y ear 2 0 11 t o rep o rtth e ex p en s es an d i n co m e o f Al t erm an ’ s real es t at e ag en tb us i n es s .- 2 3 -

[* 2 3 ] creat edth e 2 01 1 g en eral l ed g er. Th e 2 01 1 g en eral l ed g er b i zarrel y reco rd ed th at“ To t al In v en t o ry ” was $ 1 2 ,2 7 9 , wh i ch was th e s am e d o l l ar am o u n treco rd ed i n the “ To t al In v en to ry ” en try i n th e 2 0 10 l ed ger. Th e 2 0 1 1 g en eral l ed g er al s o
s h o wedfi v e s ub t o t al s . Th e 2 0 1 1 g en eral l ed ger’ s d es cri p ti o n o f each s ub t o t al , an d th e d o ll ar am o u n t o f each s ub t o t al , were t h e s am e as i n th e 2 0 1 0 g en eral l ed g er. W e are u n cert ai n wh y

th e 2 0 1 1 Sch edu l e C rep o rt ed$ 0 as the b eg i n ni n g
an d en d i n g i n v en t o ri es fo r 2 01 1 . Th at wo u l d m ean , i m p l au s i b ly , th atAl t erm ed s , LLC, h adn o m erch an d i s e o n h an datth e b eg i n n i n g an den do f 2 0 11 . As fo r t h e $ 2 5 3 ,0 8 9 rep o rt edo n th e 2 01 1 Sch edu l e C fo r p u rch as e co s ts , we are u n s ure wh ere t h is am o un t cam e fro m . Th e an al o g o u s en try i n th e 2 0 1 1 g en eral l ed g er
reco rd edth e am o u n t as $ 2 1 7 ,0 8 9
. Au d i tan dSt atu t o ry

No t i ce o f Defi ci en cy In 2 0 1 2 , th e IRS ex am i nedAl t erm an an dGi b s on ’ s 2 0 1 0 an d2 0 1 1 retu rn s . It fo cu s edex cl u si v el y

o n Al t erm ed s , LLC’ s Sch edu l es C. Rev en u e Ag en tKel l y Ti p t o n (h erei n aft er, “ RA Ti p to n ”) was th e p ri nci p al rev en u e ag en twh o ex am i n ed th e ret urn s . Al t erm an p ro v i d edRA Ti p t o n wi th d o cu m en ts , s uch as recei p t s an d d ai l y s al es reco rd s. Th e n o t i ce o f d efi ci en cy

d et erm i nedth at Al t erm ed s , LLC, un d errep o rt ed g ro s s recei p ts b y

$ 24 ,6 6 3 an d$ 8 ,3 5 9 fo r 2 0 1 0 an d2 0 1 1, res p ect iv el y . Th e n o t i ce- 2 4 -

[* 2 4 ] al l o wedco s t s o f g o o d s s o l do f $ 3 8 8,2 3 1 an d$ 1 ,0 21 fo r t ax y ears 2 0 1 0 an d 2 0 1 1 , res p ect i v el y . Fu rt h erm o re, t h e n o t i ce d i s al l o wedal l o f Al t erm ed s , LLC’ s Sch edu l e C b u s i n es s -ex p en s e d edu ct i o n s fo r t ax y ears 2 01 0 an d2 01 1 o n s ect i o n 2 8 0 E g ro u n d s , ex cep tfo r d ep reci at i on an ds ect i o n 1 7 9 ex p en s es i n th e am o u n t s o f $ 4 9 ,6 7 1 an d$ 7 1 9 fo r t ax y ears 2 0 1 0 an d2 01 1 , res p ect i v el y . Th e n o t i ce al s o d et erm i n edaccu racy -rel at edp en al t i es u nd er s ect i on 6 6 6 2 (a). RA Ti p to n m ad e t h e i n i t i al d et erm i n at i on t o i m p os e accu racy -rel at ed p en al t i es . Th e d et erm i n at i o n was ap p ro vedb y RA Ti p t o n ’ s s up erv i s o r, To m m y D. M cDo n al d
. Bo th th e i ni t i al d et erm i n at i o n an dthe ap p ro v al o f t h e i ni t i al d et erm i n at i o n were m ad e b efo re t he n o t i ce o f d efi ci en cy was m ai l ed
. Co n ced edIs su es In th e p et it i o n , Gi b s o n s o u g h ti n n o cen t-s p o us e rel i ef fro m jo i n tan ds ev eral l i ab i l i ty fo r t h e d efi ci en ci es an dp en al t i es i n th e n o t i ce o f d efi ci en cy . Attri al , Gi b so n co n ced edh is cl ai m fo r i n n o cen t -s p ou s e rel i ef fo r b o th y ears ati s s u e. At tri al , Al t erm anan dGi bs o n co n ced ed th atAl t erm ed s, LLC, un d errep o rt edi t s g ro s s recei p t s i n th e am o un t s s t at ed in th e n o t i ce o f d efi ci en cy . In th e IRS’ s b ri ef, t he IRS i ncreas ed th e am o un t s o f co s to f g o o d s s o l di t
co n ced edfo r 2 0 1 0 fro m

$ 3 8 8 ,2 3 1 i n th e n o t i ce o f d efi ci en cy t o $ 4 5 2 ,2 92 an dfo r 2 0 1 1 fro m

$ 1 ,0 2 1 t o $ 23 2 ,7 7 2 . Th e IRS’ s b ri ef s t at ed that , fo r t ax y ear 2 0 1 0 , th e- 2 5 -

[* 2 5 ] am o un tco n ced edi n ex ces s o f t he co s t -o f-g o od s -s ol dal l o wan ce i n the n o t i ce
o f d efi ci en cy was m ad e up o f t h e fo ll o w i n g : $ 9,5 8 0 fo r ren tfo r t h e g ro w s i t e; $ 2 ,0 1 0 fo r u ti l i t i es atth e g ro w s i t e; $ 4 9 , 6 7 1 fo r d ep reci at i o n an ds ect i o n 1 7 9
ex p en s es (t h e s am e am o u n t al l o wedas a d edu ct i o n i n th e n o t i ce); an d$ 2 ,8 0 0 fo r wag es . 1 6 Th e IRS’ s b ri ef s t at edth at , fo r t ax y ear 2 0 1 1, the am o u n tco n ced edi n
ex ces s o f the co s t -o f-g o o d s -s o ldal l owan ce i n th e n o t i ce o f d efi ci en cy was m ad e
up o f t h e fo l lo wi n g : $ 2 2,4 0 7 fo r ren tfo r t h e g ro w s i t e; $ 1 0,2 0 7 fo r u t i l i t i es atth e g ro w s i t e; $ 7 1 9 fo r d ep reci at io n an ds ect i o n 1 7 9 ex p en s es (t h e s am e am ou n t al l o wed as a d edu ct i o n i n the n o t i ce); $ 2 5,0 0 0 fo r wag es ; $ 2 9 5 fo r t es t i n g o f
m ari ju an a; an d $ 1 7 3 , 1 2 3 fo r p u rch as es o f m erch an d i s e. 1 7 OPINION Th e t ax p ay er b ears th e b u rd en o f p ro v in g , b y a p rep o n d eran ce o f t h e
ev i d en ce, t hatthe IRS’ s d et erm i n at i o n s i n the n o ti ce o f d efi ci en cy are i n co rrect
. See Ru l e 1 4 2 (a); W el ch v . Hel v eri n g , 2 9 0 U.S. 1 1 1 , 1 1 5 (1 9 3 3 ); Es t at e o f Gi l fo rd
v . Co m m i s s i o n er, 8 8 T.C. 3 8 , 5 1 (1 9 8 7 ). Th i s i s th e b urd en o f p ers u as i o n . Al t erm an an d G ib s o n co n ced e t h atth ey h av e t h e b u rd eno f p ers u as i o n . W i th

1 6 Th e s u m

o f t hes e am o un t s ($ 9 ,5 8 0 + $ 2 ,0 1 0 + $ 4 9 ,6 71 + $ 2 ,8 0 0 ) an d $ 3 8 8 ,2 3 1 i s $ 4 5 2 ,2 92
.

1 7 Th e s u m

o f t hes e am o un t s ($ 2 2 ,4 0 7 + $ 1 0 ,2 07 + $ 7 1 9 + $ 2 5 ,0 00 + $ 2 9 5 + $ 1 7 3 ,1 2 3 ) an d$ 1 ,0 21 i s $ 2 3 2 ,7 7 2
.- 2 6 -

[* 2 6 ] res p ectt o cert ai n i s s u es i n v o l v i n g l iab i l i ty fo r p en al t i es , th e IRS h as th e b u rd eno f p ro du ct i o n . Th i s i s d es cri b edi n g reat er d et ai l i n fra Part III. I. Bu s i n es s -Ex p en se Dedu ct i o n s Sect io n 1 6 2 al l o w s a d edu ct i o n fo r t h e ex p en s es o f carry i n g o n a b u s i n es s . Sect i o n s 1 6 7 an d1 7 9 al l o w d edu ct io n s fo r d ep reci at i o n o f as s et s u s edi n a b u s i n es s . Sect i o n 2 8 0 E , h o wev er, p ro v id es thatn o d edu ct io n i s al l o wedfo r an
am ou n tp ai do r i n cu rredi n carry i n g o n a b u s in es s i f t he b u s i nes s co n si s t s o f traffi ck i ng i n co nt ro l l eds ubs t an ces . Al th o ug h Al t erm an an dGi bs o n co n ced e t h at Al t erm ed s , LLC, traffi ck edi n co n tro l l eds ub s t an ces , th ey co n t en d t h ati th ada
s ep arat e b u s in es s o f s el l i n g n o n -m ari ju an a m erch an d i s e an dthatth e b u si n es s ex p en s e d educt i o ns o f t h i s s ep arat e b u s in es s are n o td i s al l o wedb y s ect i o n 2 8 0 E. Wh et h er s el l i n g n o n-m ari ju an a m erch an d i s e was a s ep arat e b u s i n es s fro m s el l i n g
m ari ju an a m erch an d is e i s an i s s u e o f fact th at d ep en d s o n , am o n g o th er t h i n g s , th e d eg ree o f eco n o m i c i n t errel at i o n s h i p b et ween th e t wo act i v i t i es . See Cal i fo rn i an s Hel p i n g t o Al l ev iat e M ed . Pro b l em s , In c. v . Co m m is si o n er (CHAM P), 1 2 8 T.C. 1 7 3 , 1 8 3 (2 0 0 7). Un d er th e ci rcu m s t an ces , we h o l dth ats el l i ng n o n -m ari j u an a
m erch an d i s e was n o t s ep arat e fro m th e b u s i n es s o f s el l i n g m ari ju an a m erch an d i s e. Fi rs t , Al t erm ed s, LLC, d eri v edal m o s tal l o f i t s rev en u e fro m m ari j u an a
m erch an d i s e. Seco n d , th e t y pes o f n on -m ari

j u an a p ro du ct s th ati ts o l d(p i p es an d- 2 7 -

[* 2 7 ] o th er m ari

ju an a p arap h ern al ia) co m p l em en tedi t s effo rt s t o s el l m ari j u an a. 1 8 Al t erm ed s , LLC, h ado n ly o n e u n i t ary

b u s i n es s , s el l i n g m ari

ju an a. See Can n a Care, In c. v . Co m

m i ss io n er, T.C. M em o . 2 0 1 5 -2 0 6 , at* 1 2 , aff’ d , 6 9 4 F. Ap p ’ x 5 7 0 (9 th Ci r. 2 0 17 ). If, h o wev er, s el l i n g n o n -m ari ju an a m erch an d i s e were co n s i dered a s ep arat e b u s i n es s , th en th e ex p en s es o f t h atb u si n es s wo u l db e d edu ct ib l e. See CHAM P, 1 2 8 T.C. at1 83 -1 8 5 (s t at i n g th atcareg i v i n g s erv ices were a b u s in es s s ep arat e fro m p ro v i s i o n o f m ari

ju an a; ex p en ses o f p ro v i d i n g careg i v i n g s erv i ces were d educt i b l e). Al term an an d Gi b s o n arg ue t h atth es e d edu ct i b le ex pen s e are $ 5 4 ,7 0 7 .0 3 i n 2 01 0 an d$ 57 ,5 17 .9 3 i n 2 0 11 . Th es e am o u n t s are eq u al t o 4 0 % o f a l i sto f s ub t o t al s i n a t ab l e i n th e b ri ef fi l edb y Al t erm an an dGi bs o n aft er t ri al
. Each s ub t o t al b ears a v ag ue d es cri p t i o n , fo r ex am p l e “No n -COGS Ut il i t i es ”.

1 8 Bes i d es m ari

j u an a p arap h ern al ia, Al t erm ant es t ifi edth atthe d i s p en s ary al s o s o l d(1 ) h at s an dT-s h i rt s wi th th e n am e an db u s i n es s l og o o f Al term ed s , LLC, (2 ) m ag azi n es ab o u t m ari ju an a, (3 ) an dch i ck en s oup . No d o cu m en t ary ev i d en ce co rro b o rat es th e ex i s t en ce o r ex ten to f t h es e s al es . On a p rep o n deran ce o f ev i d en ce, we fi ndth atn o s u ch i tem s were s o ld . Fu rt herm ore, t h es e t y p es o f p ro duct s as d es cri b edb y

Al t erm an wo u l dg en eral l y co m p l em en tth e s al es o f m ari ju an a b y th e d i s pen s ary . Fo r ex am p l e, t h e h at s an d T-s h irt s as d es cri b edb y Al t erm an b o re t h e n am e an d b u s i n es s l o g o o f Al t erm ed s , LLC. Thus , ev en i f Al t erm ed s , LLC, s o l ds u ch h at s an dT-s h i rt s , s el l i n g t h o se i tem s wo u l dh av e h el p edad v ert i s e m ed i cal m ari j u an a.- 2 8 -

[* 2 8 ] Ho wev er, t h e b ri ef fai l s t o ad equ at el y ex p lai n wh y

an y p o rt io n o f th o s e
s ub t o t al s i s d educt i b l e. In p art i cu l ar t h e b ri ef fai l s t o :
! i d en t i fy

an y s p eci fi c p aym en t s th atm ak e up thes e s ub t o t al s ;
! p ro v i d e reco rdci t at i o n s t o s up p o rtth es e s ubt o t al s ; an d
! p ro p o s e fi n di n g s o f fact s reg ard i ng th es e s ub t o t al s . Al t erm an an d G ib s o n ’ s arg u m en treg ard i n g the am o u nt s o f b u si n es s -ex p en s e d educt i o n s at tri b u t ab l e t o a p u tat i v e s eco n db u si n es s was n o tb ri efedp ro p erl y . See Ru l e 1 5 1 (e)(3 ) (b ri ef m u s ti n cl u d e p ro p o s edfi n d i ng s o f factwi th referen ces t o th e reco rd ); Ru l e 1 51 (e)(5 ) (b ri ef m u s ti ncl u d e arg u m en t s reg ard i n g an y d i s p u t ed qu es ti o n s o f fact ). Ev eni f we t h o u g h t thatth e s al e o f n o n -m ari ju an a m erch an d i s e
was a s ep arat e b us i nes s , Al t erm an an dGi b s on ’ s fai l ure t o p ro p erl y b ri ef t h e
am ou n to f d edu ct io n s th atwo u l db e at tri b u t ab l e t o th i s b u s in es s wo u l dp recl u d e u s fro m al l owi n g an y

d edu ct i on s fo r t h e s ep arat e b u s i n es s . 1 9 W e n o wco n s i d er wh et h er Al t erm an an dGi b s o n are en t i t l edt o an y b u s i n es s -ex p en s e d edu ct i on s fo r Al t erm ed s , LLC, ap artfro m th e am o un t s o f

1 9 Al th o u g h , u n d er t he ru l e i n Co h an v . Co m m i ss i o n er, 3 9 F.2 d5 40 , 5 4 3 -5 4 4 (2 dCi r. 1 9 3 0), t h e Co u rtcan es t i m at e t h e am o un to f d edu ct i b l e ex p en s es i f t h ere i s a reas o n ab l e b as i s fo r m ak i n g s u ch an es t i m at e, Al t erm an an d Gi b s o n d o n o t co n ten d th e Co u rts h o u l d em p l o y th e Co han ru l e t o es t i m at e t h e b u s i n es s ex p en s es o f t h e p u t at i v e s eco n db u s i n es s. Fu rt h erm o re, t hei r b ri ef fai l s t o p o i n t t o an y ev i d en ce t h atwo u l dp ro vi d e t h e reas o n ab le b as i s req u i redfo r t he Co u rt t o m ak e an es t i m at e u n d er t he Co h an ru l e.- 2 9 -

[* 2 9 ] b u s i n es s -ex p en s e d edu ct i o n s al leg ed l y at tri b u t ab l e t o t h e p u t at i v e s eco n d b u s i n es s . Becau s e we co n s i d er Al t erm ed s , LLC’ s b u s in es s t o co ns i s to f traffi ck i ng i n co nt ro l l eds ubs t an ces , al l s u ch d edu ct i o ns are d is al lo wed b y s ect i o n 2 8 0 E. Fu rt h erm o re, Al t erm an an d Gi b s o n, h av i n g fai l edt o p ro p erl y b ri ef t h ei r
en t i t l em en tt o d edu ct i o n s fo r b u s i n es s ex p en s es th ey cl ai m rel at e t o Al t erm ed s , LLC’ s p u t at i v e s eco n db u s i n es s , h av e al s o fai l edt o p ro p erl y b ri ef t h ei r en t i t l em en t t o d educt i o n s fo r an y

o th er b u s i n es s ex p en s es o f Al t erm ed s , LLC. Th ey d i dn o t
ev en al l eg e t h e am o u n t s o f s u ch d edu ct i o ns , m u ch l es s an y s peci fi c p aym en t s , p ro v id e reco rdci t at i o n s , o r p ro p o s e fi n d i ng s o f fact . Th erefo re, we co n cl u d e Al t erm an an d G ib s o n are n oten t i t l edt o an y b u s in es s -ex pen s e d edu ct i o n s fo r Al t erm ed s , LLC. 2 0

2 0 Th i s co n cl u s i o n h o l d s ev en fo r d ep reci at i o n an d s ec. 1 79 ex p en s es . Al t erm an an d G ib s o n cl ai m edd edu ct i o ns o f $ 11 9 ,6 3 9 fo r 2 0 1 0 an d$ 11 ,7 3 9 fo r 2 0 1 1 fo r d ep reci at i o n an ds ec. 1 7 9 ex p en s es an d , as d i scu s s edab o v e, t h e n o t i ce o f d efi ci en cy

p art i al l y al l o w edd edu ct i o n s fo r d ep reci at i o n an ds ec. 1 7 9 ex p en s es ($ 4 9 , 67 1 an d$ 7 1 9 fo r 2 01 0 an d2 01 1 , res p ect i vel y ). In thei r p o s t -t ri al b ri ef, Al t erm an an d G ib s o n arg u e t h atth ey are en t i t l edt o d edu ctb us i n es s ex p en ses fo r a s eco n db u s i n es s th atd i dn o tco n s i s t o f t raffi ck in g i n co nt ro l l eds ub s t an ces , b u t th ey d o n o ti d en t i fy

am o n g th es e b u s i n es s ex p en ses an y d ep reci at io n an ds ec. 1 7 9 ex p en s es . Fu rt h erm o re, t h ey arg u e t h atthe d edu ct io n s they cl ai m edfo r d ep reci at i o n an ds ec. 1 7 9 ex p en s es o n th ei r Sch edu les C fo r 2 0 1 0 an d2 0 1 1 s h o u l d b e rech aract eri zedas al l o wan ces fo r co s to f g o o d s s o l do f Al t erm ed s , LLC, i n i t s b u s i n es s o f t raffi ck i n g i n co n tro l l ed s ub s t an ces . Th e IRS arg u es i n i ts p os t -t ri al b ri ef t h ats ec. 2 8 0 E d i sal lo w s al l b u si n es s -ex p en s e d educt i o n s (i n cl ud i n g d ep reci at i o n an ds ec. 1 7 9 ex p en s es ) fo r Al t erm ed s , LLC. Furt herm o re, i t (co n ti n u ed ...)- 3 0 -

[* 3 0 ] II. Co s to f Go o d s So l d Al t erm an an d G ib s o n arg u e t h ey are en t i t l edt o co s t -o f-g o o ds -s o l d al l o wan ces i n ex ces s o f t h e am o u n t s th e IRS co n ced edi n i t s b ri efs . Th e i nd i v i du al i n co m e t ax i s co m

p u t edo n th e b as i s o f t ax ab l e i n co m e. Sec. 1 . Tax ab l e i n co m e i s equ al t o g ro s s i n co m e m i n u s d edu ct i on s . Sec. 6 3. Co st o f g o o d s s o ldi s a redu ct i o n m ad e i n th e co u rs e o f co m p u ti n g g ro s s i nco m e. Sec. 1 .6 1 -3 (a), In co m e Tax Reg s . Iti s n o ta d edu ct i o n, s ee M ax So b el Who l es al e Li qu ors v . Co m m i s s i o n er, 6 9 T.C. 4 77 (1 9 7 7 ), aff’ d , 6 3 0 F.2 d6 7 0 (9 th Ci r. 1 9 8 0 ), an d th erefo re i ti s n ot d i s al l o wed b y s ect i o n 2 80 E, Ol i v e v . Co m m i s s i o ner, 1 3 9 T.C. 1 9 , 3 2 (2 0 1 2 ), aff’ d , 7 92 F.3 d 1 1 4 6 (9 th Ci r. 2 0 1 5 ); s ec. 1 .1 6 2 -1 (a), In co m e Tax Reg s. As th e t ax p ay ers , Al t erm an an dGi b s on m us tp ro v e t he am o u n t s al lo wab l e
as co s to f g o o d s s o ld . See Ru l e 1 4 2 (a). A t ax p ay er i s req u i redt o m ai n tai n

2 0 (...co n t i nu ed ) co n ced es th atAl t erm an an dGi b s o n are en t i t l edt o co st -o f-g oo d s -s o l d al l o wan ces i n the am o u n t s al l o wedi n th e n o t i ce o f d efi ci en cy fo r d ep reci at i on an d s ec. 1 7 9 ex p en s es an d t h atth e am o u n t s are ad d i t i o n al t o th e al l o wan ces fo r co s to f g o o d s s o l dal l o wedi n th e n o ti ce o f d efi ci en cy . Becau s e Al term an an d Gi b s o n fai l edt o b ri ef t h ei r en t it l em en tt o d educt i o ns fo r b u s i n es s ex p en s es rel at edt o Al t erm ed s , LLC, i n cl u d i n g d ep reci at io n an ds ec. 1 79 ex pen s es , an d b ecau s e t h ey arg u e t h at th e am o un t s o f d educt i o n s th ey rep o rt edfo r d ep reci at io n an d s ec. 1 7 9 ex pen s es s h o u ldb e rech aract eri zed as co s to f g o o ds s o l d , th ey h av e wai v edan y

arg u m en t th atth ey are en t i t l edt o th e d edu ct i o n s al l o wedb y th e n ot i ce o f d efi ci en cy

fo r d ep reci at i o n an ds ec. 1 7 9 ex p en s es .- 3 1 -

[* 3 1 ] s u ffi ci en tp erm an en t reco rd s t o s ub s t an t i at e i n co m e, i n cl u d i n g co s to f g o o d s
s o l d . See s ec. 6 0 0 1 ; s ec. 1 .6 0 01 -1 (a), (d ), In co m e Tax Reg s. Ho wev er, t h e Co u rt
m ay es t i m at e co s to f g oo d s s o l du n d er a v ari at i o n o f t h e Co h an ru l e ev en wh en
co s to f g o o d s s o l di s n o t fu ll y s ub s t an t i at ed , p ro vi d ed th atth ere i s a reas on ab l e b as i s fo r m ak i ng s u ch an es t im at e. Co h an v . Co m m i s s io n er, 3 9 F.2 d 5 4 0 , 5 4 3 -5 4 4 (2 dCi r. 1 9 3 0); Van i cekv . Co m m i s s i o n er, 8 5 T.C. 7 3 1 , 7 4 3 (1 98 5 ); s ee Ol i v e v . Co m m i s s i o n er, 1 3 9 T.C. at3 4
. Pro p erl y co m p u t ed , co s t o f g o o d s s ol d equ al s
! th e co sto f m erch an d is e o n h an d atth e b eg i n n in g o f th e t ax ab l e y ear (“ b eg i n n i n g i n v en t o ry ”), s ec. 1 .4 7 1 -3 (a), In co m e Tax Reg s ., ! p lu s t h e co s t o f m erch an d is e p u rch as ed s in ce t h e b eg i n n i n g o f t h e t ax ab l e y ear (“ p urch as e co s ts ”), i d . p ara. (b ),
! p lu s t h e d irect an d i n d i rectco s t o f p ro du ci n g m erch an d i se (“ p ro du ct i o n co s t s”), i d . p ara. (c), s ec. 1 .4 7 1 -1 1 , In co m e Tax Reg s ., ! m i n u s t h e co s t o f i n v en t o ry o n h an d atth e en d o f t he t ax y ear (“ en d i n g i n v en t ory ”), s ec. 1
. 4 71 -1 , In co m e Tax Reg s .- 3 2 -

[* 3 2 ] In v en t o ri es m

u s tb e reco rd edi n a l eg i b l e m an n er, p ro p erl y co m p u t edan d
s u m m ari zed , an d t h es e i n v en t o ry reco rd s m

us tb e p res erv ed b y

th e t ax p ay er. Sec. 1 .4 71 -2 (e), In co m e Tax Reg s . 2 1 Al t erm an an d G ib s o n co n t en dth atthe co s t -o f-g o od s -s ol dal l o wan ces fo r 2 0 1 0 an d2 0 1 1 are: 2 0 1 0 2 0 1 1 Co s to f m erch an d i s e p urch as eddu ri n g th e y ear $ 4 6 4 ,1 1 9 $2 5 3 ,0 8 9 Co s to f m erch an d i s e p ro duced du ri n g the y ear + 1 3 6 ,0 9 4 + 1 6 4 ,4 3 1 To t al co sto f g oo ds s o l d 6 0 0 ,2 1 3 4 1 7 ,5 2 0

2 1 Fo r b u s i n es s es fo r wh i ch p ro du ct i o n , p u rch as e, o r s al e o f m erch an d i s e i s an i n co m e-p ro duci n g fact o r, i n v en t o ri es atth e b eg i nn i ng an d en do f each t ax ab l e y ear are n eces s ary . Sec. 1 .4 7 1 -1 , In co m e Tax Reg s . Al t erm ed s , LLC, was s u ch a b u s i n es s , an dtherefo re was req u i redt o u s e b eg i nn i n g an den d i n g i n v en t o ri es . At o n e p o i n tdu ri n g d i s co v ery , Al t erm an an dGi b so n as s ert ed th atRev . Pro c. 2 0 0 0
- 2 2 , 2 0 0 0 -1 C.B. 1 0 0 8, as m o di fi edan ds up ers ed edb y Rev . Pro c. 2 0 01 -1 0, 2 0 0 1 -1 C.B. 2 7 2 , rel i ev edAl t erm ed s, LLC, o f th e o bl i g at i o n t o acco u n tfo r i n v en t o ri es . In res po n s e, t h e IRS fi leda m em o ran dum t ak i n g t h e p os i t i o n th atAl t erm an an d Gi b so n m i s i n t erp ret edRev . Pro c. 2 00 0 -2 2 , s up ra. Al t erm an an d Gi b s o n d i dn o t rel y o n Rev . Pro c. 2 0 0 0 -2 2 , s upra, aft er t hat . Fo r ex am pl e, t hey d i dn otci t e Rev
. Pro c. 2 00 0 -2 2 , s up ra, i n th ei r b ri efs . Th erefo re, th ey h av e wai v edan y

arg u m en t th atRev
. Pro c. 2 0 0 0-2 2 , s up ra, rel i ev edAl t erm ed s , LLC, o f th e o bl i g at i o n t o acco u n t fo r i n v en t o ri es . Th e Sch edu l es C fo r Al term ed s , LLC, rep o rt ed th ati t s i n co m e was cal cu l at edu si n g th e cas h m et h o do f acco u n t i n g. In cert ai n s i tu at i o n s , farm ers m ay u s e t h e cas h m et h o d o f acco u n t i n g as an al t ern at i ve t o th e i n v en t o ry m eth o d
. Ken ned y v . Co m m i s s i o n er, 8 9 T.C. 9 8 , 1 0 3 (1 9 8 7). Al t erm anan d Gi b s o n h av e n o tco nt en d ed th atth ey

are farm ers fo r t h i s p u rp o se an dth erefo re h av e wai v edan y arg u m en tth atth ey

were en t i t l edt o u s e t h e cas h m et h o d o f acco u n ti n g as farm ers .- 3 3 -

[* 3 3 ] By co m pari s o n t h e IRS co n ced es th atth e co s t -o f-g oo d s -s o l dal l o w an ces fo r 2 0 1 0 an d2 0 1 1 are: 2 2 2 0 1 0 2 01 1

To t al co s t o f g o od s s o l d $ 4 5 2,2 9 2 $ 23 2 ,7 7 2 Th e IRS m ak es a t h res h o l darg u m en tthatth e m et h o do f co m pu t in g co s to f g o o d s s o l du rg edb y

Al t erm an an dGi b s o n i s i m p ro p er b ecau s e i td oes n o t acco u n t fo r b eg i n n i n g an den d i n g i n v en t o ri es . Th atth ei r m eth o di gn o res b eg i n n i n g an d
en d in g i n v en t o ri es can b e s een fro m th e fo rm u l a s upra p . 3 1 : co s t o f g o o d s s o l d equ al s b eg i n n i n g i n v en t ory , p l u s p u rch as e co s t s , p l u s p ro du ct i o n co s t s , m in u s
en d in g i n v en t o ry . Al t erm an an dGi b s o n ’ s arg u m en tfo r co s t -o f-g o o ds -s o ld al l o wan ces rel i es en t i rel y o n p urch as e co s t s an dp ro du ct i o n co st s . Itas s u m es th at
co s to f g o o d s s o l dequ al s p u rch as e co s t s p l us p ro du ct i o n co s t s . Thu s, th ei r
m et h o d l eav es o u t b eg in n i n g i n v en t ory an den d i n g i n ven t o ry . Su ch a m et h o di s i n d eedi m p ro p er. See s ec. 1 .4 7 1 -1 , In co m e Tax Reg s . As an al t ern at iv e arg u m en t , Al term anan dGi b s o n co n t en dth atth e Co u rt
s h o u ldes t i m at e, u n d er Co h an , th e rel ev an tb eg in n i n g an d en d i n g i nv en t ori es fo r each y ear. Th i s t as k i s i m p o s s ib l e o n t h i s reco rd . To cal cu l at e co s to f g o od s s o ld fo r 2 0 1 0 , th e rel ev an tb eg i n n i n g i n v en t o ry i s t h e i n v en t o ry

o n h an datth e

2 2 Fo r t h e cal cu lat i o n o f t h es e am o u nt s, s ee s up ra n o t es 1 6 an d1 7
.- 3 4 -

[* 3 4 ] b eg i n n i n g o f 2 01 0 , wh i ch i s b y d efi n it i on th e en d i n g i n v en t ory fo r 2 0 0 9
. Fo x Ch ev ro l et , In c. v . Co m m i ss i o n er, 7 6 T.C. 7 0 8 , 7 2 2 (1 9 81 ) (“ Beari n g i n m i n d th atb eg i n n i n g i n v en to ry

fo r an y g i v en y ear i s eq u al t o th e en di n g i nv en to ry fo r t h e p ri o r y ear, i ti s eas y

t o s ee t h atan erro r i n an y y ear carri es fo rward t o ev ery
s ub s equ en ty ear.”). To es t i m at e en d i n g i n ven t o ry fo r 2 0 0 9 , we wo u l d fi rs tn eedt o
es t i m at e th e t y

p es o f p ro du ct s an du n i tqu an t i t i es o n h an d atth e en do f 2 0 09 . Th i s i s cal leda p h y s i cal i nv en t o ry . 2 3 Th ere i s n o i nfo rm at i o n i n th e reco rdreg ard i n g th e p h y s i cal i n v en t o ry

o n h an datth e en do f 2 0 0 9 . Ev en i f we h ada p hy si cal i n v en t o ry fo r the en do f 2 00 9 , we wo u ldn eedt o as s i g n a co st t o each u n it . En d i n g i n v en t o ry fo r 2 0 0 9 i s co m

p o s eds ol el y o f m erch an d i s e p u rch as eddu ri n g 2 0 0 9 b ecau s e Al t erm ed s , LLC, d idn o tp ro du ce an y m ari j u an a i n 2 0 0 9 an d b ecau s e i t b eg ani t s o p erat i o n s i n 2 0 0 9. Th ere i s n o i n fo rm at i o n i n th e reco rdreg ard i n g th e
co s to f m erch an d is e p u rch as edb y Al t erm ed s , LLC, i n 2 0 0 9. 2 4 Al t erm an an d

2 3 A p h y s i cal co u n t requi res a d et erm i n at i o n o f h o w m an y ty p es o f p ro du ct s are i n i nv en t o ry . See St ep h en F. Gert zm an , Fed eral Tax Acco u n t in g , p ara. 6 .0 8[2 ] [a] (2 d ed . 1 9 9 3). Al th ou g h we g en eral l y u n ders t an d th atth e d is p en s ary s o l dp ro du ct s l i ke b u d s, jo i n t s , an db ro wn i es (an dth erefo re p ro b ab l y h adth es e p ro duct s o n h an datth e en do f 2 0 0 9 ), we d o n o tkn o w en o u g h t o d et erm i n e wh et h er each o f t h es e s h o u l db e co n s i d ereda p ro du ctty p e o r wh et h er each o f th es e g ro up s s h o u l d b e b ro k en i n t o d i fferen tp ro du ctty p es . 2 4 Al t erm an an dGi b so n at t ach eda Sch edu le C fo r Al t erm ed s , LLC, t o th ei r 2 0 0 9 retu rn . Th ey

rep ort ed$ 0 as b eg i n n i n g i nv en t ory , wh i ch i s t h e co rrect (co n ti n u ed ...)- 3 5 -

[* 3 5 ] Gi bs o n h av e p o i n tedt o n o ev i d en ce i n th e reco rdt o g iv e u s a reas o n ab l e b as i s fo r es t i m at i ng th e en d i n g i n v en t o ry fo r 2 0 0 9
. 2 5 Inco n cl u s i on , th ere i s n o way fo r u s t o es t i m at e t h e en di n g i nv en t ory fo r 2 00 9 an dth erefo re t he b eg i n n i n g i n v en t o ry fo r 2 0 1 0
. It is al s o i m

p o s s i b l e t o es t i m at e t he en d i n g i n v en t o ry fo r 2 0 1 0 . W e wo u l d fi rs tn eedt o es t i m at e t h e p h y si cal i n v en t o ry at th e en d o f 2 0 1 0 , i .e., u n i tqu an t i t i es b y p ro du ctty

p e. Th en , u s i ng a cas h fl ow as s u m p t i o n (s uch as fi rs t -i n -fi rs t -o u t ), we
wo u l das s i g n a co s tv al u e t o each u ni to f p h y s i cal i n v en t o ry atth e en d o f 2 0 1 0 b y i m p o rt i ng a co s tv al u e fro m (1 ) a u n i ti n th e b eg in n in g i n ven t o ry fo r 2 0 1 0 , (2 ) a
u n i tp u rch as ed du ri n g 2 0 1 0 , o r (3 ) a u n i tp ro duced duri n g 2 0 1 0 . Secs . 1 .4 7 1 -1 , 1 .4 71 -3 , 1 .4 7 1 -1 1 , In co m e Tax Reg s .; s ee al s o St ep h en F. Gert zm an , Fed eral Tax Acco u n t i n g, p aras . 6 .0 6 , 6 .0 7 , an d6 .0 8 (2 ded . 1 99 3 ). As ex p l ai nedab o v e,

2 4 (...co n t i nu ed ) am ou n tb ecau s e Al t erm ed s , LLC, s t art ed o p erat i n g i n 2 0 0 9 . Th ey rep o rt edn o p ro duct i o n co s t s . Th ey rep o rt edp u rch as e co s t s o f $ 7 2 ,5 6 4 b u t the reco rd d o es n o t co n tai n ev i d en ce t o s ho w h o wth i s d o l l ar am o u n twas cal cu l at ed , s uch as recei p t s fo r m erch an d i s e p u rch as es , a p h y s i cal i nv en t ory o r o th er d o cu m en t at i o n . En d i n g i n v en t o ry fo r 2 0 0 9 was rep ort edas $ 0 . W e fi n dth e en d i n g i n v en t o ry am o u n t u n rel i ab l e. If Al t erm ed s , LLC’ s i n v en to ry was $ 0 atth e en do f 2 0 0 9 , i t wo u l dn o t h av e h adan y

i n ven t o ry

o n h an d . W e fi n dthi s u n l i k el y . Al t erm an an dGi bs o n cal cu l at edco s to f g o o d s s o l du s i n g o n l y p u rch as e co s t s , i g n o ri n g en d i n g i n v en t o ry . Th i s i s i n co rrect
.

2 5 Th ey rep o rt edo n Al t erm ed s , LLC’ s 2 01 0 Sch edu l e C t h e b eg i nn i n g i n v en t o ry as zero , b u tth ey

d o n o targ u e t h atth is am o u n t i s co rrect
.- 3 6 -

[* 3 6 ] h o wev er, we d o n o th av e t h e co s tv al u es fo r u n i ts i n th e b eg i n n i n g i n v en t o ry fo r 2 0 1 0
. 2 6 An d , fo r u ni t s p u rch as eddu ri n g 2 0 10 , atm o s twe h av e ag greg at e co s t d at a, rat h er t h an th e co s t o f an y p art i cu l ar u n i to f m erch an d i s e. 2 7 An d, fo r u n i t s p ro duced du ri ng 2 0 1 0 , we can no tev en t el l fro m th e reco rdwh et h er an y

u n i t s o f
an y ty p e o f m ari

ju an a m erch an d i s e were p ro duced b y Al t erm ed s , LLC, d

u ri n g 2 0 1 0
. To es t i m at e en d i n g i nv en t o ry fo r 2 0 1 1 , th ere are s im i l ar p ro b l em s th atare
m ag n i fi edb y

th e l acko f d at a fro m

p ri o r y ears . Fu rt h erm o re, b y 2 0 1 1 , Al t erm ed s ,

2 6 Th e fo l l o wi n g h y

po th et i cal i l l u s trat es th e i m p o rt an ce o f kno wi ng th e co s t o f b eg in n i n g i n v en t o ry . Sup p os e t h e fo l l o w i ng : ! In 2 0 0 9 , Al t erm ed s , LLC, b u y s th ree jo i n t s atd i fferen tt im es du ri n g th e y ear fo r $ 3 , $ 4 , an d$ 5 , res p ect iv el y . ! In 2 0 0 9 , i ts el l s n on e o f t h es e jo in t s . So al l th ree jo i n t s are i n th e en d i n g i nv en t o ry

i n 2 0 0 9 (an dth erefo re are i n b eg i nn i n g i n v en t o ry fo r 2 0 10 ). ! In 2 0 1 0 , Al t erm ed s , LLC, s el l s tw o o f t h e t h ree jo i n t s . If we u s e t h e fi rs t -i n -fi rs t -o u tcas h fl ow as s u m p ti o n , th enth e t wo jo i nt s s o ldi n 2 0 1 0 were t h e $ 3 an d $ 4 jo in t s . Th e $ 5 jo i n trem ai n s i n i nv en t ory i n 2 0 10 an di t h as an in v en t o ry

co s to f $ 5
. Th e $ 5 am o un ti s u s edt o co m p u t e en d i ng i n ven t o ry fo r 2 0 1 0 (al o n g wi th the co sto f al l o th er p ro du ct s i n en di n g i n v en to ry ). Thu s , we can co m p u t e en d i n g i n v en t ory

fo r 2 0 1 0 o n l y i f we kn ow b eg i nn i n g i n v en t o ry fo r 2 0 1 0
. 2 7 Th e ch eck -reg is t er en tri es co nt ai n th e m o s td et ai l i n th e reco rdco n cern i n g m erch an d i s e p u rch as es . Nev ert h el es s , we can n o td et erm i ne u n i tquan t i t i es o r as s i g n u n i tco s t s as th e en tri es are m i n i m al l y i n fo rm at i v e an di n co m

p l et e an d co v er o n l y

a fract i o n o f t h e m erch an d i s e p u rch as es .- 3 7 -

[* 3 7 ] LLC, was g ro wi n g so m e o f i t s o wnm ari j u an a, b utthe reco rdd o es n ot i n cl u d e i n v en t ory d o cu m en t at io n fo r s el f-g ro wnm ari ju an a. It is i m p ro p er i n thi s cas e fo r t he Co u rtt o es t i m at e b eg i n n in g an den d i n g i n v en t o ri es . Th e Co urt need n o treach th e qu es t io n o f t h e co s to f p u rch as i ng
m erch an d i s e o r t h e co sto f p ro du ci n g m erch an d i s e du ri n g th e y ears ati s s u e. Th es e
am ou n t s are rel ev an tt o co s to f g o o d s s ol do n l y wh en th ey are u s edi n co m

b i n at i o n wi th b eg i n n in g an den d i n g i n v en t o ry . 2 8 W e h o ldth atth e co s t -o f-g o od s -s o l dal lo wan ces fo r Al term ed s, LLC, are $ 4 5 2 ,2 9 2 fo r 2 0 1 0 an d$ 2 3 2,7 7 2 fo r 2 0 1 1 , wh i ch are t h e am o un t s co nced edb y th e IRS. 2 9

2 8 As a fu rt h er al tern at i v e, Al t erm an an dGi b s on co n t en d t h atthe Co u rt s h o u ldd et erm i n e co sto f g o o d s s o l dfo r each y ear b y m u l t i p ly i n g Al t erm ed s , LLC’ s g ro ss recei p t s fo r each y ear b y a rat i o s i m i lar t o th e rat i o u s edi n Ol i v e v . Co m m i s s i o n er, 1 3 9 T.C. 1 9 (2 0 1 2 ), aff’ d , 7 9 2 F.3 d1 1 4 6 (9 th Ci r. 2 0 1 5). In Ol i v e v . Co m m i s s i o n er, 1 3 9 T.C. at3 5 , we es t i m at edth e co s t s o f g oo d s s o ld fo r a m ed i cal -m ari

ju an a b us i nes s b y

m ul t ip l y i n g i ts g ro s s recei pt s b y a co m p arat i v e rat i o of g ro s s recei p t s t o co s t s o f g o o d s s o l d . W e d et erm i n edth e co m p arat i v e rat i o o f g ro s s recei p t s t o co st s o f g o o d s s o l dfro m th e t es t i m o n y o f t wo ex p ert wi tn es s es , Hen ry

Lev y an d Dal e Gi eri n g er. Id
. Al t erm an an dGi b s o n cal l edLev y as an ex p ertwi tn es s . Ho wev er, t h e Co u rtru l edth ath i s t es t i m on y was i n ad m is s i b le an d ex cl u d edi tfro m ev i d en ce. Un l i k e t h e reco rdi n Ol i v e, t he reco rd i n thi s cas e co n t ai ns n o ev i d en ce t o s up po rta rat i o co m p ari so n wi th o th er m ed i cal

m ari ju an a b u s i n es s es . 2 9 Itap p ears th atth e IRS d et erm i nedth e am o un t s i tco n ced edb y ad di n g p ro duct i o n co s t s t o p u rch as e co s t s . Ho w ev er, i td o es n o t co nced e t h atth i s i s th e (co n ti n u ed ...)- 3 8 -

[* 3 8 ] III. Sect io n 6 6 6 2 (a) Pen al t i es Th e IRS t ak es th e p o s i t i o n th atAl t erm an an dGi b so n are l i ab l e fo r 2 0 %
accu racy -rel at edp en al ti es u n d er s ect i o n 6 6 6 2(a) b ecau se t h e u n d erp aym en t s o f t ax fo r 2 0 1 0 an d 2 0 1 1 are at tri bu t ab l e t o n eg l i g en ce o r, al t ern at i v el y , t o s ub s t an t i al
u n d ers t at em en t s o f i nco m e t ax . See s ec. 6 6 6 2(b )(1 ) an d (2 ). Sect io n 6 6 6 2 (a) i m

p o s es a p en al ty

equ al t o 2 0 % o f an u n d erp aym en tth at i s at tri b u t ab l e t o n eg l i g en ce, o r t o a s ub s t an ti al u nd ers t at em en to f i n co m e t ax , o r t o
v ari o u s o th er cau s es . Sec. 6 66 2 (b ). Anu n d ers tat em en t o f i n co m e t ax i s g en eral l y th e d i fferen ce b et ween th e co rrect t ax an dthe t ax rep o rt edo n th e ret u rn . Sec. 6 6 6 2 (d )(2 )(A). An u nd ers t at em en ti s s ub s t an ti al i f i t ex ceed s th e g reat er o f “ (i ) 1 0 p ercen to f t h e t ax req u i red to b e s h o wno n th e retu rn fo r t h e t ax ab l e y ear, o r (i i ) $ 5 ,0 0 0 .” Sec. 6 6 6 2 (d )(1 )(A). Neg l i g en ce i n cl u d es an y fai l u re b y th e t ax p ay er t o k eep ad equ at e b o o k s an dreco rd s o r t o s ub s tan t iat e i t em s p ro perl y . Sec. 1 .6 6 6 2
- 3 (b )(1 ), In co m e Tax Reg s . Th e p en al ty i s n oti m p o sedo n an y p ort i o n o f an
u n d erp aym en t i f t h ere was a reas o n ab l e cau s e fo r s u ch p o rt i o n an d th e t ax p ay er act edi n g o o dfai th wi th res pect t o th at p o rt i o n . Sec. 6 6 6 4 (c)(1 ). Sect i o n 6 7 5 1 (b )(1 ) p ro v i d es th atcert ai n p en al t i es can n o tb e as s es sedu n les s th e i ni t i al

2 9 (...co n t i nu ed ) p ro p er m et h o do f cal cu l at i n g co s to f g o od s s ol d
.- 3 9 -

[* 3 9 ] d et erm in at i o n o f t h e as s es s m en ti s p ers o n al l y ap pro v ed i n wri t i n g b y

th e i m m ed i at e s up erv i s o r o f t he i n di v i du al m ak i n g th e d et erm i n at io n . Th e IRS h as th e b urd en o f p ro du ci n g ev i d en ce t h ati ti s ap p ro p ri at e t o i m p o s e t h e p en al ty . Sec. 7 4 9 1 (c); Hi g b ee v . Co m m i s s io n er, 1 1 6 T.C. 4 38 , 4 4 6 (2 0 0 1). If t h e IRS h as m et i t s b u rd en o f p ro du ct i o n , th e t ax pay er h as th e b u rd en o f p ers u ad in g th e Co u rtth ati ti s i n ap p ro p ri at e t o i m p o se t he p en al ty , fo r ex am p l e, b ecau s e a p o rt i o n o f t h e u n d erp aym en twas du e t o reas o n ab l e cau s e an dg o o d fai th
. Hi gb ee v . Co m

m i s si o n er, 1 1 6 T.C. at 4 47
. Th e IRS’ s b urd en o f p ro du ci n g ev i d en ce i n cl u d es p ro du ci n g ev i den ce t h at th ere was a s ub s t an t i al u n ders t at em en to f i n co m e t ax . Av rah am i v . Co m m i s s i o n er, 1 4 9 T.C. _

_ , _

_ (s l i p o p . at9 8) (Au g . 2 1 , 2 0 1 7 ). Th e t ax es rep o rt edo n th e ret u rn s are d et erm in ab l e b ecau s e th e ret u rn s are i n th e reco rd . Whet h er s ub s t an t i al
u n d ers t at em en t s o f i nco m e t ax ex i s t, an di f s o, i n wh atam o u n t s , wi l l d ep en dup o n th e recal cu l at i o n o f Al t erm an an dGi b s o n ’ s 2 0 10 an d2 0 11 t ax l i ab il i t i es t ak i n g i n t o acco u n t(1 ) t hei r co n ces si o n reg ard i n g u n derrep ort ed g ro s s recei p t s an d (2 ) t h e h o l di n g s i n th i s o p i n i on . W e l eav e t h es e cal cu l at i o n s t o th e p art i es u n d er Ru l e 1 5 5
. Reg ard l es s o f wh et h er th e u n d erp aym en t s were du e t o s ub s t an t i al
u n d ers t at em en t s o f i nco m e t ax , we h ol dth atth ey were du e t o n eg li g en ce.- 4 0 -

[* 4 0 ] Al term an an d Gi b s o n d i d n o tk eep ad equ at e reco rd s t o co m p u t e rel i ab l e b eg in n i n g an d en d i ng i n v en t o ri es fo r Al t erm ed s , LLC. Al t erm an an dGi b so n act edn eg l i g en tl y

b y fai l i n g t o k eep ad equ at e b o o ks an d reco rd s . See s ec. 1 .6 6 6 2
- 3 (b )(1 ), In co m e Tax Reg s . Th e IRS h as m eti t s b u rd en o f p ro duci n g ev i d en ce t h at th e u n derp aym en ts are du e t o n eg l i g en ce. Al t erm an an dGi b s o n h av e n o t p ers u ad edu s o therwi s e. In a d efi ci en cy

cas e, t h e IRS’ s b u rd en o f p ro du ct i o n i n cl u d es the b u rd en o f p ro duci n g ev i d en ce th ati tco m p l i edwi th th e s up erv i s o ry -ap p ro v al req u i rem en to f
s ect i on 6 7 5 1 (b )(1 ) fo r cert ai n p en al t i es . See Graev v . Co m m i s s i o n er, 1 4 9 T.C. _

_ (Dec. 2 0 , 2 0 1 7 ), s up p l em en t i n g an do v erru l in g i n p art 1 4 7 T.C. 4 6 0 (2 0 1 6 ). Th e IRS s at i s fi edth i s b u rd en . Iti n tro du ceda p en al ty ap p ro v al fo rm

b eari n g RA Ti p t o n ’ s n am e an d t he s ig n atu re o f RA Ti p t on ’ s s up erv i s o r d em on s trat i n g h i s ap p ro v al . Th e s up erv i s o r t es t i fi edth at RA Ti p t o n h adi n i t i al l y d et erm i nedth e p en al t i es an d t h atth e s up erv i s or h adap p ro vedth e i n it i al d et erm i n at i o n . Attri al , Al t erm an an d Gi b s o n o b ject ed t o the ad m i s s i b i li ty o f t h e p en al ty ap p ro v al fo rm . Th ey

arg u edth atth e p en al ty

ap p ro val fo rm co nt ai n s RA Ti p t o n ’ s
ex p erto p i n i o n s an dth atth es e o p i n i o n s co u ldb e p res en t ed o n l y th ro u gh ex p ert t es t i m o ny . (RA Ti pt o n t es ti fi edattri al as a fact wi tn es s , n o t an ex pert wi tnes s .). W e o v erru l edth e o b

ject i o n an d ad m i tt edth e p en al ty ap p ro val fo rm

i n t o t h e- 4 1 -

[* 4 1 ] reco rd
. Inp o s t -t ri al b ri efi n g , Al t erm an an dGi b s o n u rg e u s t o reco n s i d er t h e ad m i s s i b i l i ty

o f t h e p en al ty

ap p ro v al fo rm

o n t h e s am e g ro u n d s t h ey g av e fo r t h ei r
o b ject i on attri al . Th ei r o b

j ect io n was m eri t l es s . Th e IRS o ffered the p en al ty ap p ro v al fo rm

t o s h o w th at RA Ti p t o n h adi n i t ial l y d et erm i n ed th atth e p en al t i es
s h o u ldb e i m

p o s ed(an d th ath i s s up erv i s or ap p ro v edth e i n i t i al d et erm i nat i o n ), n o t t o s h o w th atth e p en al ti es are ap p ro p ri at e. Al t erm an an d G ib s o n arg u e t h at the IRS d i dn o tco m p l y wi th the
s up erv i s o ry -ap p ro v al req u i rem en tb ecau s e RA Ti p to n d idn o t al l o w p et i t io n ers
en o ug h t i m e t o fu l l y

p res en t a reas o nab l e-cau s e d efen s e t o th e accu racy -rel at ed p en al ty b efo re h e s ub m i t t edth ei r cas e t o h i s s uperv i s o r. Bu t s ect i o n 6 7 5 1 (b )(1 ) req u i res o n l y

thatthe p en al ty

b e “ p ers o nal l y

ap p ro v ed(i n wri ti ng ) b y th e i m m ed i at e s up erv i s o r”. Itd o es n o treq u i re t h e s uperv i s o r t o fo l l o w an y s p eci fi c p ro cedure i n d et erm i n i n g wh et h er t o ap p ro v e t h e p en al ty
. Al t erm an an d G ib s o n arg u e t h at there was reas o n ab l e cau s e fo r t hei r
u n d erp aym en t s an dthatthey act edi n g o o d fai th . Tax p ay ers can d em o n s trat e
reas on ab l e cau s e an dg o o d fai th i f t h ey reas o n ab ly

rel i edo n ad vi ce ab o u tth e ap p ro p ri at e t ax treat m en to f t h ei r b u s i n es s . Sec. 1
. 6 6 6 4 -4 (c)(1 ), In co m e Tax Reg s . Ho wev er, Al t erm an an dGi b so n n ei th er s o u g h t o r recei vedad v i ce fro m Co m i s k ey
an d Pen d l et o n reg ard i ng ap pro p ri at e i n v en t o ry acco u n ti n g o r th e effect o f s ect i o n- 4 2 -

[* 4 2 ] 2 8 0 E. Sec. 1 .6 6 6 4 -4 (c)(2 ), In co m e Tax Reg s . Fu rt h erm o re, Al t erm an an d Gi b so n d i dn otas kwh eth er b u si n es s es th ats el l m ed i cal m ari ju an a o r v io l at e fed eral dru g traffi ck i n g l aws are t ax edd i fferen t l y fro m o th er b u s i n es ses . Th i s l ack
o f i n qu i ry ev i n ces th ei r l acko f i n t eres ti n co m p l y i n g wi th th e fed eral t ax l aws . Sec. 1 .6 6 6 4 -4 (b )(1 ), In co m e Tax Reg s . (p ro v i d i n g t h atthe m o s t i m p o rt an tfact o r i n d et erm i n i n g wh et h er a t ax p ay er act edwi th reas on ab l e cau s e an di n g oo dfai t h i s th e ex t en to f t h e t ax p ay er’ s effo rtt o as s es s h i s o r h er p ro per t ax l i ab il i ty fo r t h e y ear). Al t erm an an d G ib s o n d i dn o tactwi th reas o n ab l e cau s e an di n g o o d fai th wi th res p ect t o th e 2 0 1 0 an d2 0 1 1 u n d erp aym en t s . Th erefo re, we h o l dth ey are l i ab l e fo r t he accu racy -rel at edp en al ty fo r each y ear. In reach i n g o u r h o ld in g s , we co n s i d eredal l arg u m en t s m ad e, an d , t o th e
ex t en tn o tm en t i o n ed , we co n cl u d e t h atth ey are m o o t , i rrel ev an t , o r wi th o utm eri t
. To refl ectthe fo reg o i n g , Deci s i o n wi ll b e en t eredu n d er Ru l e 1 5 5
.