19

1 Unless otherwise indicated, section references are to the applicable versions of the Internal 

Revenue Code (Code), Rule references are to the Tax Court Rules of Practice and Procedure and 

dollar amounts are rounded to the nearest dollar. 

MARTIN OLIVE, PETITIONER v. COMMISSIONER OF INTERNAL

REVENUE, RESPONDENT

Docket No. 14406–08. Filed August 2, 2012. 

P operates a sole proprietorship whose principal business is 

the retail sale of medical marijuana pursuant to California 

law. The business also provides minimal activities and services incident to the sales. P failed to maintain sufficient 

records to substantiate the business’ income or expenditures. 

Held: P underreported the business’ gross receipts in amounts 

R alleges in an amendment to answer. Held, further, P may 

deduct cost of goods sold for the business in amounts greater 

than those R allows. Held, further, I.R.C. sec. 280E precludes 

P from deducting any expense related to the business in that 

the business is a single business that consists of trafficking in 

a controlled substance. Californians Helping to Alleviate Med. 

Problems, Inc. v. Commissioner, 128 T.C. 173 (2007), distinguished. Held, further, P is liable for accuracy-related penalties under I.R.C. sec. 6662(a) to the extent stated. 

Henry G. Wykowski and Chris Wood (student), for petitioner. 

Daniel J. Parent, for respondent. 

KROUPA, Judge: This case stems from the operation of petitioner’s sole proprietorship, the Vapor Room Herbal Center 

(Vapor Room). The Vapor Room’s principal business is the 

retail sale of marijuana (medical marijuana) pursuant to the 

California Compassionate Use Act of 1996 (CCUA), codified at 

Cal. Health & Safety Code sec. 11362.5 (West 2007). 1 The 

Vapor Room provides minimal activities and services as part 

of its principal business of selling medical marijuana. 

Respondent determined deficiencies of $367,531 and 

$1,146,633 in petitioner’s Federal income tax for 2004 and 

2005, respectively, after determining that petitioner failed to 

substantiate any costs of goods sold (COGS) or expenses 

reported for the Vapor Room. Respondent also determined for 

20 139 UNITED STATES TAX COURT REPORTS (19) 

2 COGS is not a deduction within the meaning of sec. 162(a) but is subtracted from gross receipts in determining a taxpayer’s gross income. See Max Sobel Wholesale Liquors v. Commissioner, 69 T.C. 477 (1977), aff ’d, 630 F.2d 670 (9th Cir. 1980); sec. 1.162–1(a), Income Tax Regs. 

We refer to COGS as a deduction for convenience. 

the respective years that petitioner was liable for section 

6662(a) accuracy-related penalties of $73,506 and $229,327 

due to substantial understatements of income tax or, alternatively, negligence or disregard of rules and regulations. 

Respondent, in an amendment to answer, increased the deficiencies to $692,501 for 2004 and $1,199,814 for 2005 to 

reflect unreported gross receipts that respondent discovered 

after he issued the deficiency notice. Respondent correspondingly increased the accuracy-related penalties to $138,500 

and $239,963. 

We decide as to the Vapor Room for 2004 and 2005: 

1. whether petitioner underreported gross receipts in 

amounts respondent alleges in an amendment to answer. We 

hold he did; 

2. whether petitioner may deduct COGS in amounts greater 

than those respondent allows. 2 We hold he may to the extent 

stated; 

3. whether petitioner may deduct his claimed expenses. We 

hold he may not; and 

4. whether petitioner is liable for the accuracy-related penalties. We hold he is to the extent stated. 

FINDINGS OF FACT 

I. Preliminaries 

The parties submitted stipulated facts and exhibits. We 

incorporate the stipulated facts and exhibits by this reference. Petitioner is a high school graduate who resided in 

California when he filed the petition. He filed Federal income 

tax returns for 2004 and 2005 and included in each return 

a Schedule C, Profit or Loss From Business (Sole Proprietorship), reporting the Vapor Room’s gross receipts, COGS and 

expenses for the corresponding year. He reported that the 

Vapor Room’s ‘‘principal business’’ is ‘‘Retail Sales’’ and that 

its product is ‘‘Herbal.’’ 

(19) OLIVE v. COMMISSIONER 21

3 Approximately 50 medical marijuana dispensaries were located in California in 2004. 

4Petitioner was oblivious to the licensing requirement for his medical marijuana dispensary. 

He received the requisite license from San Francisco in or about July 2004. 

5 A vaporizer is an expensive apparatus that extracts from marijuana its principal active component and allows the user to inhale vapor rather than smoke. Petitioner chose the name of 

his business to publicize that the Vapor Room had the requisite equipment to allow patrons to 

vaporize marijuana there. 

6We say ‘‘almost all’’ because patrons also included designated caregivers of the recipients, 

who were entitled to receive medical marijuana for recipients. We use the term ‘‘patrons’’ to include only recipients. 

II. CCUA 

The State of California’s voters approved the CCUA as a 

ballot initiative in 1996. The CCUA is intended to ensure that 

‘‘seriously ill Californians’’ (recipients) can obtain and use 

marijuana if physicians recommend marijuana as beneficial 

to recipients’ health. Numerous medical marijuana 

dispensaries were formed in California to dispense medical 

marijuana to recipients. 3 Medical marijuana, however, is a 

controlled substance under Federal law. 

III. Petitioner Forms the Vapor Room 

Petitioner, while pursuing a college degree in arts and education, became involved in the medical marijuana industry 

by volunteering at a medical marijuana dispensary in San 

Francisco, California. The dispensary had a single business, 

the dispensing of medical marijuana. Petitioner learned that 

an approximately 1,250-square-foot room in his low-income 

neighborhood of San Francisco was available to rent at a 

minimal cost and he decided to abandon his college studies 

during his second year and establish a medical marijuana 

dispensary in the room. He sought the help of local friends 

and marijuana suppliers and, on January 25, 2004, began 

operating an unlicensed medical marijuana dispensary as a 

sole proprietorship. 4 He named his dispensary the Vapor 

Room. 5 He established the Vapor Room so that its patrons, 

almost all of whom were recipients (including some with terminal diseases such as cancer or HIV/AIDS) could socialize and 

purchase and consume medical marijuana there. 6

Petitioner designed the Vapor Room with a comfortable 

lounge-like, community center atmosphere, placing couches, 

chairs and tables throughout the premises. He placed vaporizers, games, books and art supplies on the premises for 

patrons to use at their desire. He set up a jewelry-store-like 

22 139 UNITED STATES TAX COURT REPORTS (19) 

7The medical marijuana in the Vapor Room’s inventory was in the following three forms: (1) 

dried marijuana, (2) food (e.g., bakery goods, butter and candy) laced with marijuana and (3) 

a concentrated version of the principal active component of marijuana. 

glass counter with a cash register on top and jars of the 

Vapor Room’s medical marijuana inventory displayed underneath and behind the counter. 

IV. Operation of the Vapor Room 

The Vapor Room was generally open for business (except 

on some holidays) on weekdays from 11 a.m. to 8:30 p.m., 

and on weekends from noon to 8 p.m. The Vapor Room sold 

nothing but medical marijuana (in three different forms) and 

its patrons went to the Vapor Room primarily to consume 

marijuana, knowing that it was readily available there. 7

Patrons also frequented the Vapor Room to socialize with 

each other incident to consuming marijuana. Petitioner 

required that each patron possess either a doctor’s recommendation to use medical marijuana or a similar certificate the San Francisco government issued. This documentation contained the person’s picture and identification 

number, but not his or her name. Patrons came to know at 

least the first name of the other patrons who regularly frequented the Vapor Room. 

The Vapor Room’s staff members (collectively, staff members) were petitioner and a few other individuals (four 

working as employees and an undisclosed number working as 

volunteers) and all staff members qualified under the CCUA

to receive and consume medical marijuana. Neither the staff 

members nor the other patrons paid petitioner a stated fee 

to frequent the Vapor Room. Nor did petitioner require that 

any patron purchase medical marijuana from him to frequent 

the Vapor Room or to take part in its activities or services. 

Patrons had access to all of the activities and services that 

the Vapor Room provided and marijuana was routinely 

passed throughout the room for consumption without cost to 

patrons who wanted to partake. 

The Vapor Room’s sole source of revenue was its sale of 

medical marijuana and patrons did not specifically pay for 

anything else connected with or offered by the Vapor Room. 

Petitioner purchased for cash (or sometimes received for free) 

the Vapor Room’s medical marijuana inventory from suppliers, each of whom was eligible under the CCUA to receive 

(19) OLIVE v. COMMISSIONER 23

8Petitioner was not forthcoming with the specific prices at which he sold his marijuana or 

the specific amount of medical marijuana that was consumed for free. Nor does the record contain a formula for the price that petitioner charged a patron for medical marijuana or reveal 

whether any discount price had a set floor such as the Vapor Room’s cost. Petitioner, during 

2004, sold approximately 32% of the marijuana (inclusive of the portion he dispensed for free) 

for less than what would otherwise have been the sale price. 

and consume marijuana. Petitioner typically purchased highquality marijuana to dispense to the patrons and he allowed 

them to consume the marijuana virtually anywhere on the 

premises. Petitioner sold to the patrons for cash 93.5% of the 

marijuana that he received and he gave the rest to patrons 

(including himself and the other staff members) for free. One 

to three staff members monitored the counter in the Vapor 

Room and they explained to patrons the attributes and 

effects of the different types of medical marijuana in the 

Vapor Room’s inventory. Petitioner set each patron’s cost for 

the medical marijuana according to the quantity desired, the 

quality of the marijuana and the amount petitioner decided 

the patron should pay. Petitioner sometimes gave patrons 

medical marijuana for free. Petitioner and the other staff 

members occasionally sampled the medical marijuana inventory for free and they would regularly ‘‘hang out’’ at the 

Vapor Room after business hours and consume marijuana. 

Staff members and other patrons sometimes consumed medical marijuana together. 8

Petitioner provided regular activities at the Vapor Room, 

such as yoga classes, chess and other board games and 

movies (with complimentary popcorn and drinks). Patrons 

sometimes consumed medical marijuana while participating 

in these activities. The Vapor Room regularly offered chair 

massages with a therapist. Patrons sometimes consumed 

medical marijuana before or after a massage. Patrons, while 

at the Vapor Room, regularly drank complimentary tea or 

water and they occasionally ate complimentary snacks or 

light food such as pizza and sandwiches. 

Staff members explained to patrons the promoted benefits 

of vaporizing marijuana (as opposed to smoking it). The staff 

members also helped patrons understand how to operate a 

vaporizer and the staff members helped patrons operate

a vaporizer upon request. Petitioner did not require that a 

patron buy medical marijuana from the Vapor Room as a 

condition of using one of the Vapor Room’s vaporizers and 

patrons sometimes consumed in a vaporizer (or elsewhere in 

24 139 UNITED STATES TAX COURT REPORTS (19) 

9Petitioner used the cash method to compute the Vapor Room’s net income. Respondent does 

not challenge petitioner’s use of that method. We discuss it no further. 

the room) marijuana they obtained elsewhere. Staff members 

sometimes delivered medical marijuana to terminally ill 

patrons at locations other than the Vapor Room and joined 

those patrons in consuming marijuana at those other locations. The Vapor Room’s staff members lived near the Vapor 

Room. 

Patrons discussed with other patrons (sometimes one-onone) their illnesses and their lives in general and they counseled one another on various personal, legal or political matters related to medical marijuana. Staff members (or other 

persons the Vapor Room retained) educated patrons or members of the public on medical marijuana and about using 

medical marijuana responsibly. The Vapor Room had a program through which patrons wrote letters to individuals who 

were incarcerated for distributing medical marijuana. 

V. Vapor Room’s Gross Receipts, COGS and Reported Income 

A. Reported Income 

Petitioner’s tax returns for 2004 and 2005 reported that 

the Vapor Room’s net income was $64,670 and $33,778, 

respectively. 9 The net income was calculated as follows: 

2004 2005 

Gross receipts $1,068,830 $3,131,605

COGS 993,377 2,812,478

Gross income 75,453 319,127

Expenses: 

Advertising -0- 660

Bank fees -0- 790

Deductible meals and entertainment -0- 3,072

Depreciation -0- 11,506

Internet services and fee 1,605 -0-

Legal and professional services -0- 46,900

Office -0- 13,337

Payroll fees -0- 1,353

Postage and delivery -0- 13

Printing and reproduction -0- 1,952

Rent 4,000 14,300

Repairs and maintenance 730 3,505

Security services 750 412

Supplies 2,922 -0-

(19) OLIVE v. COMMISSIONER 25

2004 2005 

Taxes and licenses -0- 8,750

Telephone -0- 965

Travel 776 10

Utilities -0- 3,426

Wages -0- 175,934

Total 10,783 1 285,349

Net profit 64,670 33,778

1The expenses in this column actually total $286,885, or $1,536 

more than $285,349. Petitioner apparently reported the Vapor Room’s 

‘‘Deductible meals and entertainment’’ at 100% of the reported cost 

and then reduced the $286,885 to $285,349 (without noting so) to take 

into account the 50% reduction of sec. 274(n). 

B. Gross Receipts 

Staff members noted the amount of the Vapor Room’s sales 

for each business day as shown on the cash register tape and 

counted the cash in the register. The total daily sales as 

ascertained by the cash register tape and by the daily count 

were recorded in a book (recording book). 

Petitioner’s Schedules C for 2004 and 2005 reported gross 

receipts of $1,068,830 and $3,131,605, respectively. The gross 

receipts reported on the Schedule C for 2004, however, did 

not include any gross receipts received before July 14, 2004. 

C. COGS 

Petitioner’s Schedules C for 2004 and 2005 reported that 

the Vapor Room’s COGS were $993,337 and $2,812,478, 

respectively. These amounts were calculated as follows: 

2004 2005 

Purchases less cost of items withdrawn for personal use -0- $2,796,724

Cost of labor $88,209 -0-

Materials and supplies 905,168 15,754

COGS 993,377 2,812,478

The labor amounts represent petitioner’s payments to marijuana growers in return for marijuana that they grew. 

26 139 UNITED STATES TAX COURT REPORTS (19) 

D. Expenses 

Petitioner paid the Vapor Room’s expenses by using cash 

from the cash register or by using a check or a debit card 

drawn on a bank account that petitioner opened as a sole 

proprietor ‘‘DBA Vapor Room.’’ Petitioner opened this account 

on July 6, 2004, and he regularly deposited funds into the 

account to cover the draws from the account. 

Petitioner paid the Vapor Room’s employees through a payroll service. Petitioner paid the employees (who were the 

same individuals in both 2004 and 2005) wages of $37,588 

and $96,965. Petitioner reported those wages to the Internal 

Revenue Service for Federal employment tax purposes. None 

of the employees had a specific job at the Vapor Room and 

each employee at one time or another performed all required 

jobs. 

Respondent concedes that petitioner paid the following 

ordinary and necessary business expenses during 2004 and 

2005: 

Expense 2004 2005 

Advertising -0- $650

Bank and payroll (Paychex) fees $557 1,271

Bottled water -0- 473

Employment taxes 3,002 7,609

Garbage -0- 317

Office expense and supplies 2,992 13,337

Phone and Internet 681 784

Postage -0- 13

Rent 12,000 12,300

Repairs and maintenance -0- 2,297

Security alarm monitoring 361 413

Security system/locksmith -0- 11,506

Utilities 748 1,731

Wages 37,588 96,965

Total 57,929 149,666

The items underlying the office expense and supplies for 

2004 include office supplies (e.g., labels), paper cups, a step 

ladder, a shredder, zip bags, glass canisters, a degreaser, 

marijuana rolling papers and lighters. The advertising 

expense for 2005 relates to advertisements aimed at medical 

marijuana audiences. The items underlying the office 

expense and supplies for 2005 include paper towels, marijuana-related calendars, magazines and books, marijuana 

(19) OLIVE v. COMMISSIONER 27

10Petitioner filed his Federal income tax return for 2005 during the last week of September 

2006. The audit was expanded at or about that time to include 2005. 

rolling papers, zip bags, vaporizer bags, lighters, brown 

paper bags, containers and storage jars. 

E. Petitioner’s Withdrawals 

Petitioner regularly took cash from the cash register to use 

personally, including to pay for personal trips to New York, 

New York, to Barcelona, Spain, to Amsterdam, the Netherlands, to Venice, Italy, to Cabo San Lucas, Mexico, and to the 

British Virgin Islands. He coded these withdrawals in the 

recording books so that the Vapor Room’s employees would 

not know the amount of money he was taking from the business. 

VI. Audit 

Respondent began auditing petitioner’s 2004 tax return in 

April 2006 and respondent’s revenue agent met with petitioner (accompanied by his independent accountant/tax preparer William Ehardt and an attorney) on July 6, 2006. 10

The revenue agent requested the Vapor Room’s bank statements and substantiation for COGS and petitioner gave the 

revenue agent two documents Mr. Ehardt had prepared: a 

document entitled ‘‘Vapor Room Profit and Loss January 

through December 2004’’ (Ehardt P&L) and a document entitled ‘‘Vapor Room General Ledger As of December 2004’’ 

(Ehardt GL). The Ehardt GL reports that the Vapor Room’s 

first sale occurred on July 14, 2004. The Ehardt P&L and the 

Ehardt GL each report that the Vapor Room’s total income 

for 2004 was $1,068,830, which corresponds to the amount of 

gross receipts reported on the Federal income tax return for 

2004. Many (but not all) of the expenditures shown on the 

Ehardt P&L and the Ehardt GL were reported on the return 

for 2004. 

The revenue agent next met with Mr. Ehardt in August 

2006 (the second and last meeting that the revenue agent 

had with petitioner or his representatives) and was informed 

that petitioner had ‘‘ledgers’’ showing cash received for sales 

and cash paid for purchases, but no further documents. Petitioner did not tender any ledgers at that time. 

28 139 UNITED STATES TAX COURT REPORTS (19) 

VII. Deficiency Notice 

Respondent issued the deficiency notice to petitioner. The 

deficiency notice states that petitioner may not deduct any of 

the reported COGS on account of lack of substantiation. Petitioner, after the deficiency notice was issued, provided 

respondent’s counsel with $25,776 in receipts for COGS for 

2004 and $27,370 in receipts for COGS for 2005. Respondent 

concedes that petitioner may deduct those respective 

amounts as COGS for 2004 and 2005. 

The deficiency notice also states that petitioner may not 

deduct any of the reported expenses on account of lack of 

substantiation. Respondent later conceded that petitioner 

substantiated the $57,929 and $149,666 of expenses previously mentioned but asserts that section 280E precludes 

any deduction of these expenses. Respondent’s revenue agent 

had relied upon sections 280E and 6001 during the audit to 

disallow all of the Vapor Room’s reported expenses, but the 

deficiency notice does not specifically say that. Respondent 

formalized the applicability of section 280E in a second 

amendment to answer. 

VIII. Ledgers 

Petitioner gave respondent five ledgers (collectively, 

ledgers) during this proceeding. The credible evidence in the 

record fails to establish when the ledgers were prepared. The 

ledgers, however, do not appear to be (and we do not find 

that they are) the same as the recording books. 

The ledgers purport to show the Vapor Room’s receipts and 

cash disbursements (not including payments through the 

Vapor Room’s bank account) for January 25 through March 

13, 2004; June 1 through October 30, 2004; November 1, 

2004, through April 25, 2005; April 26 through October 8, 

2005; and October 9, 2005, through February 18, 2006, 

respectively. Petitioner has never produced a ledger (or 

recording book) for the 79-day period from March 14 through 

May 31, 2004. 

The ledgers show categories of cash received and expenditures made during each business day in a total figure for 

each category and they list few (and in some cases no) specifics on the components of the categories. The ledgers someVerDate Nov 24 2008 09:42 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00010 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\OLIVE.AUG JAMIE
(19) OLIVE v. COMMISSIONER 29

11Petitioner does not argue that respondent bears the burden of proving the applicability of 

sec. 280E. We need not decide that issue because our resolution of that issue does not rest on 

which party bears the burden of proof. See Estate of Morgens v. Commissioner, 133 T.C. 402, 

409 (2009), aff ’d, 678 F.3d 769 (9th Cir. 2012); see also Knudsen v. Commissioner, 131 T.C. 185, 

186–189 (2008). 

times contain no identification for an expenditure. Petitioner 

cannot definitively identify some of the entries in the ledgers. 

The ledgers (as respondent adjusted for 2004 to reflect the 

missing 79-day period) report that the Vapor Room’s gross 

receipts for 2004 and 2005 were $1,967,956 and $3,301,898, 

respectively. 

OPINION 

I. Overview 

California law allows petitioner to dispense medical marijuana to the recipients through the Vapor Room. Federal law 

prohibits taxpayers, however, from deducting any expense of 

a trade or business that consists of the trafficking of a controlled substance such as marijuana. See sec. 280E. We are 

asked to decide whether the Vapor Room, a medical marijuana dispensary permitted by California law, may deduct 

any of its expenses. We also are asked to decide whether 

petitioner underreported the Vapor Room’s gross receipts, 

whether petitioner overreported the Vapor Room’s COGS and 

whether petitioner is liable for an accuracy-related penalty. 

We first discuss the burden of proof and our perception of 

the witnesses. We then decide the referenced issues. 

II. Burden of Proof 

Petitioner bears the burden of proving that respondent’s 

determination of the deficiencies set forth in the deficiency 

notice is incorrect. See Rule 142(a)(1); Welch v. Helvering, 

290 U.S. 111, 115 (1933). Section 7491(a) sometimes shifts 

the burden of proof to the Commissioner, but that section 

does not apply where a taxpayer fails to satisfy the recordkeeping and substantiation requirements. See sec. 

7491(a)(2)(A) and (B). Petitioner has failed to satisfy those 

requirements. Respondent bears the burden of proof only 

with respect to the increased deficiencies pleaded in the 

amendment to answer. 11 See Rule 142(a)(1). 

30 139 UNITED STATES TAX COURT REPORTS (19) 

III. Witness Testimony 

We determine the credibility of each witness, weigh each 

piece of evidence, draw appropriate inferences and choose 

between conflicting inferences in finding the facts of a case. 

The mere fact that one party presents unopposed testimony 

on that party’s behalf does not necessarily mean that we will 

find the elicited testimony to be credible. We will not accept 

the testimony of witnesses at face value to the extent we perceive the testimony to be incredible or otherwise unreliable. 

See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 

84 (2000), aff ’d, 299 F.3d 221 (3d Cir. 2002); see also Ruark 

v. Commissioner, 449 F.2d 311, 312 (9th Cir. 1971), aff ’g per 

curiam T.C. Memo. 1969–48; Clark v. Commissioner, 266 

F.2d 698, 708–709 (9th Cir. 1959), aff ’g in part and 

remanding T.C. Memo. 1957–129. 

Petitioner’s testimony and the testimony of his other witnesses were rehearsed, insincere and unreliable. We do not 

rely on petitioner’s testimony to support his positions in this 

case, except to the extent his testimony is corroborated by 

reliable documentary evidence. We also do not rely on the 

uncorroborated testimony of petitioner’s other witnesses, 

three of whom are (or were) patrons of the Vapor Room and 

all of whom are closely and inextricably connected with the 

medical marijuana industry and with a desired furtherance 

of that movement. 

IV. Unreported Gross Receipts 

We start our analysis of the substantive issues by determining the amount of the Vapor Room’s gross receipts. Petitioner reported that the Vapor Room’s gross receipts were 

$1,068,830 for 2004 and $3,131,605 for 2005. Respondent did 

not adjust those amounts in the deficiency notice. Petitioner 

later, however, gave respondent the ledgers that revealed 

that the Vapor Room’s gross receipts were greater than the 

reported amounts. Respondent then computed the Vapor 

Room’s gross receipts using the ledgers. Respondent first 

totaled the cash that petitioner recorded in the ledgers for 

each year as sales receipts ($1,513,370 and $3,301,898, 

respectively). Respondent then extrapolated from the ledgers’ 

recording of the sales receipts for 2004 that the Vapor 

Room’s total sales during the missing 79-day period were 

(19) OLIVE v. COMMISSIONER 31

$454,586. Respondent concluded that the Vapor Room’s gross 

receipts for 2004 and 2005 were $1,967,956 ($1,513,370 + 

$454,586) and $3,301,898, respectively, and asks the Court to 

find the same. 

Petitioner does not dispute that he underreported the 

Vapor Room’s gross receipts for 2004 and 2005 (including 

that he failed to report any gross receipts received before 

July 14, 2004). He asks the Court, however, to find that the 

Vapor Room’s gross receipts for the respective years totaled 

$1,969,331 and $3,264,798 (i.e., $1,375 more and $37,100 less 

than the respective amounts respondent determined). He 

supports his proposed finding with citations to profit and loss 

statements that his current accountant, Marlee Taxy, C.P.A., 

prepared for the respective years. One statement reports 

without further explanation that the Vapor Room’s ‘‘Sales (as 

per Ledger)’’ for 2004 were $1,948,882 (inclusive of a 

$450,904 adjustment to reflect the 79 missing days) and that 

its total income for 2004 also included a $20,448 upward 

adjustment for ‘‘Actual to agree with cash in Ledger’’ 

($1,948,882 + $20,448 = $1,969,331). The other statement 

reports without further explanation that the Vapor Room’s 

‘‘Sales (as per Ledger)’’ for 2005 were $3,308,328 and that its 

total income for 2005 also included a $43,530 downward 

adjustment for ‘‘Actual to agree with cash in Ledger’’ 

($3,308,328 – $43,530 = $3,264,798). Neither petitioner nor 

any of his witnesses explained the calculation of the numbers 

in those statements. 

Petitioner’s reporting in the ledgers of the Vapor Room’s 

sales is reliable evidence of the amount of the Vapor Room’s 

gross receipts for 2004 and 2005. Respondent and Ms. Taxy 

calculated the Vapor Room’s gross receipts using those 

ledgers. They arrived at slightly different totals for each 

year. We place more weight on respondent’s calculations. 

They were accompanied by sufficient detail. We accept 

respondent’s computation as the more accurate calculation of 

the Vapor Room’s gross receipts for 2004 and 2005. We hold 

that the Vapor Room’s gross receipts for the respective years 

were $1,967,956 and $3,301,898. We note that petitioner in 

his answering brief sets forth no objection to respondent’s 

request in his opening brief that the Court find that the 

ledgers (as adjusted for the missing period) stated that the 

32 139 UNITED STATES TAX COURT REPORTS (19) 

Vapor Room’s sales during the respective years were in the 

amounts that respondent calculated. 

V. COGS 

We now turn to the parties’ dispute as to the Vapor Room’s 

COGS. Petitioner argues that respondent arbitrarily determined the Vapor Room’s COGS in the deficiency notice 

because the notice states that the Vapor Room’s COGS were 

zero for 2004 and 2005. Petitioner argues that the burden of 

proof is therefore upon respondent. See Helvering v. Taylor, 

293 U.S. 507, 515 (1935); Palmer v. United States, 116 F.3d 

1309, 1312 (9th Cir. 1997). We disagree that respondent’s 

determination of the Vapor Room’s COGS was arbitrary so as 

to shift the burden of proof on that issue to respondent. 

A cash method taxpayer like petitioner may generally 

deduct all ordinary and necessary expenses of the business 

upon payment of those expenses. See sec. 162(a). Deductions 

are strictly a matter of legislative grace, however, and petitioner must prove he is entitled to deduct the Vapor Room’s 

claimed amounts of COGS (as well as the Vapor Room’s 

claimed amounts of expenses). See Rule 142(a)(1); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Goldsmith 

v. Commissioner, 31 T.C. 56, 62 (1958); Hahn v. Commissioner, 30 T.C. 195, 198 (1958), aff ’d, 271 F.2d 739 (5th Cir. 

1959); see also Briggs v. Commissioner, T.C. Memo. 2000– 

380; King v. Commissioner, T.C. Memo. 1994–318, aff ’d without published opinion, 69 F.3d 544 (9th Cir. 1995); Whatley 

v. Commissioner, T.C. Memo. 1992–567, aff ’d without published opinion, 21 F.3d 1119 (9th Cir. 1994). Petitioner is 

required to maintain sufficient permanent records to 

substantiate the Vapor Room’s deductions. See sec. 6001; see 

also Briggs v. Commissioner, T.C. Memo. 2000–380; sec. 

1.6001–1(a), (d), Income Tax Regs. Respondent’s determination in the notice of deficiency of the Vapor Room’s COGS as 

zero reflects that petitioner failed to produce credible records 

supporting any greater deductions of COGS. Petitioner, in 

fact, concedes in his posttrial brief that he ‘‘freely admitted’’ 

to the revenue agent that he had no receipts for COGS. 

Petitioner argues nonetheless that the ledgers alone are 

sufficient substantiation for taxpayers operating in the medical marijuana industry because, he states, that industry 

(19) OLIVE v. COMMISSIONER 33

‘‘shun[s] formal ‘substantiation’ in the form of receipts.’’ We 

disagree with petitioner that the ledgers standing alone are 

sufficient substantiation. The ledgers did not specifically 

identify the marijuana vendors or reflect any marijuana that 

was received or given away. The ledgers neither were 

independently prepared nor bore sufficient indicia of reliability or trustworthiness. The substantiation rules require a 

taxpayer to maintain sufficient reliable records to allow the 

Commissioner to verify the taxpayer’s income and expenditures. See sec. 6001; sec. 1.6001–1(a), Income Tax Regs.; see 

also Obot v. Commissioner, T.C. Memo. 2005–195. Neither 

Congress nor the Commissioner has prescribed a rule stating 

that a medical marijuana dispensary may meet that substantiation requirement merely by maintaining a self-prepared 

ledger listing the amounts and general categories of its 

expenditures. It is not this Court’s role to prescribe the special substantiation rule that petitioner desires for medical 

marijuana dispensaries and we decline to do so. 

Petitioner seeks to strengthen the probative value of the 

ledgers through his and Ms. Taxy’s testimony. He testified 

that he contemporaneously recorded in the ledgers all of the 

Vapor Room’s purchases of marijuana and Ms. Taxy testified 

that she totaled the Vapor Room’s COGS for the respective 

years at $1,651,554 and $2,713,128. Respondent rebuts that 

petitioner has failed to substantiate that the amount of the 

Vapor Room’s COGS exceeded $25,776 for 2004 or $27,370 for 

2005. Respondent concludes that the Vapor Room’s COGS are 

limited to the amounts petitioner was able to substantiate to 

respondent’s satisfaction. We disagree with both parties. 

The Vapor Room’s sales for the respective years were 

$1,967,956 and $3,301,898. We consider it unreasonable to 

conclude that the Vapor Room’s COGS totaled the small 

amounts that respondent asks us to find. We also consider it 

unreasonable, however, to conclude that the Vapor Room’s 

COGS are those amounts set forth in the ledgers. We do not 

believe that the COGS entries set forth in the ledgers are 

entirely accurate and we decline to rely upon those entries 

in their entirety. Petitioner consciously chose to transact the 

Vapor Room’s business primarily in cash. He also chose not 

to keep supporting documentation for the Vapor Room’s 

34 139 UNITED STATES TAX COURT REPORTS (19) 

12Petitioner asserts that he minimized the Vapor Room’s use of checks because he did not 

want his bank to know that the Vapor Room was a medical marijuana dispensary. We find that 

assertion incredible, especially given that petitioner informed the bank that his business was 

named ‘‘Vapor Room.’’ 

13The ledgers apparently were not available at the start of this proceeding when petitioner 

admitted under Rule 90 that the Vapor Room started its business in July 2004. The ledgers 

show sales for the Vapor Room on most (if not all) of the days from January 25 through March 

13, 2004, and June 1 through October 30, 2004. 

14Petitioner informs us that California did not allow medical marijuana dispensaries to earn 

a profit for the years at issue. The need to report no profit may improperly cause a dispensary 

to understate gross receipts or to overstate expenditures. We are especially wary here, where 

petitioner by his own admission understated his gross receipts and took steps to disguise his 

cash withdrawals from his business to conceal them from his employees. We also note that petitioner in his petition challenged only respondent’s disallowance of the COGS and expenses petitioner reported on the returns and stated in the petition that he had incurred the reported expenditures in the amounts stated (without mention of any greater or additional expense 

amounts). 

expenditures. He did so at his own peril. 12 The mere fact 

that we rely on the ledgers to determine the amounts of the 

Vapor Room’s gross receipts is not necessarily inconsistent 

with our refusing to rely upon the ledgers to determine the 

amount of the Vapor Room’s COGS (or expenses). Nor are the 

ledgers necessarily accurate as to COGS (and expenses) 

simply because petitioner recorded more sales receipts in the 

ledgers than he did in the Federal income tax returns he 

filed for the years at issue. We find the expenditure entries 

in the ledgers vague and incomplete in many instances. 

Moreover, we seriously doubt that they were recorded 

contemporaneously or accurately with the expenditures. 13

We also doubt that petitioner made each recorded expenditure in the amount and for the purpose (if any) stated. 14

We are left to ascertain the Vapor Room’s COGS on the 

basis of the record. The evidence is not satisfactory for this 

purpose. We nevertheless must do our best with the materials at hand. ‘‘Absolute certainty in such matters is usually 

impossible and is not necessary; * * * [we] make as close an 

approximation as * * * [we] can, bearing heavily * * * upon 

the taxpayer whose inexactitude is of his own making.’’ 

Cohan v. Commissioner, 39 F.2d 540, 543–544 (2d Cir. 1930); 

accord Edelson v. Commissioner, 829 F.2d 828, 831 (9th Cir. 

1987) (stating that ‘‘a court should allow the taxpayer some 

deductions [under the Cohan rule] if the taxpayer proves he 

[or she] is entitled to the deduction but cannot establish the 

full amount claimed’’), aff ’g T.C. Memo. 1986–223; see also 

Lollis v. Commissioner, 595 F.2d 1189, 1190 (9th Cir. 1979), 

(19) OLIVE v. COMMISSIONER 35

15Petitioner also called Dale Gieringer, Ph.D., and Ms. Taxy to testify as experts on the medical marijuana industry and the Court recognized them as such. We similarly consider their testimony to be unreliable for similar reasons. We adopt their opinions only to the limited extent 

stated. 

aff ’g T.C. Memo. 1976–15; Goldsmith v. Commissioner, 31 

T.C. at 62. 

We are aided, in small part, by the testimony of Henry C. 

Levy, C.P.A. Petitioner called Mr. Levy as an expert on the 

medical marijuana industry and the Court recognized him as 

such. Having said that, we generally found Mr. Levy to be 

unreliable. He was unreliable in that he was not sufficiently 

independent of petitioner and his cause (e.g., Mr. Levy is 

petitioner’s current bookkeeper and accountant and has 

approximately 100 other medical marijuana dispensaries as 

clients). See Neonatology Assocs., P.A. v. Commissioner, 115 

T.C. at 86–87. In addition, his testimony improperly consisted mainly of legal opinions and conclusions. 15 See Gibson 

& Assocs., Inc. v. Commissioner, 136 T.C. 195, 229–230 

(2011); Alumax, Inc. v. Commissioner, 109 T.C. 133, 171 

(1997), aff ’d, 165 F.3d 822 (11th Cir. 1999); see also United 

States v. Scholl, 166 F.3d 964, 973 (9th Cir. 1999). 

We have broad discretion to evaluate the cogency of an 

expert’s analysis. We may adopt only those parts of an 

opinion we consider to be reliable. See Helvering v. Nat’l Grocery Co., 304 U.S. 282, 294–295 (1938); Neonatology Assocs., 

P.A. v. Commissioner, 115 T.C. at 85–86; IT & S of Iowa, Inc. 

v. Commissioner, 97 T.C. 496, 508 (1991). Mr. Levy opined 

that the average COGS of three of his medical marijuana 

dispensary clients was 75.16% of their sales for 2005 and 

that part of his opinion comports with Dr. Gieringer’s opinion 

that the COGS of medical marijuana dispensaries ranged from 

70 to 85% of sales during the years at issue. We consider 

75.16% of sales to be a reasonable measure of the Vapor 

Room’s COGS. We therefore adopt that percentage of sales as 

a measure of the Vapor Room’s COGS for each year at issue. 

This does not mean, however, that the Vapor Room’s COGS

equals 75.16% of its gross receipts. We are mindful that this 

is not the right percentage because petitioner gave some of 

the Vapor Room’s inventory to patrons for free and the parties dispute whether the Vapor Room’s cost of that portion of 

the medical marijuana is includable in the Vapor Room’s 

36 139 UNITED STATES TAX COURT REPORTS (19) 

16 Both staff members (including petitioner) and other patrons received medical marijuana for 

free. The record does not disclose how much of the free marijuana actually went to ‘‘needy’’ individuals. 

17The medical marijuana petitioner gave away might arguably still qualify as an ordinary and 

necessary business expense under sec. 162(a). We need not decide that issue, however, because 

we hold later that sec. 280E precludes any such deduction. 

COGS. Petitioner argues that these costs are so includable. 

We disagree. 

Petitioner did not sell the marijuana underlying these 

costs and he did not hold all the marijuana out for sale. 

These costs, therefore, hardly reflect the cost of the goods 

that petitioner sold. See Fuller v. Commissioner, 20 T.C. 308, 

316 (1953), aff ’d, 213 F.2d 102 (10th Cir. 1954). Petitioner 

acknowledges that inventory withdrawn for personal use is 

not included in a COGS calculation and petitioner withdrew 

the referenced medical marijuana from the Vapor Room’s 

inventory of marijuana for sale. He personally consumed 

some of it and gave the rest to his selected patrons for free. 

Petitioner’s claim that he gave the marijuana to needy 

patrons out of compassion, even if true (which we need not 

decide), does not dictate a different result. 16 Inventory that 

is given to a qualified charitable organization may receive 

special treatment. The recipients of petitioner’s gratuities, 

however, were not qualified charitable organizations. Nor 

does the record or caselaw support petitioner’s characterization of the free medical marijuana distributions as rebates to 

customers. We conclude that the Vapor Room’s COGS for each 

year at issue equals 75.16% of the Vapor Room’s gross 

receipts for the year, as further adjusted to take into account 

our finding that petitioner gave away 6.5% of the Vapor 

Room’s purchases. 17 We therefore hold that the Vapor 

Room’s COGS for 2004 and 2005 are $1,382,973 ($1,967,956 × 

75.16% × 93.5%) and $2,320,396 ($3,301,898 × 75.16% × 

93.5%), respectively. 

VI. Expenses 

A. Overview 

We turn now to decide the parties’ dispute on the deductibility of the Vapor Room’s expenses. Respondent argues that 

petitioner failed to substantiate expenses in amounts greater 

than $57,929 for 2004 and $149,666 for 2005. Respondent 

also argues that section 280E precludes petitioner from 

(19) OLIVE v. COMMISSIONER 37

18The largest claimed expense is wages paid in cash. Petitioner opted not to specifically identify the purported recipients of these ‘‘wages.’’ We are troubled with petitioner’s claimed cash 

transactions and doubt that any of the claimed cash wages were ever reported as income. 

deducting any of those amounts notwithstanding that the 

amounts were substantiated. Petitioner argues that he is 

entitled to deduct the Vapor Room’s expenses in full. Petitioner asserts that the Vapor Room’s expenses are as follows: 18

Expense 2004 2005 

Advertising $1,466 $5,902

Bank fees 724 1,271

Charity -0- 7,810

Donations 683 3,330

Internet services and fee 2,219 784

Legal and professional services 390 36,670

Other 12,787 24,596

Payroll taxes 2,876 7,418

Rent 14,369 12,300

Repairs and maintenance 1,328 11,486

Security services 827 5,988

State -0- 1,547

Supplies 26,649 31,401

Taxes and licenses 195 2,500

Travel and meals and entertainment 2,549 3,602

Utilities 973 2,248

Wages: 

Paid in cash 133,071 161,751

Paid through Paychex 37,588 96,965

Total 1 236,502 417,569

1This column totals $238,694. Petitioner does not explain how his 

total differs. 

Petitioner asserts that section 280E, if applicable, which he 

argues it is not, precludes deductions for the years at issue 

of only $12,636 and $20,748 of expenses. He calculates those 

amounts on the basis of his reading of our Opinion in 

Californians Helping to Alleviate Med. Problems, Inc. v. 

Commissioner (CHAMP), 128 T.C. 173 (2007). We disagree 

with petitioner’s reading of our Opinion in CHAMP and further find that the factual settings of CHAMP and this case 

are distinguishable. 

B. Substantiation 

Petitioner has failed to maintain required permanent 

records. He also has failed to substantiate the Vapor Room’s 

38 139 UNITED STATES TAX COURT REPORTS (19) 

19The parties agree that sec. 280E disallows deductions only for the expenses of a business 

and not for its COGS. See also Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner, 128 T.C. 173, 178 n.4 (2007). 

expenses with the exception of those expenses respondent 

concedes. We decline to attempt to estimate any of his 

expenses pursuant to Cohan v. Commissioner, 39 F.2d 540, 

because, as discussed below, we hold that section 280E precludes any deduction of the Vapor Room’s expenses. See also 

Lewis v. Commissioner, 560 F.2d 973, 977 (9th Cir. 1977) 

(stating that the Cohan rule may not be applied to certain 

expenses), rev’g on other grounds T.C. Memo. 1974–59; Sanford v. Commissioner, 50 T.C. 823, 827–828 (1968) (same), 

aff ’d, 412 F.2d 201 (2d Cir. 1969). We hold that petitioner 

may not deduct any expense other than the expenses that 

respondent concedes. Those conceded expenses, however, 

must still fall outside section 280E to be deductible. 

C. Section 280E 

We now turn to section 280E. A taxpayer may not deduct 

any amount for a trade or business where the ‘‘trade or business (or the activities which comprise such trade or business) 

consists of trafficking in controlled substances * * * which is 

prohibited by Federal law.’’ 19 Sec. 280E. We have previously 

held, and the parties agree, that medical marijuana is a controlled substance under section 280E. See CHAMP, 128 T.C. 

at 181; see also Gonzalez v. Raich, 545 U.S. 1 (2005); United 

States v. Oakland Cannabis Buyers’ Coop., 532 U.S. 483 

(2001). 

Petitioner argues that he may deduct the Vapor Room’s 

expenses notwithstanding section 280E because, he claims, 

the Vapor Room’s business did not consist of the illegal trafficking in a controlled substance. He argues that the illegal 

trafficking in controlled substances is the only activity covered by section 280E. We disagree that section 280E is that 

narrow and does not apply here. We therefore reject petitioner’s contention that section 280E does not apply because 

the Vapor Room was a legitimate operation under California 

law. We have previously held that a California medical marijuana dispensary’s dispensing of medical marijuana pursuant 

to the CCUA was ‘‘trafficking’’ within the meaning of section 

280E. See CHAMP, 128 T.C. at 182–183. That holding 

applies here with full force. 

(19) OLIVE v. COMMISSIONER 39

20Our research reveals for information purposes that 17 States and the District of Columbia 

have legalized medical marijuana as of July 19, 2012. See http://medicalmarijuana.procon.org/ 

view.resource.php?resourceID=000881 (last visited July 19, 2012). Those States are Alaska, Arizona, California, Colorado, Connecticut, Delaware, Hawaii, Maine, Michigan, Montana, Nevada, 

New Jersey, New Mexico, Oregon, Rhode Island, Vermont and Washington. Id. 

Petitioner asserts that the Vapor Room provided caregiving 

services in addition to dispensing medical marijuana. He 

invites the Court to reinterpret section 280E more narrowly 

than we did in CHAMP to reach only those illegal underground businesses that have a single business of drug trafficking. We decline to do so. The taxpayer in CHAMP was a 

legitimate (under State law) operation that had a second 

business (providing caregiving services) and we applied section 280E there. The dispensing of medical marijuana, while 

legal in California (among other States), 20 is illegal under 

Federal law. Congress in section 280E has set an illegality 

under Federal law as one trigger to preclude a taxpayer from 

deducting expenses incurred in a medical marijuana dispensary business. This is true even if the business is legal under 

State law. 

Petitioner argues alternatively that he may deduct all of 

the Vapor Room’s expenses attributable to the Vapor Room’s 

caregiving business. He asserts that he trafficked marijuana 

only during the short time it took for the staff members to 

pass the medical marijuana to the patrons in exchange for 

payment and that the rest of the Vapor Room’s business was 

providing caregiving services. He compares his business to 

the medical marijuana dispensary in CHAMP. We found 

there that the taxpayer had two businesses (one the dispensing of medical marijuana and the other the providing of 

caregiving services). Petitioner asserts that the Vapor Room’s 

overwhelming purpose was to provide caregiving services, 

that the Vapor Room’s expenses are almost entirely related 

to the caregiving business and that the Vapor Room would 

continue to operate even if petitioner did not sell medical 

marijuana. We disagree. The record does not establish these 

assertions. Moreover, as previously stated, all of the testimony from petitioner and from his other witnesses was 

rehearsed, not impartial and not credible. We find instead 

that petitioner had a single business, the dispensing of medical marijuana, and that he provided all of the Vapor Room’s 

services and activities as part of that business. 

40 139 UNITED STATES TAX COURT REPORTS (19) 

The record establishes that the Vapor Room is not the 

same type of operation as the medical marijuana dispensary 

in CHAMP that we found to have two businesses. The differences between the operations are almost too numerous to 

list. The dispensary there was operated exclusively for charitable, educational and scientific purposes and its income was 

slightly less than its expenses. See CHAMP, 128 T.C. at 174, 

176–177. The director there was well experienced in health 

services and he operated the dispensary with caregiving as 

the primary feature and the dispensing of medical marijuana 

(with instructions on how to best consume it) as a secondary 

feature. See id. at 174–175. Seventy-two percent of the 

CHAMP dispensary’s employees (18 out of 25) worked exclusively in its caregiving business and the dispensary provided 

its caregiving services regularly, extensively and substantially independent of its providing medical marijuana. See id. 

at 175–176, 178, 183, 185. It rented space at a church for 

peer group meetings and yoga classes and the church did not 

allow marijuana on the church’s premises. See id. at 176. It 

provided its low-income members with hygiene supplies and 

with daily lunches consisting of salads, fruit, water, soda and 

hot food. See id. at 175. Its members, approximately 47% of 

whom suffered from AIDS, paid a single membership fee for 

the right to receive caregiving services and medical marijuana from the taxpayer. See id. at 174–175. The names of 

the dispensaries are even diametrically different. The name 

of the dispensary there, ‘‘Californians Helping To Alleviate 

Medical Problems,’’ stresses the dispensary’s caregiving mission. The name of the dispensary here, ‘‘The Vapor Room 

Herbal Center,’’ stresses the sale and consumption (through 

vaporization) of marijuana. 

Petitioner essentially reads our Opinion in CHAMP to hold 

that a medical marijuana dispensary that allows its customers to consume medical marijuana on its premises with 

similarly situated individuals is a caregiver if the dispensary 

also provides the customers with incidental activities, consultation or advice. Such a reading is wrong. A business that 

dispenses marijuana does not necessarily consist simply of 

the act of dispensing marijuana, just as a business that sells 

other goods does not necessarily consist simply of the passing 

of those goods. 

(19) OLIVE v. COMMISSIONER 41

All facts and circumstances must be taken into account to 

ascertain the parameters of a business. Two activities can be 

separated or aggregated for tax purposes depending on the 

‘‘degree of organizational and economic interrelationship 

* * *, the business purpose which is (or might be) served by 

carrying on the various undertakings separately or together 

in a trade or business * * *, and the similarity of * * * [the] 

undertakings.’’ Sec. 1.183–1(d)(1), Income Tax Regs.; see also 

Tobin v. Commissioner, T.C. Memo. 1999–328 (listing certain 

factors to consider in deciding whether a taxpayer’s 

characterization of two or more undertakings as a single 

activity for purposes of section 183 is unreasonable). The 

Commissioner usually will accept a taxpayer’s characterization of several undertakings either as a single activity or as 

separate activities. See sec. 1.183–1(d)(1), Income Tax Regs. 

The Commissioner will reject the characterization, however, 

if it is artificial and cannot be reasonably supported under 

the facts and circumstances of the case. See id. A taxpayer, 

to be engaged in a trade or business for purposes of section 

162, must be involved in the activity with continuity and 

regularity and the taxpayer’s primary purpose for engaging 

in the activity must be for income or profit. See Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). 

The facts here persuade us that the Vapor Room’s dispensing of medical marijuana and its providing of services 

and activities share a close and inseparable organizational 

and economic relationship. They are one and the same business. Petitioner formed and operated the Vapor Room to sell 

medical marijuana to the patrons and to advise them on 

what he considered to be the best marijuana to consume and 

the best way to consume it. Petitioner provided the additional services and activities incident to, and as part of, the 

Vapor Room’s dispensing of medical marijuana. Petitioner 

and the Vapor Room’s employees were already in the room 

helping the patrons receive and consume medical marijuana 

and the entire site of the Vapor Room was used for that purpose. The record does not establish that the Vapor Room paid 

any additional wages or rent to provide the incidental services and activities. Nor does the record establish that the 

Vapor Room made any other significant payment to provide 

the incidental activities or services. Petitioner also oversaw 

all aspects of the Vapor Room’s operation and the Vapor 

42 139 UNITED STATES TAX COURT REPORTS (19) 

Room had a single bookkeeper and a single independent 

accountant for its business. These facts further support our 

conclusion that the Vapor Room had only one trade or business. See Tobin v. Commissioner, T.C. Memo. 1999–328. 

That petitioner may have sometimes overcharged patrons 

for marijuana to subsidize the cost of the Vapor Room’s limited services or activities does not change our view. Petitioner’s payment of the Vapor Room’s expenses to dispense 

medical marijuana allowed the Vapor Room to fulfill its business purpose of selling medical marijuana that in turn 

allowed the Vapor Room to offer its incidental services and 

activities in support of that purpose. Moreover, the Vapor 

Room’s only revenue was from patrons’ purchase of marijuana. The Vapor Room would not have had any revenues at 

all (and could not have operated) if none of the patrons had 

purchased marijuana from petitioner. The Vapor Room did 

not spawn a second business simply by occasionally providing 

the patrons with snacks, a massage, or a movie, or allowing 

the patrons to play games in the room and to talk there to 

each other. 

Petitioner also has not established that the Vapor Room’s 

activities or services independent of the dispensing of medical marijuana were extensive. He tried to establish that they 

were but failed. His counsel, at trial, repeatedly asked petitioner’s patrons/witnesses to describe ‘‘caregiving’’ services 

that petitioner provided at the Vapor Room. The witnesses 

strained to come up with any such service, other than 

through their rehearsed statements that fell short of establishing caregiving services of the type and extent described 

in CHAMP, 128 T.C. at 175–176. Petitioner’s actions spoke 

loudly when he filed the tax returns for 2004 and 2005, 

reporting that the Vapor Room’s principal business was the 

retail sale of ‘‘herbal’’ (which we understand to be marijuana). We perceive his claim now that the Vapor Room actually consists of two businesses as simply an after-the-fact 

attempt to artificially equate the Vapor Room with the medical marijuana dispensary in CHAMP so as to avoid the disallowance of all of the Vapor Room’s expenses under section 

280E. We conclude that section 280E applies to preclude 

petitioner from deducting any of the Vapor Room’s claimed 

expenses. 

(19) OLIVE v. COMMISSIONER 43

VII. Accuracy-Related Penalty 

We now turn to decide whether petitioner is liable for an 

accuracy-related penalty under section 6662(a). A taxpayer 

may be liable for a 20% penalty on any underpayment of tax 

attributable to negligence or disregard of rules or regulations 

or any substantial understatement of income tax. See sec. 

6662(a) and (b)(1) and (2). ‘‘Negligence’’ includes any failure 

to make a reasonable attempt to comply with the provisions 

of the Code and includes ‘‘any failure by the taxpayer to keep 

adequate books and records or to substantiate items properly.’’ Sec. 6662(c); sec. 1.6662–3(b)(1), Income Tax Regs. 

Negligence has also been defined as a lack of due care or 

failure to do what a reasonable person would do under the 

circumstances. See Allen v. Commissioner, 925 F.2d 348, 353 

(9th Cir. 1991), aff ’g 92 T.C. 1 (1989). ‘‘Disregard’’ includes 

any careless, reckless or intentional disregard of rules or 

regulations. See sec. 6662(c); sec. 1.6662–3(b)(2), Income Tax 

Regs. An individual’s understatement of income tax is 

substantial if the understatement exceeds the greater of 10% 

of the tax required to be shown on the return or $5,000. See 

sec. 6662(d)(1)(A). An accuracy-related penalty does not 

apply, however, to any portion of an underpayment for which 

there was reasonable cause and where the taxpayer acted in 

good faith. See sec. 6664(c)(1). 

Respondent bears the burden of production to establish 

that it is appropriate to impose the accuracy-related penalty. 

See sec. 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446 

(2001). The burden of proof is then upon petitioner (except 

for the increased portions of the accuracy-related penalty 

raised in the amendment to answer) if and once respondent 

meets his burden of production. See Higbee v. Commissioner, 

116 T.C. at 447, 449. Respondent bears the burden of proof 

as to the increased portions of the accuracy-related penalty 

raised in the amendment to answer. See Rule 142(a)(1). 

Respondent argues that petitioner is liable for the 

accuracy-related penalty to the extent he has understated 

the Vapor Room’s gross receipts and failed to substantiate 

the Vapor Room’s COGS and expenses. Petitioner’s sole argument in brief is that the penalty does not apply because, he 

states, any inaccuracy underlying an understatement was 

‘‘accidental, not substantial, and/or not negligent on the part 

44 139 UNITED STATES TAX COURT REPORTS (19) 

21The underpayments also appear to be ‘‘substantial’’ within the statutory definition of that 

word. The accuracy-related penalty will also apply to the referenced portions of the underpayments if that definition is met. 

of the taxpayer.’’ Petitioner asserts that the Vapor Room was 

his first business and that he was not instructed on the 

proper way to keep the books and records of a business. 

We agree with respondent that the accuracy-related penalty applies in this case but disagree that it applies to the 

full amounts of the underpayments. Respondent concedes 

that petitioner substantiated $57,929 and $149,666 of the 

Vapor Room’s reported expenses for 2004 and 2005, respectively. We nonetheless disallowed the deduction of those 

expenses under section 280E. The application of section 280E 

to the expenses of a medical marijuana dispensary had not 

yet been decided when petitioner filed his Federal income tax 

returns for 2004 and 2005. The accuracy-related penalty does 

not apply, therefore, to the portion of each underpayment 

that would not have resulted had petitioner been allowed to 

deduct his substantiated expenses. Cf. Van Camp & Bennion 

v. United States, 251 F.3d 862, 868 (9th Cir. 2001) (‘‘Where 

a case is one ‘of first impression with no clear authority to 

guide the decision makers as to the major and complex 

issues,’ a negligence penalty is inappropriate[.]’’ (quoting 

Foster v. Commissioner, 756 F.2d 1430, 1439 (9th Cir. 1985), 

aff ’g in part and vacating as to an addition to tax for negligence 80 T.C. 34 (1983))). 

The accuracy-related penalty does apply, however, to the 

remainder of each underpayment because those portions of 

the underpayments are attributable to negligence. 21 Petitioner consciously opted not to keep adequate books and 

records and that action was in reckless or conscious disregard of rules or regulations. See Higbee v. Commissioner, 

116 T.C. at 449. He also did not record or report any of the 

Vapor Room’s gross receipts for approximately the first six 

months of its business. He also initially gave respondent’s 

revenue agent one set of documents (the Ehardt GL and the 

Ehardt P&L) that does not correspond with the ledgers he 

now relies upon. Our decision to find petitioner liable does 

not change even though the Vapor Room may have been petitioner’s first business or he was not ‘‘instructed’’ on the 

proper way to keep books. The Code requires that taxpayers 

who decide to go into business for themselves maintain suffiVerDate Nov 24 2008 09:42 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00026 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\OLIVE.AUG JAMIE
(19) OLIVE v. COMMISSIONER 45

cient records to substantiate their income and expenditures. 

A reasonable person would have sought to comply with this 

requirement. We sustain respondent’s determination (as 

supplemented through the amendment to answer but as we 

modify) that petitioner is liable for the penalty for each year. 

VIII. Epilogue 

We have considered all arguments that the parties made 

and have rejected those arguments not discussed here as 

without merit. 

To reflect the foregoing, 

Decision will be entered under Rule 155. 

f