TAX COURT OPINION

Case: Golden State Cooperative, Inc.
Docket Number: 2502-15
Judge: Holmes
Opinion Type: bench
Filed: 09/20/2016
Pages: 20

Á«(cid:16)060mÀte/ -)L|aW UNITED STATES TAX COURT WASHINGTON, DC 20217 GOLDEN STATE COOPERATIVE, INC., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. ) ) ) ) ) Docket No. 2502-15. ) ) ) ORDER Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit herewith to petitioner and to respondent a copy of the pages of the transcript of the trial in the above case before Judge Mark V. Holmes at San Francisco, California, containing his oral findings of fact and opinion rendered at the trial session at which the case was heard. In accordance with the oral findings of fact and opinion, an appropriate decision will be entered. (Signed) Mark V. Holmes Judge Dated: Washington, D.C. September, 20, 2016 SERVED SEP 2 1 2016 Capital Reporting Company 3 1 2 Bench Opinion by Judge Mark V. Holmes June 13, 2016 3 Golden State Cooperative, Inc. v. Commissioner 4 5 Docket No. 2502-15 THE COURT: In the case of Golden State 6 Cooperative, Incorporated v. Commissioner, Docket 7 8 9 10 11 12 No. 2502-15, the Court has decided to render oral findings of fact and opinion, and the following is the Court's bench opinion. This bench opinion is made pursuant to the authority granted by Section 7459(b) of the Internal Revenue Code of 1986, as amended, and Rule 152 of the Tax Court's Rules of 13 Practice & Procedure. 14 15 16 This case was brought by a corporation organized under subchapter C of the Internal Revenue Code, Golden State Cooperative. Golden State 17 Cooperative is a medical marijuana cooperative 18 operating in the state of California. On its City of 19 Bakersfield business license, issued on March 1st, 20 21 22 2011, it states that the Golden State Cooperative is a medical cannabis cooperative. The cooperative is licensed as a seller of medical marijuana by the 23 California State Board of Equalization, and on its 24 25 Form 1120, the US corporation income tax return, for 2011, the cooperative listed its business activity as 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 4 1 2 3 4 5 6 retail sales. These sales consist of marijuana and take place in a trade room at the cooperative's one location. In addition to setting up and breaking down this trade room, Petitioner's employees engage in additional activities relating to a lending library, food bank, political action, and social 7 media. 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 The Golden State Cooperative operates in a far more difficult political environment than some other dispensaries the Court has become familiar with recently. It is also extremely thinly capitalized for a business that, after all, deals with drugs that are illegal under federal law. One of its unusual characteristics is that its business model is not buying marijuana from those who grow it and then reselling it to its customers, but rather accepting on consignment that marijuana from growers and then selling it to the customers, and only after it's sold paying the growers of the marijuana that is being sold. However, even in this difficult political environment where the State supports the cooperative's activity but the federal government regards it as illegal -- and the city in which it's located apparently isn't too pleased with its 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 5 1 2 3 4 5 6 7 8 9 10 11 12 13 14 presence either -- nevertheless, the cooperative kept very good books. I was able to track back to the profit-and-loss statement from individual receipts, cash receipts, daily statements, etc. Its returns were prepared by a CPA. They were audited and a notice of deficiency was issued for the 2009 through 2011 tax years. The parties settled the 2009 and 2010 tax years before trial, leaving only the 2011 year. For that year, the issues included three. One was a very small underreporting of income. The other was, and most major issue, was the disallowance of all deductions under Section 280E of the Internal Revenue Code. The cooperative filed a petition, 15 which challenged only the expenses, "The audit did 16 17 18 19 20 not include expense deductions that were apportioned to non-cannabis trade and services," under reported deductions for business expenses per CHAMPS case; and then under the facts-upon-which-you-rely section of the petition, "Petitioner's activities included 21 political action, patient education, voter 22 23 24 25 registration, food bank donations and distributions, and clothing bank donations and distributions." So the cooperative was asking for an allowance for at least some deductions under the 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 6 1 first of our medical marijuana cases, Californians 2 Helping to Alleviate Medical Problems, Inc. v. 3 4 5 Commissioner, 128 TC 173 (2007), otherwise known as the CHAMPS case. We tried the case in San Francisco and the parties were able to reach a stipulation 6 which, together with the testimony and exhibits that 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 the Court admitted, constitute the record of the case. There were a couple issues that were not in the notice of deficiency or in the petition. The first was that underreporting of income. The second was the cost-of-goods-sold allowance for 2011. I find that these were tried by consent of the parties under Rule 41(b)(1), "When issues not raised by the pleadings are tried by express or implied consent of the parties, they shall be treated in all respects as if they had been raised in the pleadings. The Court, upon motion of any party at any time, may allow such amendment to the pleadings as may be necessary to cause them to conform to the evidence and raise these issues, but failure to amend does not affect the result of the trial of these issues." So that left me with three issues of substance. The first is the underreported income; 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 7 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 second is the adjustment, if any, for the cost of goods sold to that income. The third were deductions in light of Section 280E. And then there was also the assertion by the Commissioner of a penalty under 6662. I'll take these in order. First, the income. There was underreported income of $1807, but this was out of $330,000 in gross income. I find that this underreporting was largely a time lag at the end of the year; purchases made by credit card were reported to the State Board of Equalization for the state sales tax that was owed by the cooperative, but the actual receipt of funds from the merchant bank issuing the credit card was received three or four days later, thus putting them in a different year. The parties actually agreed on settlement of this issue with a concession by the Petitioner of the full $1807, including it in the 2011 tax year. I 19 mention it now only because the parties continued to 20 21 22 23 24 25 disagree about the penalty, which I'll deal with later. So on this one, by concession, the Commissioner wins. The second issue, one also tried by consent, was the cost-of-goods-sold allowance. The 866.488.DEPO www.Capita1ReportingCompany.com Capital Reporting Company 8 1 2 3 4 usual definition of the cost of goods sold is beginning inventory for a business plus its purchases throughout the year minus its ending inventory. The consignment model that the cooperative filed usually 5 makes no difference. For instance, the Supreme Court 6 7 8 9 10 11 12 13 14 15 itself has said, albeit in dicta, that "a consignment seller's gross sales might properly be measured by his gross receipts from sales of the product even though he did not actually hold title to the product that he sold. Realistically, such a seller is in the business of selling the product that's consigned to him, and he is functionally in a position no different from that of a seller who has purchased the product before resale. The only practical difference may be that the cost-of-goods-sold element of the 16 profit equation is expended before resale in the one 17 18 19 20 21 22 23 24 25 case and after resale in the other." Falk v. Brennan, 414 US 190, -- ,38 -- I'm sorry, 94 SCT 427, 433 (1973). Similarly, our Court has also noticed that the distinction between a consignee's cost of goods sold and the consignee's expenses relating to reimbursing the consignor usually is a wash. As we said in Cleo Perfume, Inc. v. Commissioner, 75 TCM 2200 (1998), merchandise included in petitioner's 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 9 1 2 ending inventory means that petitioner's cost of goods sold for those years was not overstated. 3 Petitioner received no tax benefit as a result of 4 mistakenly treating and reporting the consigned 5 merchandise as a purchase. 6 7 8 9 10 11 12 And, indeed, in the grandmother of all illegal drug cases, Edmondson v. Commissioner, 42 TCM 1533 (1981), we found, as a matter of fact, that drugs were being fronted to the taxpayer, meaning that "he received the goods on consignment and paid his supplier out of funds which he received on sale." We referred to this issue as determination of the 13 petitioner's cost of goods sold. 14 15 16 17 18 19 20 21 22 23 24 In any event, both parties certainly assumed that the inventories that were being sold by the cooperative constituted a cost of goods sold; both Commissioner and Petitioner alike treated it this way. So the first issue that was actually argued by the parties was the potential allocation of indirect costs to this inventory under Section 263A. This section is relatively new -- it's certainly newer than Section 280E -- and was actually designed to increase the cost-of-goods-sold adjustment for 25 many businesses. This was actually harmful to most 866.488.DEPO www.Capita1ReportingCompany.com Capital Reporting Company 10 1 2 3 4 businesses because it is a form of capitalization rather than immediate expensing. But in the marijuana trade, the incentive to argue that indirect costs are included in COGS is 5 much greater because COGS are an adjustment that 6 medical marijuana dispensaries can take; deductions 7 8 9 10 11 12 13 14 15 they cannot. However, in this particular case, I have to hold that Section 263A does not apply. 263A(b) (2) (B) states this section shall apply to "personal property," which is acquired by the taxpayer for resale. Subparagraph (a) shall not apply to any personal property acquired during any taxable year by the taxpayer for resale if the average annual gross receipts of the taxpayer or any predecessor for the three-taxable-year period ending, 16 with the taxable year preceding such taxable year, do 17 18 19 20 21 22 23 24 25 not exceed $10 million. As I said, Golden State Cooperative was a very small dispensary. Its total sales never exceeded $340,000. So Section 263A simply doesn't apply. This means that, for hg finding COGS, I have to look to the general revenue, general inventory rules, Section 471. Code Section 471(a) says, "Whenever in the opinion of the Secretary the use of inventories is 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 11 1 2 3 4 5 necessary in order clearly to determine the income of any taxpayer, inventory shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business, and as 6 most clearly reflecting the income." 7 8 9 10 11 12 Not much guidance in the Code then, but the regulations are much more extensive. The regulations that apply in this case to Golden State Cooperative can be found at 26 CFR Section 1.471-1, which states that "The inventory should include all finished or partly finished goods and, in the case of raw 13 materials and supplies, only those which have been 14 15 16 acquired for sale or which will physically become a part of merchandise intended for sale, in which class fall containers such as kegs, bottles, and cases, 17 whether returnable or not, if title thereto will pass 18 to the purchaser of the product to be sold therein. 19 Merchandise should be included in the inventory only 20 if title thereto is vested in the taxpayer. 21 Accordingly, the seller should include in his 22 23 24 inventory...goods out on consignment." So this inventory regulation is written from the perspective not of a retailer consignee like 25 Golden State Cooperative but from the viewpoint of 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 12 1 the gardener or supplier of marijuana to Golden State 2 Cooperative. This means that there is a potential 3 4 5 problem in medical marijuana cases that has not previously been discussed by any party; namely, that in a model that works on consignment, title to the 6 marijuana that is being sold by the cooperative is 7 8 9 10 11 12 13 14 15 16 17 18 not with the cooperative but with the consignor. This means that the marijuana involved is not technically, or at least is arguably not technically, part of the inventory of the seller, and thus the seller might not be entitled to a cost-of- goods-sold adjustment for goods sold on consignment. Instead, as we said in cases decided before, 280E, such a consignee might have to take account of the cost of purchasing or rather reimbursing the gardeners or suppliers of the marijuana not as a cost-of-goods-sold adjustment but as another ordinary business expense, which means, in the end, that it 19 might be the case that a cooperative that is working 20 21 22 23 24 25 on the consignment model will have even the costs of its inventory swept up under Section 280E. However, that was not argued in this case, and I will not decide this case on that basis. I note that, by doing this as a bench opinion, I raise the subject but this bench opinion has no 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 13 1 2 3 4 5 precedential value. So I'll take the case as the parties presented it. And we return to the regulations here and stress that the cost of goods sold includes not only the cost of the inventory, in this case the 6 marijuana, but such things as "containers such as 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 kegs, bottles, and cases, whether returnable or not, if title thereto will pass to the purchaser of the product to be sold therein." Again, as I said, I was impressed by this kind of business having such good accounting records, and they allowed me to go through and figure out what the cost-of-goods-sold adjustment in this case as tried by the parties would be. The first and largest, of course, is the cost of the marijuana that was being sold to Golden State Cooperative's customers. That totaled, for calendar year 2011, $234,241.79, a very small increase from what was claimed on the return. However, because merchandise which contains that marijuana is also allowed under the Section 471 regulations, I'm able to increase the cost-of-goods- sold adjustment by three other items. One is a specific item for bags. As explained in the testimony of the manager of Golden State Cooperative, 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 14 1 marijuana is sold to the customers in bags and 2 3 4 5 6 7 8 9 there's at least one identifiable charge of $22.56 for that. There were undoubtedly other bags being purchased and used to contain the marijuana, but I couldn't tell from these records what that might be. So by preponderance of the evidence, I find that there's only this one $22.56 charge that increases the cost-of-goods-sold adjustment. In addition, there was a box of cones, explained as 10 another form of containing the marijuana, for $90.60, 11 which will increase the cost of goods sold a tiny bit 12 13 14 15 16 17 18 19 20 21 22 23 24 as well. Finally, there was what are identified in the records of Golden State something called "grow supplies." One of the forms of marijuana that this cooperative sells are clones, immature marijuana plants grown from roots, apparently, which are then stored and resold to customers for those customers to grow into the mature marijuana plants. While in the custody or possession of Golden State Cooperative, these clones, living plants, have to be fed, and these are called "grow supplies" in the industry. There were grow supplies substantiated at $1838.25. Because such supplies include plant food, 25 water, and other things which physically become part 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 15 1 2 of the clones, I will include them in the cost-of- goods-sold adjustment on the theory that title to the 3 water, the growing supplies, the fertilizer, the 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 increase in the roots, etc., of the clones, the little pots in which the clones are bought and sold, title to those passes to the purchaser. So they are included in the cost-of-goods-sold adjustment under the 471 regulation as well. So my conclusion is that, for the cost-of- goods-sold adjustment, there's a slightly higher figure on the purchase side and a tiny bit of an increase for bags, cones, and grow supplies. The third issue in the case are the deductions. These are generally disallowed under 280E of the Code. That section states, "No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business, or the 19 activities which comprise such trade or business, 20 consists of trafficking in controlled substances 21 within the meaning of Schedule I and II of the 22 Controlled Substances Act which is prohibited by 23 24 25 federal law or the law of any state in which such trade or business is conducted." Golden State made several arguments. The 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 16 1 2 3 4 first was that, because California state law allows the sale of medical marijuana, Golden State could not be regarded as engaged in trafficking. This specific point, however, was rejected by the Ninth Circuit, as 5 well as Tax Court in a case called Olive v. 6 7 Commissioner, 792 F.3d 1146, 1148 (9th Cir. 2015), where the court held, "Although the use and sale of 8 medical marijuana are legal under California State 9 law, see California Health & Safety Code Section 10 11 12 13 14 15 16 17 18 19 20 21 22 23 11362.5, the use and sale of marijuana remain prohibited under federal law, see 21 USC section 812(c)." So I have to rule against the cooperative on this point, which the cooperative's lawyer understood. He wanted to preserve the issue, and it is indeed preserved. The second argument the cooperative made for why Section 280E doesn't bar all deductions in this case is that, like in CHAMPS, they are a dispensary that has more than one trade or business. In CHAMPS we found that the dispensaries' "caregiving services generated income attributable to those services". CHAMPS was based on a business 24 model in which its customers paid a set fee and in 25 exchange for which they received both caregiving 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 17 1 2 3 4 5 6 7 8 services and a fixed amount of marijuana each month. We held that that allowed a characterization that the dispensary in that case was conducting two trades or businesses and that Section 280E's prohibition on deductions applied only to the part of the trade or business that consisted of dispensing mar1Juana. However, in Golden State's circumstances, it simply received money in exchange for marijuana, 9 whether clones or marijuana that was smokable or 10 11 12 edible. This makes it much more like the situation in Olive where the Ninth Circuit used an interesting analogy to illustrate the difference. Said the Ninth 13 Circuit, "Bookstore A sells books; it also provides 14 15 16 17 18 19 20 21 22 23 24 25 some complimentary amenities. Patrons can sit in comfortable seating areas while considering whether to buy a book; they can drink coffee or tea and eat cookies, all of which the bookstore offers at no charge. They can obtain advice from the staff about new authors, book clubs, community events, and the like. They can bring their children to a weekend story time or an after-school reading circle. The 'trade or business' of bookstore A 'consists of' selling books. Its many amenities do not alter that conclusion. Presumably the owner hopes to attract buyers of books by creating an alluring atmosphere. 866.488.DEPO www.Capita1ReportingCompany.com Capital Reporting Company 18 1 2 3 4 5 6 7 8 "By contrast, bookstore B sells books but also sells coffee and pastries, which customers can consume in a café-like seating area. Bookstore B has two 'trades or businesses', one of which 'consists of' selling books and the other of which 'consists of' selling food and beverages." Olive, 792 F.3d at 1150. That's the situation that Golden State has. 9 All of its gross receipts came from the sale of 10 marijuana, not from a membership fee that could be 11 12 13 14 15 split between two activities. See also Beck v. Commissioner, 110 TCM 141, 145 (2015) ("Petitioner has provided no evidence that the...dispensary sold any non-marijuana-related items. The sole purpose of the...dispensaries was to provide customers with 16 medical marijuana and instruct those customers on how 17 18 to use it. Unlike the taxpayer in CHAMPS, petitioner has provided no evidence that he had any business 19 activity unrelated to the sale or distribution of 20 marijuana. Further, petitioner has not established 21 which, if any, expenses were for any alleged services 22 offered and which expenses related to the sale of 23 marijuana"). 24 25 So on the deductions point, I have to conclude that the Commissioner's disallowance of all 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 1 the ordinary and necessary business deductions that 2 Golden State Cooperative had must be disallowed under 19 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Section 280E. That ends the substantive portion of the dispute between the parties, and all that remains is the issue of whether a penalty should be applied under 6662. Code Section 6662(a) provides that there shall be added to the underpayment of tax an amount equal to 20 percent of the portion of the underpayment if the underpayment is attributable to negligence or disregard of rules and regulations. See code Section 6662(b) (1). Negligence is defined as "any failure to make a reasonable attempt to comply", and includes any "careless, reckless, or intentional disregard" of rules and regulations. Code Section 6662(c). A substantial understatement is an understatement that exceeds the greater of 10 percent of the tax required to be shown on the return, or $5000. Code Section 6662(d)(1) (A). Golden State stated on its 2011 income tax return a tax liability of zero dollars. The correct tax liability is over $20,000, and for the tax year at issue, this means that Golden State understated its tax liability by more than $5000 and more than 866.488.DEPO www.Capita1ReportingCompany.com Capital Reporting Company 20 1 2 3 4 10 percent of the tax required to be shown on its income tax return. So the Commissioner's met his burden of production in this case, and the issue shifts to 5 whether Golden State has proven up a defense to this 6 7 8 9 10 11 12 13 14 15 16 17 18 19 penalty. The most common defense, of course, is reasonable cause and good faith. There are three substantive issues, as I said, in this case. On the income issue, the addition to income of $1800 or so on gross receipts of $330,000 due to this end-of-the-year mismatch between credit card receipts and sales tax liabilities is so small that I find it to have been reasonable for the cooperative to have reported its credit card receipts in the year that they received them -- I'm sorry, the year that they received the credit card receipts, not the years in which they were actually paid by the bank issuing the credit cards. And this was obviously in good faith as 20 well, so I will not sustain the penalty under 6662 21 22 23 24 25 for that very small increase in deficiency. On the COGS issue that I discussed, I actually found an increase in the COGS adjustment, so there's no penalty attributable to that issue. The big issue here are the deductions. And 866.488.DEPO www.Capita1ReportingCompany.com Capital Reporting Company 21 1 2 3 4 here I find that it was not completely settled until the Olive case in 2015, or perhaps the Olive case in Tax Court in 2012, that a business could not more easily segregate between marijuana sales and non- 5 marijuana sales. The tax return for the 2011 tax 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 year was filed and couldn't really take into account our Tax Court decision in Olive which came out only in August of 2012. And in any event, the law remained unsettled, in my view, until that case was affirmed by the Ninth Circuit just last year. So I do find that the position taken by the cooperative on its tax return regarding these deductions under Section 280E was reasonable. And having observed Ms. Clarke's testimony, I find that she acted in good faith on this account. So I will not sustain penalties under Section 6662. With some findings in Petitioner's favor and some findings in the Commissioner's favor, decision will have to be entered under Rule 155. This concludes the Court's oral findings of fact and opinion. (Whereupon, at 10:40 a.m., the above- entitled matter was concluded.) 866.488.DEPO www.CapitalReportingCompany.com