Court Opinion

ID: 6318549
Source: CourtListenerOpinion
Date Created: 2022-03-01 20:02:19.289678+00
Date Added: 2024-06-11T09:01:36.940702
License: Public Domain

United States Tax Court

                            T.C. Memo. 2022-14

                JOHN D. LORD AND BELINDA LORD,
                           Petitioners

                                      v.

             COMMISSIONER OF INTERNAL REVENUE,
                         Respondent

                                 —————

Docket No. 19224-18.                                   Filed March 1, 2022.

                                 —————

Jennifer E. Benda, for petitioners.

Luke D. Ortner and Tamara L. Kotzker, for respondent.

                       MEMORANDUM OPINION

       KERRIGAN, Judge: In a notice of deficiency (notice) dated July
3, 2018, respondent determined that petitioners had a deficiency of
$376,299 and an accuracy-related penalty pursuant to section 6662(a) of
$75,260 for 2012. In the notice respondent made adjustments to
passthrough income petitioners received from two businesses—Beyond
Broadway, LLC (Broadway), and Artistant Dispensary Center, Inc.
(Artistant) (together, businesses).

       After concessions, the sole issue for consideration is whether tax
depreciation methods for inventory production assets can be used under
either section 263A or section 471 when section 280E is applied. 1

       1 The parties have stipulated the amounts needed to compute a deduction
pursuant to section 199.

                             Served 03/01/22
                                      2

[*2] Unless otherwise indicated, all statutory references are to the
Internal Revenue Code (Code), Title 26 U.S.C., in effect at all relevant
times, all regulation references are to the Code of Federal Regulations,
Title 26 (Treas. Reg.), in effect at all relevant times, and all Rule
references are to the Tax Court Rules of Practice and Procedure. We
round all monetary amounts to the nearest dollar.

                                Background

       This case was submitted pursuant to Rule 122. The stipulated
facts are incorporated by this reference. When they timely filed their
petition, petitioner husband resided in Colorado and petitioner wife
resided in Arkansas.

       For 2012 petitioners, then married, timely filed a joint Form 1040,
U.S. Individual Income Tax Return. They reported passthrough income
attributable to two businesses in which petitioner husband held
ownership interests—Broadway and Artistant.

       In 2012 the State of Colorado licensed the businesses to cultivate,
process, and distribute medical marijuana and medical marijuana
products. The businesses produced medical marijuana products for sale
to patients and other licensees. Broadway was formed under Colorado
state law as a limited liability company and in 2012 was treated as a
partnership for tax purposes. On its 2012 Form 1065, U.S. Return of
Partnership Income, Broadway reported gross receipts of $9,687,191.
After agreed adjustments, Broadway’s costs of goods sold (COGS) for
2012 was $5,864,999. 2

       Artistant was incorporated under Colorado state law and in 2012
was treated as an S corporation for tax purposes. On its 2012 Form
1120S, U.S. Income Tax Return for an S Corporation, Artistant reported
gross receipts of $1,112,588. After agreed adjustments, Artistant’s
COGS was $1,085,006. Petitioner husband acquired a 90% ownership
interest in Artistant on July 31, 2012.

       For 2012 petitioner husband was allocated 50% of Broadway’s
allocable items and 37.38% of Artistant’s allocable items.       The
businesses did not have audited financial statements for 2012 and for

       2If the bonus and accelerated depreciation methods are disallowed, this
amount will be adjusted accordingly.
                                   3

[*3] nontax purposes were not required to maintain books and records
or financial reports in accordance with U.S. Generally Accepted
Accounting Principles (GAAP). In 2012 the businesses maintained their
books and records and financial reports on a tax basis using QuickBooks.
The businesses computed their depreciation included in COGS for 2012
using the accelerated cost recovery method detailed in section 168(a);
they also claimed bonus depreciation for 2012 pursuant to section
168(k). The businesses used methods pursuant to section 168(a) and (k)
that did not conform with GAAP, but the recovery periods that they used
did conform with GAAP. The parties agree that depreciation related to
production assets is includible in inventory costs.

       In the notice issued to petitioners on July 3, 2018, respondent
determined adjustments to the depreciation deductions claimed by the
businesses for 2012. Respondent adjusted Broadway’s and Artistant’s
depreciation by $65,813 and −$716, respectively.          Respondent’s
adjustments reflect respondent’s position that section 263A should not
be relied upon for the calculation of inventory and determination of
COGS. Petitioners’ income attributable to the businesses was likewise
adjusted by $32,907 and −$268, reflecting petitioner husband’s
ownership interests in Broadway and Artistant, respectively.

                              Discussion

I.    Burden of Proof

       Generally, the Commissioner’s determinations in a notice of
deficiency are presumed correct, and the taxpayer bears the burden of
proving those determinations erroneous. Rule 142(a)(1); Welch v.
Helvering, 290 U.S. 111, 115 (1933). Under section 7491(a) in certain
circumstances the burden of proof may shift from the taxpayer to the
Commissioner. Petitioners have neither shown nor claimed that the
burden of proof should shift to respondent as to any relevant factual
issue. Accordingly, the burden of proof remains with petitioners.

II.   Section 280E

      Generally, section 162(a) allows a taxpayer to deduct from gross
income ordinary and necessary expenses paid or incurred during the
taxable year in carrying on a trade or business. Section 261, however,
provides that “[i]n computing taxable income no deduction shall in any
case be allowed in respect of the items specified in this part,” which
includes section 280E. See Californians Helping to Alleviate Med.
Probs., Inc. v. Commissioner (CHAMP), 128 T.C. 173, 180 (2007).
                                      4

[*4] Section 280E precludes taxpayers from deducting any expense
related to a business that consists of trafficking in a controlled
substance. See Olive v. Commissioner, 139 T.C. 19, 29 (2012), aff’d, 792
F.3d 1146 (9th Cir. 2015). Section 280E disallows deductions only for
business expenses and does not preclude the businesses from taking into
account their COGS. See CHAMP, 128 T.C. at 178 n.4.

       We have previously held that medical marijuana is a controlled
substance. Id. at 180–81; see also Gonzales v. Raich, 545 U.S. 1 (2005);
United States v. Oakland Cannabis Buyers’ Coop., 532 U.S. 483 (2001).
The dispensing of medical marijuana, while legal in Colorado, is illegal
under federal law. See Olive, 139 T.C. at 39. 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. Id. This is true even if the business is legal under
state law. Id.

III.   Cost of Goods Sold

       COGS is not a deduction within the meaning of section 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); Treas. Reg. § 1.162-1(a).
COGS is the cost of acquiring inventory, through either production or
purchase. Patients Mut. Assistance Collective Corp. v. Commissioner,
151 T.C. 176, 205 (2018), aff’d, 995 F.3d 671 (9th Cir. 2021); Reading v.
Commissioner, 70 T.C. 730, 733 (1978), aff’d, 614 F.2d 159 (8th Cir.
1980). COGS is generally determined under section 471 and its
accompanying regulations. See Treas. Reg. §§ 1.471-3, 1.471-11.
Producers are required to include in COGS both the direct and indirect
costs of creating their inventory. See Treas. Reg. §§ 1.471-3(c), 1.471-11.

        Section 471 and its accompanying regulations direct taxpayers to
section 263A for additional rules. Section 263A instructs both producers
and resellers to include “indirect” inventory costs in the cost of their
inventory. See § 263A(a)(2)(B), (b); Treas. Reg. § 1.263A-1(a)(3),
(c)(1), (e). Indirect costs are defined broadly as all costs other than direct
material costs and direct labor costs (for producers) and acquisition costs
(for resellers). Treas. Reg. § 1.263A-1(e)(3). Depreciation of production
assets is an indirect cost. See Treas. Reg. § 1.471-11(c)(2).
                                     5

[*5] IV.     Section 263A

        The flush text of section 263A(a)(2) provides: “Any cost which (but
for this subsection) could not be taken into account in computing taxable
income for any taxable year shall not be treated as a cost described in
this paragraph.” Deductions disallowed by section 280E are costs
subject to the prohibition of section 263A(a)(2). Patients Mut., 151 T.C.
at 209–10. Petitioners argue that the holding in Patients Mutual was
overbroad. Citing legislative history, petitioners argue that the word
“cost” in the flush text of section 263A(a)(2) is limited to personal, rather
than business, costs. We disagree.

       Section 263A(2)(a) does not define “cost”; therefore, the word is
given its ordinary meaning: “the amount or equivalent paid or charged
for something.” Cost, Webster’s New Collegiate Dictionary 255 (1980).
Nothing in the text of section 263A suggests that Congress intended to
restrict the prohibition of section 263A(2)(a) to any personal expenses.
Petitioners do not offer any evidence demonstrating a clear intent on the
part of Congress to enforce section 263A(2)(a) contrary to the plain text
of the statute. See Conn. Nat’l Bank v. Germain, 503 U.S. 249, 253–54
(1992) (“We have stated time and again that courts must presume that
a legislature says in a statute what it means and means in a statute
what it says there.”). Had Congress intended to exclude business
expenses from this restriction it could have; it did not. The statute as to
this point is unambiguous; therefore, the inquiry is complete. Id. at 254
(citing Rubin v. United States, 449 U.S. 424, 430 (1981)). Petitioners are
therefore not able to rely on section 263A to calculate inventory costs.

V.    Constitutional Entitlement

       Petitioners argue the businesses are constitutionally entitled to
accelerated and bonus depreciation because, as they claim, enforcement
of respondent’s adjustments would result in an impermissible tax on
gross receipts, rather than gross income. They contend it would be
unconstitutional not to be able to calculate their businesses’ inventories
pursuant to section 263A. We are not persuaded.

       In general, gross income is gross receipts less COGS. Treas. Reg.
§ 1.61-3(a). COGS is calculated by using either section 263A or 471. By
using section 471 to calculate inventory, the businesses are able to
deduct their direct inventory costs. See Patients Mut., 151 T.C. at 208–
09. Other deductions from gross receipts are permitted at Congress’
discretion. Helvering v. Indep. Life Ins. Co., 292 U.S. 371, 381 (1934).
                                   6

[*6] Depreciation is an indirect cost of production, and the businesses
are not entitled by the Constitution or statute to deduct depreciation of
production assets.

       Petitioners also contend that section 280E is unconstitutional.
Petitioners argue that section 280E cannot be upheld because Congress
did not describe it as an excise tax. We disagree. The terms that
Congress uses to describe exactions have no bearing on whether the
taxes themselves are constitutional. See Nat’l Fed’n of Indep. Bus. v.
Sebelius, 567 U.S. 519, 564–65 (2012).

      They further argue that section 280E is unconstitutional on Fifth
Amendment grounds. We disagree. The U.S. Court of Appeals for the
Tenth Circuit has stated that “the unlawfulness of an activity does not
prevent its taxation.” Alpenglow Botanicals, LLC v. United States, 894
F.3d 1187, 1197 (10th Cir. 2018) (quoting Marchetti v. United States,
390 U.S. 39, 44 (1968)).

VI.   Inventory Accounting

      Respondent has determined that the businesses’ inventory
accounting method does not clearly reflect income because, as the
parties have stipulated, it does not conform with GAAP. Respondent
changed the businesses’ inventory accounting method to one that
respondent concluded does clearly reflect income. Petitioners argue that
the businesses’ inventory accounting method is permitted under section
471.

       In general, a taxpayer challenging the Commissioner’s decision to
change an accounting method must show that the Commissioner’s
action was “arbitrary and capricious and without sound basis in fact or
law.” Ford Motor Co. v. Commissioner, 102 T.C. 87, 92 (1994), aff’d, 71
F.3d 209 (6th Cir. 1995).

       For the purpose of inventory accounting the businesses are
subject to section 471. Under section 471, an inventory accounting
method must: (1) conform as nearly as may be to the best accounting
practice in the trade or business and (2) clearly reflect income. Treas.
Reg. § 1.471-2. “Best accounting practice” has been held to be
synonymous with GAAP, and GAAP-conforming methods have been
held to satisfy the first prong of section 471. Thor Power Tool Co. v.
Commissioner, 439 U.S. 522, 532 (1979).
                                    7

[*7] Under section 471, an accounting method must also clearly reflect
income. In general an accounting method will be held to clearly reflect
income if it has been consistently applied and conforms with GAAP.
Treas. Reg. § 1.446-1(a)(2). GAAP is a set of accounting principles,
rather than stringent rules, so there may be instances in which several
accounting methods conform with GAAP but do not all clearly reflect
income. Thor Power Tool v. Commissioner, 439 U.S. at 544; see also
Godchaux v. Conveying Techs., Inc., 846 F.2d 306, 315 (5th Cir. 1988)
(stating that generally accepted accounting principles are flexible, and
a reviewing court must decide “only whether the accountant chose a
procedure from the universe of generally accepted accounting
principles”). Such was the case in Thor Power Tool, where the Supreme
Court held that GAAP conformity was insufficient to protect the
taxpayer against the Commissioner’s determination that its accounting
method did not clearly reflect income.              Thor Power Tool v.
Commissioner, 439 U.S. at 539–44.             Therefore, although GAAP
conformity is not dispositive in determining whether an accounting
method clearly reflects income, it is a “pertinent criterion.” Am. Fletcher
Corp. v. United States, 832 F.2d 436, 439 (7th Cir. 1987); see also RLC
Indus. Co. & Subs. v. Commissioner, 98 T.C. 457, 502 (1992) (stating
that the Commissioner had appropriately exercised discretion in
changing accounting method “where a taxpayer’s method was contrary
to accounting principles”), aff’d, 58 F.3d 413 (9th Cir. 1995).

       Petitioners argue that the businesses’ inventory accounting
method is permitted under section 471. Petitioners, however, have
stipulated that the businesses’ inventory accounting method does not
conform with GAAP. They contend that Treasury Regulation § 1.471-
11 allows the use of both accelerated and bonus depreciation methods.
Petitioners have not provided any evidence to suggest that the
businesses’ inventory accounting method conforms with the best
accounting practice for their trade or business. The businesses’
inventory accounting method does not satisfy the requirements of
section 471 as defined by Treasury Regulation § 1.471-2.

VII.   Section 446

       Section 446 provides the general rule for accounting methods.
Under section 446(b), the Commissioner may change a taxpayer’s
accounting method if it does not, in the opinion of the Commissioner,
clearly reflect income. The Commissioner’s authority to determine
whether an accounting method clearly reflects income is not without
limit. See RLC Indus. Co. & Subs., 98 T.C. at 501. When a taxpayer
                                   8

[*8] consistently applies an accounting method explicitly provided to it
by the Code or regulations, the Commissioner cannot find that the
method does not clearly reflect income and cannot, therefore, change the
taxpayer’s accounting method. See Orange & Rockland Utils., Inc. v.
Commissioner, 86 T.C. 199, 215 (1986).

      To calculate part of their inventory costs, the businesses used a
depreciation method outlined in section 168. Because the method they
used is explicitly provided by the Code, petitioners argue that
respondent is not permitted to change it. Petitioners’ analysis is
incomplete.

       Section 168 provides a depreciation method for section 167
depreciation deductions. This Court has previously held depreciation
deductions under section 167 are unavailable to section 280E-affected
taxpayers. San Jose Wellness v. Commissioner, 156 T.C. 62, 67–68
(2021); N. Cal. Small Bus. Assistants Inc. v. Commissioner, 153 T.C. 65,
73 (2019). By enacting section 280E Congress intended to prohibit
affected taxpayers from reducing their taxable income “to the extent of
its constitutional authority.” San Jose Wellness, 156 T.C. at 72 n.11.

       In the absence of new legislation from Congress, the legislative
intent of section 280E remains unchanged; shifts in public sentiment
and legalization of marijuana do not change the purpose or applicability
of section 280E. Olive v. Commissioner, 792 F.3d at 1150. The
prohibitions of section 280E apply in full force to state-sanctioned
medical marijuana businesses. See N. Cal. Small Bus. Assistants, 153
T.C. at 74 (finding that section 280E applies to a “medical marijuana
dispensary legally operated under California State law”). Businesses
that traffic in controlled substances are denied deductions, including
deductions under section 167. Id. at 73. By the same logic, the
associated section 168 deprecation method is likewise disallowed to
section 280E-affected taxpayers. While the businesses’ accounting
method is explicitly provided by the Code, it is not available to them
because of section 280E, and respondent may determine that it does not
clearly reflect income.

      We have considered all arguments made by the parties, and to the
extent not mentioned or addressed, they are irrelevant or without merit.

      To reflect the foregoing,

      Decision will be entered under Rule 155.