It is common that marijuana businesses operating in States that have legalized marijuana for medical and/or recreational use (Medical marijuana is now legal in 29 states plus the District Of Columbia and recreational marijuana is legal in 8 states plus the District Of Columbia) deal in cash and do not maintain accounting systems that are ordinarily established with other businesses. So if your marijuana-related business is selected by the IRS for an audit, do not be so willing to concede disallowance all of your Cost Of Goods Sold expenses due to lack of documentation. Here is a case of a marijuana business owner who prevailed on this issue despite his lack of sufficient receipts and records.
The Olive Case
In 2012 the Tax Court ruled on the case of, Martin Olive vs. Commissioner, 139 T.C. 19 (2012). Mr. Olive established the Vapor Room in San Francisco, California selling medical marijuana which at the time and through the present is legal in California. Mr. Olive was selected for audit by the IRS who asserted that Mr. Olive (1) understated the income of the Vapor Room, (2) overstated the Cost Of Goods Sold, and (3) was not entitled to any operating expenses under I.R.C. §280E. Mr. Olive acknowledged that he did not maintain an adequate system of maintaining books and records. So regarding issue (1), the IRS prevailed with their calculation of gross income. As to issue (3), the IRS prevailed as IRC Section 280E which applies to marijuana-related businesses regardless of such businesses operating in a State where it is legal, that the business is not allowed to deduct operating expenses. So that then leaves issue (2) which is where the Tax Court refused to side with the IRS that Mr. Olive was not entitled to deduct any Cost Of Goods Sold.
Tax Code Requires Substantiation Of Expenses
In the context of businesses that conduct lawful activity, taxpayers bear the burden of proving that claimed business expenses were actually incurred and were “ordinary and necessary”. I.R.C. §162(a). A taxpayer is required to maintain sufficient permanent records to substantiate his business deductions. IRC §6001; Briggs v. Commissioner, T.C. Memo. 2000-380; Income Tax Regs. §1.6001-1(a), (d).
But since marijuana businesses are still illegal under Federal law, taxpayers cannot claim “ordinary and necessary” business expenses pursuant to I.R.C. §280E. This code section states: “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedules I and II of the Controlled Substances Act, 21 U.S.C §812) which is prohibited by federal law or the law of any state in which such trade or business is conducted.”
In reading I.R.C. §280E one would think that no deductions are allowed in a marijuana-related business but if that were the case, the U.S. Tax Court has stated that this statute would have been stricken as unconstitutional as the Sixteenth Amendment to the U.S. Constitution prohibits the Federal government from taxing “gross receipts”. Reading vs. Commissioner Of Internal Revenue, 70 T.C. 730 (1978). So the way I.R.C. §280E operates is to allow marijuana-related businesses to deduct Costs Of Good Sold but not “ordinary and necessary” business expenses. This tax treatment prevails regardless that you are conducting a marijuana business that is duly licensed in a State that has legalized marijuana because such business is still illegal under federal law.
But Unsubstantiated Expenses May Still Be Recognized Under The Cohan Rule
If a taxpayer with inadequate business records proves that he incurred certain expenses but cannot substantiate the exact amount, the Court in appropriate circumstances may estimate the amount allowable. George M. Cohan v. Commissioner Of Internal Revenue, 39 F.2d 540, 542-544 (2nd Cir. 1930). Under this so called “Cohan Rule”, the Court “bears heavily…upon the taxpayer whose inexactitude is of his own making.” This means that the taxpayer must provide some reasonable evidentiary basis for the estimate. The Tax Court should then only allow you to deduct the least amount of money that you could have possibly spent. Although this may not be the entire sum you are claiming, it is better to get something than nothing when you do not have the receipts to back up your expenses.
So Back To Mr. Olive’s Case
By applying the Cohan Rule, the Tax Court through the taxpayer’s testimony (or other credible testimony) establishing a reasonable evidentiary basis for estimated Cost Of Goods Sold expenses, can find for the taxpayer deductions which ordinarily would be denied by IRS. A Marijuana industry leader testified at trial that on average, the cost of goods sold of medicinal marijuana facilities were approximately 75.16% of revenue. The Tax Court used this figure applied to the gross revenues that it deemed correct by the IRS’ audit. At trial Mr. Olive testified that he 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. So the Tax Court then reduced Mr. Olive’s Cost Of Goods Sold by 6.5% to account for the fact that he gave away some of his product for free. The court rightfully justified this reduction on the reasoning that because he gave it away, it wasn’t held for sale and thus couldn’t be included in Cost Of Goods Sold.
The lesson to learn from this is that a taxpayer who maintains adequate books and records should be more successful in asserting his claimed expenses in an IRS audit than one who disregards record keeping.
What Should You Do?
For those marijuana-related businesses that fail to maintain adequate records or whose records got lost or damaged, all hope is still not lost in surviving an IRS audit. Taxpayers who hire an experienced tax attorney in audits and tax appeals who at the earliest opportunity introduces and applies the Cohan Rule should result in the least possible audit adjustments and avoiding costly litigation. Let the tax attorneys of the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County, San Jose and other California locations get you the best possible result.