Marijuana Dispensary’s Deductions go Up in Smoke

Medical-Marijuana-SymbolIn an opinion that would make Willie Nelson shake his head, the Tax Court held that a taxpayer was not entitled to deduct business expenses related to his “Health Care” business (read: medical marijuana dispensary).  The Court also disallowed the taxpayer’s cost of goods sold (COGS) and casualty loss for items seized during the Drug Enforcement Administration’s (DEA) raid of his dispensary in 2007.

The taxpayer resided in California and owned two medical marijuana dispensaries in 2007 operating under the name Alternative Herbal Health Services (“AHHS”).  AHHS sold various strands of marijuana, pre-rolled marijuana joints, and edible food items prepared with marijuana.  It did not sell any pipes, papers, or vaporizers, however they were made available to customers to medicate on site.  AHHS provided several educational activities to its customers at no charge including “loading, grinding, and packing marijuana for customers’ use of bongs, pipes and vaporizers.”  On January 11, 2007 the DEA searched the taxpayer’s dispensary in West Hollywood and seized marijuana, food items suspected to contain marijuana, and marijuana plants.

The taxpayer had a very short record retention policy, as his typical practice was to shred all sales and inventory records at the end of the day or by the next day.  When it came time to prepare his 2007 tax return, the taxpayer gave the numbers to his attorney who then gave them to his tax return preparer.  The Schedule C for his 2007 tax return reported a “Health Care” business with $1,700,000 in gross receipts and $1,429,614 in COGS and $194,094 in expenses.  The taxpayer included $600,000 attributable to the value of the marijuana seized by the DEA in his gross receipts and COGS entries for 2007.  All of the gross receipts and expenses reported on the taxpayer’s 2007 return were from the sale or expenses associated with AHHS’s marijuana or marijuana edibles.  After three amended answers, the IRS asserted a tax deficiency of $1,047,743 and assessed a $209,549 accuracy-related penalty under section 6662(a) for the 2007 tax year.

Under IRC § 280E a taxpayer may not deduct any amount paid or incurred in carrying on a trade or business if such trade or business consists of trafficking controlled substances which is prohibited by Federal law or the law of any state in which the trade or business is conducted.  The Court relied on its own decision in Californians Helping To Alleviate Med. Problems, Inc. (CHAMP) v. Commissioner, 128 T.C. 173 (2007) and the U.S. Supreme Court’s decision in Gonzales v. Raich, 545 U.S. 1 (2005) to determine that the taxpayer was trafficking in a controlled substance within the meaning of IRC § 280E.

However, Judge Goeke distinguished this case from CHAMP, where a potion of the taxpayer’s operating expenses were allowed because the taxpayer’s activities included those unrelated to the sale or distribution of marijuana.  In this case, the taxpayer provided no evidence that AHHS sold any non-marijuana-related items.

The Court also disallowed the taxpayer’s IRC § 165 casualty loss deduction and denied his characterization of the marijuana seized by the DEA as COGS in 2007.  The Court found that characterizing the marijuana seized by the DEA as COGS was difficult the taxpayer’s record retention policy left little substantiation for the value of items seized.  Even if he had been able to provide substantiation the product could not be considered COGS because was confiscated and, in fact, was not sold.  When the smoke cleared, Jude Goeke unsurprisingly upheld the accuracy-related penalty under IRC § 6662(a).

Read the full opinion here: Beck v. Commissioner, T.C. Memo. 2015-149.

 

Tax Court Denies Conservation Easement Donation on Qualified Appraisal

farms_ag_howard_countyQuality appraisals are still key to conservation easement donation deductions. In Costello v. Commissioner, T.C. Memo 2015-87, the Tax Court held that the taxpayers did not submit a “qualified appraisal” within the meaning of IRC § 170(f)(11)(E)(1) and upheld the substantial valuation misstatement penalties imposed on the taxpayers for the 2006, 2007, and 2008 tax years.

The taxpayers own a farm in Howard County, Maryland. Howard County uses a density exchange program in which each property has a certain number of development rights that may be sold to another developer of property, referred to as a “density exchange option.” Each development right essentially equates to one additional residence that a developer can build on a given property. In order to sell their development rights to a third party, the landowner must grant an easement to Howard County.

In 2006, the taxpayers granted the county a land preservation easement on their property. The taxpayers sold 16 of their 17 available development rights to a developer for a total purchase price of $2.56 million. Upon recordation of the deed of easement on October 17, 2006 all future development was prohibited on the taxpayers’ farm with the exception of farming.

The taxpayers obtained an appraisal on July 1, 2007. The appraisal assumed they could purchase eight additional development rights and the highest and best use of the subdivision would be a subdivision with 25 homes. The appraiser estimated a fair market value of $7.69 million before the sale of the development rights and gauged the fair market value of the property after the sale of the development rights at $2.1 million.

The taxpayers’ appraisal stated the assumption that the property was “free and clear of any and all liens or encumbrances” as of December 1, 2006. The appraisal did not account for the $2.56 million that the taxpayers received from the developer and the easement granted to the county in exchange for 16 of their 17 available development rights.

Additionally, the taxpayers’ 2007 appraisal omitted a number of required items, including an accurate description of the property contributed, the date of the contribution, or the terms of agreement. It also did not use the words “conservation easement” or “land preservation easement.” Judge Lauber concluded that the appraiser was not aware of the deed of easement that the taxpayer’s transferred to Howard County.

The donee (Howard County) did not sign the appraisal summary, as required under Treas. Reg. § 1.170A-13(c)(4)(i)(B), because it had serious doubts about the taxpayer’s ability to take a charitable contribution deduction. At the taxpayers’ request, the appraiser prepared an addendum on March 25, 2008 taking into account the $2.56 million that the taxpayer’s received for their development rights in 2006. The addendum reduced the taxpayers’ noncash charitable contribution to $3,004,692.

An official from Howard County signed off on the addendum and the taxpayers filed an amended 2006 return on May 16, 2008. The taxpayers’ claimed a charitable contribution deduction of $1,058,643 on their amended 2006 return, $1,666,528 on their 2007 return, and the remaining $278,521 on their 2008 return.

The IRS issued a notice of deficiency for all three years on July 13, 2012 disallowing the charitable contribution deductions in full and assessing accuracy-related penalties. The notice of deficiency also disallowed like-kind exchange treatment on the sale of the development rights and deductions claimed for business use of the home. The taxpayers’ timely petitioned the Tax Court challenging the disallowance of the charitable contribution deductions, asserting a higher basis on the sale of the development rights, and disputing the accuracy-related penalties.

At trial, Judge Lauber did not consider the taxpayer’s addendum to the appraisal because it was made more than five months after the due date (including extensions) of the taxpayer’s 2006 return. Under Treas. Reg. § 1.170A-13(c)(3)(i)(A) to be “qualified” an appraisal must be made no more than 60 days before the contribution and no later than the due date (including extensions) of the return on which the charitable deduction is first claimed.

The taxpayers argued for application of the substantial compliance doctrine under Bond v. Commissioner, 100 T.C. 32 (1993) and Hewitt v. Commissioner, 109 T.C. 258 (1997). Judge Lauber held that the numerous defects and missing categories in the taxpayers’ appraisal prevented the taxpayers’ from successfully asserting substantial compliance.  Judge Lauber further opined that even if the court assumed substantial compliance, the contribution was part of a quid pro quo exchange as defined in Hernandez v. Commissioner, 490 U.S. 680 (1989), because the taxpayers could not legally sell the development rights without first granting an easement to Howard County.

The Court also dismissed the taxpayers’ contention that the transaction was a bargain sale because once the taxpayers signed the contract to sell their development rights, they had no excess development potential to grant Howard County through a bargain sale.

In sum, the Court held that the appraisal “failed to inform the IRS of the essence of the transaction in which petitioner’s engaged.” Thus, the appraisal was not a qualified appraisal under Treas. Reg. § 1.170A-13(c)(3)(i).

Judge Lauber also denied the taxpayers’ reasonable cause defense to the application of the 20% substantial valuation misstatement penalties under IRC § 6662(b)(3) for all three-tax years because the taxpayers did not get a qualified appraisal under IRC § 170(f)(11)(E)(1).

Read the full opinion here:  Costello v. Commissioner, T.C. Memo 2015-87 (2015)

Conservation Easement Yields New Rule on Reasonable Cause Penalty Defense

us_Tax_Court_fasces-with-red-ribbonThe Tax Court disallowed another charitable deduction for the donation of a façade easement in Boston’s South End Historic District. This time the decision was based on valuation principles, not technical foot faults, and the taxpayers were able to avoid certain penalties.

In Chandler v. Commissioner, 142 TC No. 16 (2014), the taxpayers owned two homes in Boston’s South End Historic District, the Claremont Property and the West Newton Property. The homes were purchased in 2003 and 2005, respectively. The taxpayers entered into an agreement in 2004 to grant the National Architectural Trust (“NAT”) a façade easement on the Claremont Property. They then executed a similar arrangement when they purchased the West Newton Property in 2005.

The taxpayers used an NAT recommended expert to value the easements. He valued the Claremont easement at $191,400 and the West Newton easement at $371,250. The taxpayers took charitable deductions related to the easements of more than $450,000 between 2004 and 2006.

The IRS did not challenge the easements’ compliance with §170(h). However, the IRS did allege that the easements had no value because they did not meaningfully restrict the taxpayers’ properties beyond the provisions under local law. The taxpayers’ countered that the easement restrictions were broader than local law because they limited construction on the entire exterior of the home and required the owners to make repairs. Local law only restricted construction on portions of the property visible from a public way and did not require owners to make repairs. The taxpayers’ also noted that the easement subjected the property to stricter monitoring and enforcement of the restrictions. The Tax Court, citing its recent opinion in Kaufman v. Commissioner, T.C. Memo 2014-52, (discussed below), rejected the taxpayers’ arguments because “buyers do not perceive any difference between the competing sets of restrictions.”

The only remaining issue was valuation. The taxpayers abandoned their original appraisals and presented new expert testimony at trial. The taxpayers’ new expert used the comparable sales approach to calculate a before value of $1,385,000 for the Claremont Property and $2,950,000 for the West Newton Property. The taxpayers’ expert chose seven properties for comparison: four properties in Boston and three properties in New York City. On the basis of data from these properties, he estimated that the taxpayers’ easements diminished the value of both properties by 16%.

The Tax Court found the taxpayers’ expert unpersuasive. The Court dismissed the three New York City comparables because they “tell us little about easement values in Boston’s unique market.” The court also found that three of the four Boston properties were “obviously flawed.” The Court took particular exception to the expert’s use of a comparable unencumbered property that was not actually unencumbered. The Court stated that the “error undermines [the expert’s] credibility concerning not only this comparison, but the entire report.”

The Tax Court also found the respondent’s expert report unpersuasive. The respondent’s expert examined nine encumbered Boston properties that sold between 2005 and 2011. He compared the sales prices immediately before and after the imposition of the easements. Each property sold for more after it had been encumbered by the easement. However, the expert failed to account for significant renovations that took place on many of the properties after they were encumbered. Thus, the Court found the expert’s analysis unpersuasive because “it does not isolate the effect of easements on the properties in his sample.” However, in the final analysis, the Court sided with the IRS and disallowed the taxpayer’s deductions.

However, the Court did accept the taxpayers’ reasonable cause defense for gross valuation misstatement penalties in 2004 and 2005. Unfortunately, the reasonable cause exception for gross valuation misstatements of charitable contribution property was eliminated with the Pension Protection Act of 2006, so the Court denied the taxpayers’ reasonable cause defense for the 2006 tax period.

Read the full opinion here: Chandler v. Commissioner, 142 T.C. No. 16

Tax Court Reminder: Hours Alone Do Not Turn a Hobby into a Business

430_horse0One of my best friends emailed me yesterday. He’s up for partner at one of the largest law firms in the world. He has dedicated many hours to the practice of law since our days together as law clerks at the Tax Court.

However, the key to partnership in the modern practice of law requires more than substantial legal skill – it takes a business plan. He has been asked to write one and I have no doubt that it will be thorough, detailed and realistic. That is, it will be the product of the same skills that have made him a great lawyer already. When he is invited into the partnership of his firm, which I am confident that he will be, I know that he will be expected to execute on that business plan, and I know that he will. After all, the objective of a law firm is to provide excellent legal services and make a profit while doing it.

Yesterday, the Tax Court issued a fairly lengthy Summary Opinion reminding us that the same standard applies to every business. A Summary Opinion is not a legal precedent and cannot be cited for authority, but Craig v. Commissioner amply shows that lengthy hours and dedicated labor alone are not enough to turn an activity into a business. The opinion is instructive for those who might be unsure about the right standard. There must be a plan to make money – and some profits along the way won’t hurt either.

Ms. Craig worked 25-40 hours per week as a real estate agent. She worked 25-30 more hours per week attending to her several horses – an activity for which she claimed losses for the tax years in question. She also worked part time preparing tax returns for H&R Block. The IRS denied Ms. Craig’s losses from the horse breeding activity and she challenged the Commissioner’s determinations by filing a pro se petition in Tax Court.

The Tax Court accepted the fact that Ms. Craig dedicated many hours a week to cleaning stalls, feeding, grooming, training, and otherwise caring for her horses. It did not, however, accept the fact that Ms. Craig engaged in any of those efforts with “an actual and honest objective of making a profit.”

Notable was Ms. Craig’s business plan for the horse-breeding activity. It was prepared in early 2011, months after the IRS began its examination of Ms. Craig’s tax returns, and listed a total of 10 items (all of which are reproduced in the Court’s opinion). From the time the business plan was written until the date of trial in November 2012, Ms. Craig had accomplished only one item on the business plan (she finished training one horse for handling).

Neither the concise and late-breaking business plan nor the lackadaisical approach to execution helped Ms. Craig’s case. It also didn’t help that she also didn’t maintain a separate bank account for the alleged horse breeding business, instead preferring to run expenses through her personal checking account, and reported gross receipts from the business in only one of seven years ($950 of revenue, not even profit). All of these factors contributed to the Court’s conclusion that Ms. Craig’s horse activities were a hobby and not a business. The Court also sustained a 20% accuracy-related penalty against Ms. Craig. A timely-written and well-executed business plan might not have changed the outcome of Ms. Craig’s case, but it certainly wouldn’t have hurt.

Read the entire opinion here:
Craig v. Commissioner, T.C. Summary Opinion 2013-58