Tax Court in Brief: Lord v. Comm’r—Marijuana and COGS

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Tax Court in Brief: Lord v. Comm’r—Marijuana and COGS

The Tax Court in Brief – February 28th-March 4th, 2022

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Tax Litigation:  The Week of February 28, 2022, through March 4, 2022

Lord v. Comm’r, T.C. Memo. 2022-14 | March 4, 2022 | Kerrigan, J. | Dkt. No. 19224-18

Opinion

Short Summary:  In 2012, Mr. Lord owned interests in a limited liability company and an S corporation, both of which were formed in the State of Colorado and both of which were licensed by that state to cultivate, process, and distribute medical marijuana.  The businesses did not have audited financial statements for 2012 and were not otherwise required to maintain books and records or financial reports in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”).  The businesses calculated the depreciation included in their cost of goods sold (“COGS”) for the year by using the accelerated cost recovery method in section 168(a), and they claimed bonus depreciation under section 168(k).  The businesses used methods under section 168(a) and (k) that did not conform with GAAP.

Mr. and Mrs. Lord (“Petitioners”) timely filed a joint Form 1040 for 2012.  In a notice of deficiency for that year, the Commissioner determined adjustments to the depreciation deductions that the businesses had claimed.  The adjustments reflected the Commissioner’s position that section 263A should not have been relied upon for the calculation of inventory and the determination of COGS.

Key Issues

  • Does the flush text of section 263A(a)(2), which provides that any costs that could not be taken into account in computing taxable income could not be included in inventory costs, only apply to personal costs?
  • Does the denial of accelerated and bonus depreciation create an unconstitutional tax on gross receipts rather than gross income?
  • Is section 280E unconstitutional because Congress did not describe it as an excise tax?
  • Is section 280E unconstitutional under the Fifth Amendment?
  • Was the Commissioner’s decision to change the inventory accounting method of Petitioners’ businesses arbitrary and capricious and without a sound basis in fact or law?

Primary Holdings

  • No, the flush text of section 263A(a)(2) does not apply only to personal costs but also includes business costs. The ordinary meaning of the word “costs” is not limited to personal expenses.
  • No, the denial of accelerated and bonus depreciation does not create an unconstitutional tax on gross receipts. Depreciation is an indirect cost of production, and the businesses are not entitled by Constitution or statute to deduct depreciation of production assets.
  • No, any failure of Congress to describe section 280E as an excise tax does not render that section unconstitutional, because the terms that Congress uses to describe exactions have no bearing on whether the taxes themselves are constitutional.
  • No, Section 280E does not violate the Fifth Amendment because the unlawfulness of an activity does not prevent its taxation.
  • No, the Commissioner’s decision to change the inventory accounting method of Petitioners’ businesses was not arbitrary and capricious and without a sound basis in fact or law. Petitioners stipulated that the businesses’ inventory accounting method did not conform with GAAP and did not provide any evidence that this method conformed with the best accounting method for their trade or business.  Moreover, Petitioners could not rely on a depreciation method outlined in section 168 because section 280E rendered such a method unavailable.

Key Points of Law

  • The Commissioner’s determinations in a notice of deficiency generally are presumed to be correct, and the taxpayer bears the burden of proving those determinations erroneous. Tax Court Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
  • Under section 162(a), a taxpayer generally may deduct from gross income ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. I.R.C. § 162(a).
  • However, Section 261 provides that “[i]n computing taxable income no deduction shall be allowed in respect of the items specified in this part”—including section 280E. See Californians Helping  to  Alleviate Med. Probs., Inc. v. Comm’r, 128 T.C. 173, 180 (2007) (hereinafter, “CHAMP”).
  • Section 280E prohibits taxpayers from deducting expenses related to a business that consists of trafficking in controlled substances. See Olive v. Comm’r, 139 T.C. 19, 29 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015).  Section 280E applies only to deductions for business expenses and does not prevent businesses from taking into account their COGS.  CHAMP, 128 T.C. at 178 n.4.
  • Medical marijuana is a controlled substance. at 180-181; see also Gonzales v. Raich, 545 U.S. 1 (2005); U.S. v. Oakland Cannabis Buyers’ Coop., 532 U.S. 483 (2001).
  • While dispensing medical marijuana is legal in Colorado, it is illegal under federal law, and Congress has set illegality under federal law as one trigger for the application of section 280E. See Olive, 139 T.C. at 39.
  • COGS is not a deduction under section 162(a) but is subtracted from gross receipts in determining a taxpayer’s gross income. See Max Sobel Wholesale Liquors v. Comm’r, 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, including by production. Patients Mut. Assistance Collective Corp. v. Comm’r, 151 T.C. 176, 205 (2018), aff’d, 995 F.3d 671 (9th Cir. 2021); Reading v. Comm’r, 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, and producers are required to include in COGS both direct and indirect costs of creating their inventory. See 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 Reg. § 1.471-11(c)(2).
  • However, the flush text of section 263A(a)(2) provides: that “[a]ny 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 prohibited by the flush text of section 263A(a)(2). Patients Mut., 151 T.C. at 209–10.
  • Because section 263A(2)(a) does not define “cost,” the word is given its ordinary meaning: “the amount or equivalent paid or charged for something.” Cost, Webster’s New Collegiate Dictionary 255 (1980).
  • Gross income generally is gross receipts less COGS. Reg. § 1.61-3(a).  Other deductions from gross receipts are permitted at Congress’ discretion. Helvering v. Indep. Life Ins. Co., 292 U.S. 371, 381 (1934).
  • 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).
  • “The unlawfulness of an activity does not prevent its taxation.” Alpenglow Botanicals, LLC U.S., 894 F.3d 1187, 1197 (10th Cir. 2018) (quoting Marchetti v. U.S., 390 U.S. 39, 44 (1968)).
  • A taxpayer challenging the Commissioner’s decision to change an accounting method must show that the decision was “arbitrary and capricious and without a sound basis in fact or law.” Ford Motor Co. v. Comm’r, 102 T.C. 87, 92 (1994), aff’d, 71 F.3d 209 (6th Cir. 1995).
  • Section 471 requires an inventory accounting method to: (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” is synonymous with GAAP, and GAAP-conforming methods satisfy the first prong of Section 471.  Thor Power Tool Co. v. Comm’r, 439 U.S. 522, 532 (1979).  Generally, an accounting method will be held to clearly reflect income if it has been consistently applied and conforms with GAAP.   Reg. § 1.446-1(a)(2)
  • The Commissioner may change a taxpayer’s method of accounting if it does not clearly reflect income. R.C. § 446(b).
  • If a taxpayer consistently applies an accounting method explicitly provided to it by the Internal Revenue Code or Treasury Regulations, the Commissioner cannot find that the method does not clearly reflect income and thereby change the taxpayer’s accounting method. Orange & Rockland Utils., Inc. v. Comm’r, 86 T.C. 199, 215 (1986).
  • Depreciation deductions are unavailable to taxpayers to whom section 280E applies. San Jose Wellness v. Comm’r, 156 T.C. 62, 67–68 (2021); Cal. Small Bus. Assistants Inc. v. Comm’r, 153 T.C. 65, 73 (2019).
  • Absent Congressional action, changes in public opinion and legalization of marijuana do not change the applicability of section 280E. Olive, 792 F.3d at 1150.

Insights: This case illustrates the continuing difficulties that state-sanctioned marijuana businesses face in obtaining an even playing field with other types of businesses under the federal income tax as well as the Tax Court’s continued resistance to entertaining end-runs around section 280E in the absence of legislation by Congress.