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Archive for August 2nd, 2012

We may well remember today as the day the Tax Court, with its decision in Olive v. Commissioner, 139 T.C. 2, put an end to the medicinal marijuana industry.

We previously dropped you a heads up that the IRS has been wielding a little known Code section — I.R.C. § 280E, to be exact — to wage war on medicinal marijuana facilities. Section 280E provides that no deduction shall be allowed for any amount incurred in a business that consists of trafficking in controlled substances. Since marijuana finds itself on Schedule I of the Controlled Substances Act, the IRS has the ammunition necessary to deny all deductions — rent, utilities, wages, etc…– of any facility that buys and sells the drug.

So despite the fact that more than 15 states have legalized the sale of marijuana for medical purposes, the IRS may well effectively tax the industry out of existence, as it’s hard to imagine that any company can survive while paying income tax on 100% of its gross revenue.

As best we can tell, prior to today, the application of Section 280E to medicinal marijuana facilities has only been litigated once since the birth of the industry. In Californians Helping to Alleviate Medical Problems, 128 T.C. 173, (2002), a medical marijuana facility suffered a partial victory in defending itself against the application of I.R.C. § 280E. While the Tax Court agreed with the Service’s position that Section 280E was applicable despite the legality of the facility, the court only applied the provision to deny the deductions of the business that were attributable to the buying and selling of marijuana. Because the taxpayers in Californians were able to effectively argue that only a portion of their business involved the trafficking of marijuana, with the rest of their business focusing on counseling customers on which type of marijuana would best treat their particular ailment, they were able to salvage the deductions attributable to the counseling segment of their business.

Today in Olive, the taxpayer wasn’t so lucky. Again the IRS had denied all of the deductions of the medicinal marijuana facility pursuant to I.R.C. § 280E, and this time, the Tax Court showed no leniency.

The Vapor Room — established as a sole proprietorship by its owner, Martin Olive — was a California facility whose sole source of revenue was its sale of medical marijuana. Patrons went to the Vapor Room to relax and smoke or inhale vaporized marijuana; they did not specifically pay for anything else connected with or offered by the facility.  Olive sold the majority of the marijuana to his customers for cash, though he did give some away for free.

Upon an audit, the IRS hit Olive from all angles, asserting that he 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.

Olive and the IRS split on the first two issues. The Tax Court agreed with the IRS that Olive’s shoddy records — in typical burn-out fashion, he bragged that the industry “shun[s] formal ‘substantiation’ in the form of receipts” — did not adequately substantiate his revenue. As a result, the Court required Olive to include in income the revenue reflected on one of Olive’s ledgers, which was significantly in excess of the amounts reported on his tax returns.

With regards to the cost of goods sold, the Tax Court refused to side with the Service’s assertion that because Olive’s records were lacking, he wasn’t entitled to any deduction for cost of goods sold. Instead, the court looked to the testimony of industry insiders to determine that on average, the cost of goods sold of medicinal marijuana facilities were approximately 75.16% of revenue. The court then reduced Olive’s COGS to account for the fact that he gave away some of his product for free, reasoning that because he gave it away, it wasn’t held for sale and thus couldn’t be included in cost of goods sold.

Lastly, in the issue that the entire industry will be analyzing over their Friday morning wake-and-bake, the Tax Court agreed with the IRS that the Vapor Room was not entitled to deduct any of its operating expense pursuant to I.R.C. § 280E.  

Even more damning, the Tax Court refused to afford Olive the wiggle room it showed the taxpayer in Californians. Despite Olive’s contention that his business was similar to the one in Californians — equal parts the sale of goods and the provision of counseling services — the Tax Court was unconvinced.

Petitioner asserts that the Vapor Room’s overwhelming purpose was to provide caregiving services, that the Vapor Room’s expenses are almost entirely related to the caregiving business and that the Vapor Room would continue to operate even if petitioner did not sell medical marijuana. We disagree. We find instead that petitioner had a single business, the dispensing of medical marijuana, and that he provided all of the Vapor Room’s services and activities as part of that business. The record establishes that the Vapor Room is not the same type of operation as the medical marijuana dispensary in CHAMP that we found to have two businesses.

In reaching its decision, the Tax Court established a precedent that it will hold a medicinal marijuana facility to a strict standard in establishing that it offers multiple lines of business.

Petitioner essentially reads our Opinion in CHAMP to hold that a medical marijuana dispensary that allows its customers to consume medical marijuana on its premises with similarly situated individuals is a caregiver if the dispensary also provides the customers with incidental activities, consultation or advice. Such a reading is wrong.  Petitioner also has not established that the Vapor Room’s activities or services independent of the dispensing of medical marijuana were extensive. We perceive his claim now that the Vapor Room actually consists of two businesses as simply an after-the-fact attempt to artificially equate the Vapor Room with the medical marijuana dispensary in CHAMP so as to avoid the disallowance of all of the Vapor Room’s expenses under section 280E. We conclude that section 280E applies to preclude petitioner from deducting any of the Vapor Room’s claimed expenses.

What’s the lesson? Obviously, it’s a strange dichotomy of authority the medicinal marijuana industry finds itself governed by. Blessed by state law, but persecuted by the IRS. In light of the Tax Courts decisions in Californians and now Olive — and understanding that there are at least two more I.R.C. § 280E cases working their way through the legal system — its hard to foresee any way the industry can survive.

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I’ve never been one to shy away from a little shameless self-promotion, so I’m proud to say that an article I had published in the Tax Adviser last August — titled “S Corporation Shareholder Compensation: How Much is Enough?” — was recently selected by the editorial board of the Adviser as its “Best Article of 2011.”  And all this despite the fact that article was largely bereft of the inappropriate humor and gratuitous Simpsons’ references that have come to define this here blog.

Recognition in the Adviser is here, full article here.

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For our country’s top athletes, the Olympic games represent more than just the opportunity to don the red, white and blue, compete with the world’s best in their respective sports, and fornicate like bunnies.  They also represent a chance to earn some much-needed coin, because PEDs ain’t free, and God knows The Home Depot isn’t paying the bills anymore.

Few people realize this, but with an Olympic medal comes a cash payout: $25,000 for a gold, $15,000 for  a silver, and $10,000 for a bronze.

And where there’s cash, you’ll invariably find the IRS lurking, looking to collect its share. Pursuant to  I.R.C. § 74, a prize or award is included in gross income unless it (1) is received in recognition of religious, charitable, or similar meritorious achievement and satisfies a host of additional restrictive requirements found in § 74(b); (2) qualifies as an employee achievement award under § 74(c); or (3) is a scholarship or fellowship grant excludable under § 117.  Since Olympic medals — and the cash prizes that come with them — don’t fit under any of these exceptions, winning athletes find themselves indebted to Uncle Sam for up to 35% of the value of their winnings, nearly $9,000 if they’re lucky enough to bring home a gold.

Today, however, Florida Senator and Republican Vice President-hopeful Marco Rubio struck a blow for the Missy Franklins and Gwen Jorgensons of the world, introducing a bill that would exempt Olympic winnings from federal income tax.

“Our tax code is a complicated and burdensome mess that too often punishes success, and the tax imposed on Olympic medal winners is a classic example of this madness,” said Rubio, a Tea Party favorite. “Athletes representing our nation overseas in the Olympics shouldn’t have to worry about an extra tax bill waiting for them back home.”

A nice gesture, to be sure, but truth be told, the whole thing reeks of a publicity grab. We’re not talking about a situation where the athletes are being taxed on the value of a tangible award without the underlying cash to pay the tax, a situation that would place an undue burden on the athlete, perhaps even forcing them to sell the medal in order to pay the tax. A gold medal winner earns $25,000 cash, leaving him or her enough to pay his federal tax bill and still pocket $16,000.

It’s not that I’m not sympathetic; I am. When you recognize that young Olympians like Missy Franklin are forced to pass up countless lucrative sponsorship offers in order to retain their amateur status so they can compete at the college level, it certainly seems unfair to reward them for victory with a federal tax bill. But if you’re going to exempt Olympic medalists from federal taxation, then why not Jeopardy! winners or Wheel of Fortune champions?

Look, I understand that Ken Jennings wasn’t a source of national pride when he cleaned out Alex Trebec for six straight months, but he earned cash via competition, just the same as Michael Phelps or Ryan Lochte. Call me a cynic, but Rubio’s well-timed bill makes me wonder if he’s looking to capitalize on Olympic pride and increase his name recognition in advance of the November elections.

UPDATE: The more I think about it, it’s almost hypocritical that on the same date Rubio publicly pushes to exempt Olympic medalists from federal income tax on their winnings, the House passed a bill that would allow to expire refundable tax credits that benefit college students and low-income families. Among those who historically benefitted from the credits were low-income military families. Odd that you’d want to increase taxes on those serving in Iraq and Afghanistan, but exempt it from those who really, really kick ass at ping-pong.

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