This case stems from the operation of petitioner’s sole proprietorship, the Vapor Room Herbal Center (Vapor Room). The Vapor Room’s principal business is the retail sale of marijuana (medical marijuana) pursuant to the California Compassionate Use Act of 1996 (CCUA), codified at Cal. Health & Safety Code sec. 11362.5 (West 2007). 1 The Vapor Room provides minimal activities and services as part of its principal business of selling medical marijuana.
Respondent determined deficiencies of $367,531 and $1,146,633 in petitioner’s Federal income tax for 2004 and 2005, respectively, after determining that petitioner failed to substantiate any costs of goods sold (COGS) or expenses reported for the Vapor Room. Respondent also determined for
We decide as to the Vapor Room for 2004 and 2005:
1. whether petitioner underreported gross receipts in amounts respondent alleges in an amendment to answer. We hold he did;
2. whether petitioner may deduct COGS in amounts greater than those respondent allows. 2 We hold he may to the extent stated;
3. whether petitioner may deduct his claimed expenses. We hold he may not; and
4. whether petitioner is liable for the accuracy-related penalties. We hold he is to the extent stated.
FINDINGS OF FACT
I. Preliminaries
The parties submitted stipulated facts and exhibits. We incorporate the stipulated facts and exhibits by this reference. Petitioner is a high school graduate who resided in California when he filed the petition. He filed Federal income tax returns for 2004 and 2005 and included in each return a Schedule C, Profit or Loss From Business (Sole Proprietorship), reporting the Vapor Room’s gross receipts, COGS and expenses for the corresponding year. He reported that the Vapor Room’s “principal business” is “Retail Sales” and that its product is “Hеrbal.”
The State of California’s voters approved the CCUA as a ballot initiative in 1996. The CCUA is intended to ensure that “seriously ill Californians” (recipients) can obtain and use marijuana if physicians recommend marijuana as beneficial to recipients’ health. Numerous medical marijuana dispensaries were formed in California to dispense medical marijuana to recipients. 3 Medical marijuana, however, is a controlled substance under Federal law.
III. Petitioner Forms the Vapor Room
Petitioner, while pursuing a college degree in arts and education, became involved in the medical marijuana industry by volunteering at a medical marijuana dispensary in San Francisco, California. The dispensary had a single business, the dispensing of medical marijuana. Petitioner learned that an approximately 1,250-square-foot room in his low-income neighborhood of San Francisco was available to rent at a minimal cost and he decided to abandon his college studies during his second year and establish a medical marijuana dispensary in the room. He sought the help of local friends and marijuana suppliers and, on January 25, 2004, began operating an unlicensed medical marijuana dispensary as a sole proprietorship. 4 He named his dispensary the Vapor Room. 5 He established the Vapor Room so that its patrons, almost all of whom were recipients (including some with terminal diseases such as cancer or Hiv/AIDS) could socialize and purchase and consume medical marijuana there. 6
Petitioner designed the Vapor Room with a comfortable lounge-like, community center atmosphere, placing couches, chairs and tables throughout the premises. He placed vaporizers, games, books and art supplies on the premises for patrons to use at their desire. He set up a jewelry-store-like
IV. Operation of the Vapor Room
The Vapor Room was generally open for business (except on some holidays) on weekdays from 11 a.m. to 8:30 p.m., and on weekends from noon to 8 p.m. The Vapor Room sold nothing but medical marijuana (in three different forms) and its patrons went to the Vapor Room primarily to consume marijuana, knowing that it was reаdily available there. 7 Patrons also frequented the Vapor Room to socialize with each other incident to consuming marijuana. Petitioner required that each patron possess either a doctor’s recommendation to use medical marijuana or a similar certificate the San Francisco government issued. This documentation contained the person’s picture and identification number, but not his or her name. Patrons came to know at least the first name of the other patrons who regularly frequented the Vapor Room.
The Vapor Room’s staff members (collectively, staff members) were petitioner and a few other individuals (four working as employees and an undisclosed number working as volunteers) and all staff members qualified under the CCUA to receive and consume medical marijuana. Neither the staff members nor the other patrons paid petitioner a stated fee to frequent the Vapor Room. Nor did petitioner require that any patron purchase medical marijuana from him to frequent the Vapor Room or to take part in its activities or services. Patrons had acсess to all of the activities and services that the Vapor Room provided and marijuana was routinely passed throughout the room for consumption without cost to patrons who wanted to partake.
The Vapor Room’s sole source of revenue was its sale of medical marijuana and patrons did not specifically pay for anything else connected with or offered by the Vapor Room. Petitioner purchased for cash (or sometimes received for free) the Vapor Room’s medical marijuana inventory from suppliers, each of whom was eligible under the CCUA to receive
Petitioner provided regular activities at the Vapor Room, such as yoga classes, chess and other board games and movies (with complimentary popcorn and drinks). Patrons sometimes consumed medical marijuana while participating in these activities. The Vapor Room regularly offered chair massages with a therapist. Patrons sometimes consumed medical marijuana before or after a massage. Patrons, while at the Vapor Room, regularly drank complimentary tea or water and they occasionally ate complimentary snacks or light food such as pizza and sandwiches.
Staff members explained to patrons the promoted benefits of vaporizing marijuana (as opposed to smoking it). The staff members also helped patrons understand how to operate a vaporizer and the staff members helped patrons operate a vaporizer upon request. Petitioner did not require that a patron buy medical marijuana from the Vapor Room as a condition of using one of the Vapor Room’s vaporizers and patrons sometimes consumed in a vaporizer (or elsewhere in
Patrons discussed with other patrons (sometimes one-on-one) their illnesses and their lives in general and they counseled one another on various personal, legal or political matters related to medical marijuana. Staff members (or other persons the Vapor Room retained) educated patrons or members of the public on medical marijuana and about using medical marijuana responsibly. The Vapor Room had a program through which patrons wrote letters to individuals who were incarcerated for distributing medical marijuana.
V. Vapor Room’s Gross Receipts, COGS and Reported Income
A. Reported Income
Petitioner’s tax returns for 2004 and 2005 reported that the Vapor Room’s net income was $64,670 and $33,778, respectively. 9 The net income was calculated as follows:
2004 2005
Gross receipts $1,068,830 $3,131,605
COGS 993,377 2,812,478
75,453 319,127 Gross income
Expenses:
Advertising o CO
Bank fees o 05
3,072 Deductible meals and entertainment ‘
11,506 Depreciation ‘
-0-Internet services and fee 05 o cn
46,900 Legal and professional services '
13,337 Office 1
1,353 Payroll fees 1
13 Postage and delivery 1
1,952 -0-Printing and reproduction
14,300 4,000 Rent
3,505 730 Repairs and maintenance
412 750 Security services
-0-2,922 Supplies
2004 2005
Taxes and licenses -0- 8,750
Telephone -0- 965
Travel 776 10
Utilities -0- 3,426
Wages -0- 175,934
Total 10,783 1 285,349
Net profit 64,670 33,778
B. Gross Receipts
Staff members noted the amount of the Vapor Room’s sales for each business day as shown on the cash register tape and counted the cash in the register. The total daily sales as ascertained by the cash register tape and by the daily count were recorded in a book (recording book).
Petitioner’s Schedules C for 2004 and 2005 reported gross receipts of $1,068,830 and $3,131,605, respectively. The gross receipts reported on the Schedule C for 2004, however, did not include any gross receipts received before July 14, 2004.
C. COGS
Petitioner’s Schedules C for 2004 and 2005 reported that the Vapor Room’s COGS were $993,337 and $2,812,478, respectively. These amounts were calculated as follows:
2004 2005
Purchases less cost of items withdrawn for personal use -0- $2,796,724
Cost of labor $88,209 -0-
Materials and supplies 905,168 15,754
COGS 993,377 2,812,478
The labor amounts represent petitioner’s payments to marijuana growers in return for marijuana that they grew.
Petitioner paid the Vapor Room’s expenses by using cash from the cash register or by using a check or a debit card drawn on a bank account that petitioner opened as a sole proprietor “DBA Vapor Room.” Petitioner opened this account on July 6, 2004, and he regularly deposited funds into the account to cover the draws from the account.
Petitioner paid the Vapor Room’s employees through a payroll service. Petitioner paid the employees (who were the same individuals in both 2004 and 2005) wages of $37,588 and $96,965. Petitioner reported those wages to the Internal Revenue Service for Federal employment tax purposes. None of the employees had a specific job at the Vapor Room and each employee at one time or another performed all required jobs.
Respоndent concedes that petitioner paid the following ordinary and necessary business expenses during 2004 and 2005:
Expense 2004 2005
Advertising -0-
Bank and payroll (Paychex) fees $557 1,271
Bottled water -0-473
Employment taxes 3,002 7,609
Garbage -0-317
Office expense and supplies 2,992 13,337
Phone and Internet 681 784
Postage -0-13
Rent 12,000 12,300
Repairs and maintenance -0-2,297
Security alarm monitoring 361 413
Security system/locksmith -0-11,506
Utilities 748 1,731
Wages 37,588 96,965
Total 57,929 149,666
The items underlying the office expense and supplies for 2004 include office supplies (e.g., labels), paper cups, a step ladder, a shredder, zip bags, glass canisters, a degreaser, marijuana rolling papers and lighters. The advertising expense for 2005 relates to advertisements aimed at medical marijuana audiences. The items underlying the office expense and supplies for 2005 include paper towels, marijuana-related calendars, magazines and books, marijuana
E. Petitioner’s Withdrawals
Petitioner regularly took cash from the cash register to use personally, including to pay for personal trips to New York, New York, to Barcelona, Spain, to Amsterdam, the Netherlands, to Venice, Italy, to Cabo San Lucas, Mexico, and to the British Virgin Islands. He coded these withdrawals in the recording books so that the Vapor Room’s employees would not know the amount of money he was taking from the business.
VI. Audit
Respоndent began auditing petitioner’s 2004 tax return in April 2006 and respondent’s revenue agent met with petitioner (accompanied by his independent accountant/tax preparer William Ehardt and an attorney) on July 6, 2006. 10 The revenue agent requested the Vapor Room’s bank statements and substantiation for COGS and petitioner gave the revenue agent two documents Mr. Ehardt had prepared: a document entitled “Vapor Room Profit and Loss January through December 2004” (Ehardt P&L) and a document entitled “Vapor Room General Ledger As of December 2004” (Ehardt GL). The Ehardt GL reports that the Vapor Room’s first sale occurred on July 14, 2004. The Ehardt P&L and the Ehardt GL each report that the Vapor Room’s total income for 2004 was $1,068,830, which corresponds to the amount of gross receipts reported on the Federal income tax return for 2004. Many (but not all) of the expenditures shown on the Ehardt P&L and the Ehardt GL were reported on the return for 2004.
The revenue agent next met with Mr. Ehardt in August 2006 (the second and last meeting that the revenue agent had with petitioner or his representatives) and was informed that petitioner had “ledgers” showing cash received for sales and cash paid for purchases, but no further documents. Petitioner did not tender any ledgers at that time.
Respondent issued the deficiency notice to petitioner. The deficiency notice states that petitioner may not deduct any of the reported cogs on account of lack of substantiation. Petitioner, after the deficiency notice was issued, provided respondent’s counsel with $25,776 in receipts for COGS for 2004 and $27,370 in receipts for COGS for 2005. Respondent concedes that petitioner may deduct those respective amounts as COGS for 2004 and 2005.
The deficiency notice also states that petitioner may not deduct any of the reported expenses on account of lack of substantiation. Respondent later conceded that petitioner substantiated the $57,929 and $149,666 of expenses previously mentioned but asserts that section 280E precludes any deduction of these expenses. Respondent’s revenue agent had relied upon sections 280E and 6001 during the audit to disallow all of the Vapor Room’s reported expenses, but the deficiency notice does not specifically say that. Respondent formalized the applicability of section 280E in a second amendment to answer.
VEIL Ledgers
Petitioner gave respondent five ledgers (collectively, ledgers) during this proceeding. The credible evidence in the record fails to establish when the ledgers were prepared. The ledgers, however, do not appear to be (and we do not find that they are) the same as the recording books.
The ledgers purport to show the Vapor Room’s receipts and cash disbursements (not including payments through the Vapor Room’s bank account) for January 25 through March 13, 2004; June 1 through October 30, 2004; November 1, 2004, through April 25, 2005; April 26 through October 8, 2005; and October 9, 2005, through February 18, 2006, respectively. Petitioner has never produced a ledger (or recording book) for the 79-day period from March 14 through May 31, 2004.
The ledgers show categories of cash received and expenditures made during each business day in a total figure for each category and they list few (and in some cases no) specifics on the components of the categories. The ledgers sometimes
The ledgers (as respondent adjusted for 2004 to reflect the missing 79-day period) report that the Vapor Room’s gross receipts for 2004 and 2005 were $1,967,956 and $3,301,898, respectively.
OPINION
I. Overview
California law allows petitioner to dispense medical marijuana to the recipients through the Vapor Room. Federal law prohibits taxpayers, however, from deducting any expense of a trade or business that consists of the trafficking of a controlled substance such as marijuana. See sec. 280E. We are asked to decide whether the Vapor Room, a medical marijuana dispensary permitted by California law, may deduct any of its expenses. We also are asked to decide whether petitioner underreported the Vapor Room’s gross receipts, whether petitioner overreported the Vapor Room’s COGS and whether petitioner is liable for an accuracy-related penalty.
We first discuss the burden of proof and our perception of the witnesses. We then decide the referenced issues.
II. Burden of Proof
Petitioner bears the burden of proving that respondent’s determination of thе deficiencies set forth in the deficiency notice is incorrect. See Rule 142(a)(1); Welch v. Helvering,
We determine the credibility of each witness, weigh each piece of evidence, draw appropriate inferences and choose between conflicting inferences in finding the facts of a case. The mere fact that one party presents unopposed testimony on that party’s behalf does not necessarily mean that we will find the elicited testimony to be credible. We will not accept the testimony of witnesses at face value to the extent we perceive the testimony to be incredible or otherwise unreliable. See Neonatology Assocs., P.A. v. Commissioner,
Petitioner’s testimony and the testimony of his other witnesses were rehearsed, insincere and unreliable. We do not rely on petitioner’s testimony to support his positions in this case, except to the extent his testimony is corroborated by reliable documentary evidence. We also do not rely on the uncorroborated testimony of petitioner’s other witnesses, three of whom are (or were) patrons of the Vapor Room and all of whom are closely and inextricably connected with the medical marijuana industry and with a desired furtherance of that movement.
IV. Unreported Gross Receipts
We start our analysis of the substantive issues by determining the amount of the Vapor Room’s gross receipts. Petitioner reported that the Vapor Room’s gross receipts were $1,068,830 for 2004 and $3,131,605 for 2005. Respondent did not adjust those amounts in the deficiency notice. Petitioner later, however, gave respondent the ledgers that revealed that the Vapor Room’s gross receipts were greater than the reported amounts. Respondent then computed the Vapor Room’s gross receipts using the ledgers. Respondent first totaled the cash that pеtitioner recorded in the ledgers for each year as sales receipts ($1,513,370 and $3,301,898, respectively). Respondent then extrapolated from the ledgers’ recording of the sales receipts for 2004 that the Vapor Room’s total sales during the missing 79-day period were
Petitioner does not dispute that he underreported the Vapor Room’s gross receipts for 2004 and 2005 (including that he failed to report any gross receipts received before July 14, 2004). He asks the Court, however, to find that the Vapor Room’s gross receipts for the respective years totaled $1,969,331 and $3,264,798 (i.e., $1,375 more and $37,100 less than the respective amounts respondent determined). He supports his proposed finding with citations to profit and loss statements that his current accountant, Marlee Taxy, C.P.A., prepared for the respective years. One statement reports without further explanation that the Vapor Room’s “Sales (as per Ledger)” for 2004 were $1,948,882 (inclusive of a $450,904 adjustment to reflect the 79 missing days) аnd that its total income for 2004 also included a $20,448 upward adjustment for “Actual to agree with cash in Ledger” ($1,948,882 + $20,448 = $1,969,331). The other statement reports without further explanation that the Vapor Room’s “Sales (as per Ledger)” for 2005 were $3,308,328 and that its total income for 2005 also included a $43,530 downward adjustment for “Actual to agree with cash in Ledger” ($3,308,328 - $43,530 = $3,264,798). Neither petitioner nor any of his witnesses explained the calculation of the numbers in those statements.
Petitioner’s reporting in the ledgers of the Vapor Room’s sales is reliable evidence of the amount of the Vapor Room’s gross receipts for 2004 and 2005. Respondent and Ms. Taxy calculated the Vapor Room’s gross receipts using those ledgers. They arrived at slightly different totals for each year. We place more weight on respondent’s calculations. They were accompanied by sufficient detail. We accept respondent’s computation as the more accurate calculation of the Vapor Room’s gross receipts for 2004 and 2005. We hold that the Vapor Room’s gross receipts for the respective years were $1,967,956 and $3,301,898. We note that petitioner in his answering brief sets forth no objection to respondent’s request in his opening brief that the Court find that the ledgers (as adjusted for the missing period) stated that the
V. COGS
We now turn to the parties’ dispute as to the Vapor Room’s COGS. Petitioner argues that respondent arbitrarily determined the Vapor Room’s COGS in the deficiency notice because the notice states that the Vapor Room’s COGS were zero for 2004 and 2005. Petitioner argues that the burden of proof is therefore upon respondent. See Helvering v. Taylor,
A cash method taxpayer like petitioner may generally deduct all ordinary and necessary expenses of the business upon payment of those expenses. See sec. 162(a). Deductions are strictly a matter of legislative grace, however, and petitioner must prove he is entitled to deduct the Vapor Room’s claimed amounts of COGS (as well as the Vapor Room’s claimed amounts of expenses). See Rule 142(a)(1); New Colonial Ice Co. v. Helvering,
Petitioner argues nonetheless that the ledgers alone are sufficient substantiation for taxpayers operating in the medical marijuana industry because, he states, that industry
Petitioner seeks to strengthen the probative value of the ledgers through his and Ms. Taxy’s testimony. He testified that he contemporaneously recorded in the ledgers all of the Vapor Room’s purchases of marijuana and Ms. Taxy testified that she totaled the Vapor Room’s COGS for the respective years at $1,651,554 and $2,713,128. Respondent rebuts that petitioner has failed to substantiate that the amount of the Vаpor Room’s COGS exceeded $25,776 for 2004 or $27,370 for 2005. Respondent concludes that the Vapor Room’s COGS are limited to the amounts petitioner was able to substantiate to respondent’s satisfaction. We disagree with both parties.
The Vapor Room’s sales for the respective years were $1,967,956 and $3,301,898. We consider it unreasonable to conclude that the Vapor Room’s COGS totaled the small amounts that respondent asks us to find. We also consider it unreasonable, however, to conclude that the Vapor Room’s COGS are those amounts set forth in the ledgers. We do not believe that the COGS entries set forth in the ledgers are entirely accurate and we decline to rely upon those entries in their entirety. Petitioner consciously chose to transact the Vapor Room’s business primarily in cash. He also chose not to keep supporting documentation for the Vapor Room’s
We are left to ascertain the Vapor Room’s COGS on the basis of the record. The evidence is not satisfactory for this purpose. We nevertheless must do our best with the materials at hand. “Absolute certainty in such matters is usually impossible and is not necessary; * * * [we] make as close an approximation as * * * [we] can, bearing heavily * * * upon the taxpayer whose inexactitude is of his own making.” Cohan v. Commissioner,
We are aided, in small part, by the testimony of Henry C. Levy, C.P.A. Petitioner called Mr. Levy as an expert on the medical marijuana industry and the Court recognized him as such. Having said that, we generally found Mr. Levy to be unreliable. He was unreliable in that he was not sufficiently independent of petitioner and his cause (e.g., Mr. Levy is petitioner’s current bookkeeper and accountant and has approximately 100 other medical marijuana dispensaries as clients). See Neonatology Assocs., P.A. v. Commissioner,
We have broad discretion to evaluate the cogency of an expert’s analysis. We may adopt only those parts of an opinion we consider to be reliable. See Helvering v. Nat’l Grocery Co.,
This does not mean, however, that the Vapor Room’s COGS equals 75.16% of its gross receipts. We are mindful that this is not the right percentage because petitioner gave some of the Vapor Room’s inventory to patrons for free and the parties dispute whether the Vapor Room’s cost of that portion of the medical marijuana is includable in the Vapor Room’s
Petitioner did not sell the marijuana underlying these costs and he did not hold all the marijuana out for sale. These costs, therefore, hardly reflect the cost of the goods that petitioner sold. See Fuller v. Commissioner,
VI. Expenses
A. Overview
We turn now to decide the parties’ dispute on thе deductibility of the Vapor Room’s expenses. Respondent argues that petitioner failed to substantiate expenses in amounts greater than $57,929 for 2004 and $149,666 for 2005. Respondent also argues that section 280E precludes petitioner from
[[Image here]]
1This column totals $238,694. Petitioner does not explain how his total differs.
Petitioner asserts that section 280E, if applicable, which he argues it is not, precludes deductions for the years at issue of only $12,636 and $20,748 of expenses. He calculates those amounts on the basis of his reading of our Opinion in Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP),
B. Substantiation
Petitioner has failed to maintain required permanent records. He also has failed to substantiate the Vapor Room’s
C. Section 280E
We now turn to section 280E. A taxpayer may not deduct any amount for a trade or business where the “trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances * * * which is prohibited by Federal law.”
19
Sec. 280E. We have previously held, and the parties agree, that medical marijuana is a controlled substance under section 280E. See CHAMP,
Petitioner argues that he may deduct the Vapor Room’s expenses notwithstanding section 280E because, he claims, the Vapor Room’s business did not consist of the illegal trafficking in a controlled substance. He argues that the illegal trafficking in controlled substances is the only activity covered by section 280E. We disagree that section 280E is that narrow and does not apply here. We therefore reject petitioner’s contention that section 280E does not apply because the Vapor Room was a legitimate operation under California law. We have previously held that a California medical marijuana dispensary’s dispensing of medical marijuana pursuant to the CCUA was “trafficking” within the meaning of section 280E. See CHAMP,
Petitioner argues alternatively that he may deduct all of the Vapor Room’s expenses attributable to the Vapor Room’s caregiving business. He asserts that he trafficked marijuana only during the short time it took for the staff members to pass the medical marijuana to the patrons in exchange for payment and that the rest of the Vapor Room’s business was providing caregiving services. He compares his business to the medical marijuana dispensary in CHAMP. We found there that the taxpayer had two businesses (one the dispensing of medical marijuana and the other the providing of caregiving services). 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. The record does not establish these assertions. Moreover, as previously stated, all of the testimony from petitioner and from his other witnesses was rehearsed, not impartial and not credible. 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.
Petitioner essentially reads our Opinion in CHAMP to hold that a mеdical 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. A business that dispenses marijuana does not necessarily consist simply of the act of dispensing marijuana, just as a business that sells other goods does not necessarily consist simply of the passing of those goods.
The facts here persuade us that the Vapor Room’s dispensing of medical marijuana and its providing of services and activities share a close and inseparable organizational and economic relationship. They are one and the same business. Petitioner formed and operated the Vapor Room to sell medical marijuana to the patrons and to advise them on what he considered to be the best marijuana to consume and the best way to consume it. Petitioner provided the additional services and activities incident to, and as part of, the Vapor Room’s dispensing of medical marijuana. Petitioner and the Vapor Room’s employees were already in the room helping the patrons receive and consume medical marijuana and the entire site of the Vapor Room was used for that purpose. The record does not establish that the Vapor Room paid any additional wages or rent to provide the incidental services and activities. Nor does the record establish that the Vapor Room made any other significant payment to provide the incidental activities or services. Petitioner also oversaw all aspects of the Vapor Room’s operation and the Vapor
That petitioner may have sometimes overcharged patrons for marijuana to subsidize the cost of the Vapor Room’s limited services or activities does not change our view. Petitioner’s payment of the Vapor Room’s expenses to dispense medical marijuana allowed the Vapor Room to fulfill its business purpose of selling medical marijuana that in turn allowed the Vapor Room to offer its incidental services and activities in support of that purpose. Moreover, the Vapor Room’s only revenue was from patrons’ purchase of marijuana. The Vapor Room would not have had any revenues at all (and could not have operated) if none of the patrons had purchased marijuana from petitioner. The Vapor Room did not spawn a second business simply by occasionally providing the patrons with snacks, a massage, or a movie, or allowing the patrons to play games in the room and to talk there to each other.
Petitioner also has not established that the Vapor Room’s activities or services independent of the dispensing of medical marijuana were extensive. He tried to establish that they were but failed. His counsеl, at trial, repeatedly asked petitioner’s patrons/witnesses to describe “caregiving” services that petitioner provided at the Vapor Room. The witnesses strained to come up with any such service, other than through their rehearsed statements that fell short of establishing caregiving services of the type and extent described in CHAMP,
We now turn to decide whether petitioner is liable for an accuracy-related penalty under section 6662(a). A taxpayer may be liable for a 20% penalty on any underpayment of tax attributable to negligence or disregard of rules or regulations or any substantial understatement of income tax. See sec. 6662(a) and (b)(1) and (2). “Negligence” includes any failure to make a reasonable attempt to comply with the provisions of the Code and includes “any failure by the taxpayer to keep adequate books and records or to substantiate items properly.” Sec. 6662(c); sec. 1.6662-3(b)(l), Income Tax Regs. Negligence has also been defined as a lack of due care or failure to do what a reasonable person would do under the circumstances. See Allen v. Commissioner,
Respondent bears the burden of production to establish that it is appropriate to impose the accuracy-related penalty. See sec. 7491(c); Higbee v. Commissioner,
Respondent argues that petitioner is liable for the accuracy-related penalty to the extent he has understated the Vapor Room’s gross receipts and failed to substantiate the Vapor Room’s COGS and expenses. Petitioner’s sole argument in brief is that the penalty does not apply because, he states, any inaccuracy underlying an understatement was “accidental, not substantial, and/or not negligent оn the part
We agree with respondent that the accuracy-related penalty applies in this case but disagree that it applies to the full amounts of the underpayments. Respondent concedes that petitioner substantiated $57,929 and $149,666 of the Vapor Room’s reported expenses for 2004 and 2005, respectively. We nonetheless disallowed the deduction of those expenses under section 280E. The application of section 280E to the expenses of a medical marijuana dispensary had not yet been decided when petitioner filed his Federal income tax returns for 2004 and 2005. The accuracy-related penalty does not apply, therefore, to the portion of each underpayment that would not have resulted had petitioner been allowed to deduct his substantiated expenses. Cf. Van Camp & Bennion v. United States,
The accuracy-related penalty does apply, however, to the remainder of each underpayment because those portions of the underpayments are attributable to negligence.
21
Petitioner consciously opted not to keep adequate books and records and that action was in reckless or conscious disregard of rules or regulations. See Higbee v. Commissioner,
VIII. Epilogue
We have considered all arguments that the parties made and have rejected those arguments not discussed here as without merit.
To reflect the foregoing,
Decision will be entered under Rule 155.
Notes
Unless otherwise indicated, section references are to the applicable versions of the Internal Revenue Code (Code), Rule references are to the Tax Court Rules of Practice and Procedure and dollar amounts are rounded to the nearest dollar.
COGS is not a deduction within the meaning of sec. 162(a) but is subtracted from gross receipts in determining a taxpayer’s gross income. See Max Sobel Wholesale Liquors v. Commissioner,
Approximately 50 medical marijuana dispensaries were located in California in 2004.
Petitioner was oblivious to the licensing requirement for his medical marijuana dispensary. He received the requisite license from San Francisco in or about July 2004.
A vaporizer is an expensive apparatus that extracts from marijuana its principal active component and allows the user to inhale vapor rather than smoke. Petitioner chose the name of his business to publicize that the Vapor Room had the requisite equipment to allow patrons to vaporize marijuana there.
We say “almost all” because patrons also included designated caregivers of the recipients, who were entitled to receive medical marijuana for recipients. We use the term “patrons” to include only recipients.
The medical marijuana in the Vapor Room’s inventory was in the following three forms: (1) dried marijuana, (2) food (e.g., bakery goods, butter and candy) laced with marijuana and (3) a concentrated version of the principal active component of marijuana.
Petitioner was not forthcoming with the specific prices at which he sold his marijuana or the specific amount of mediсal marijuana that was consumed for free. Nor does the record contain a formula for the price that petitioner charged a patron for medical marijuana or reveal whether any discount price had a set floor such as the Vapor Room’s cost. Petitioner, during 2004, sold approximately 32% of the marijuana (inclusive of the portion he dispensed for free) for less than what would otherwise have been the sale price.
Petitioner used the cash method to compute the Vapor Room’s net income. Respondent does not challenge petitioner’s use of that method. We discuss it no further.
The expenses in this column actually total $286,885, or $1,536 more than $285,349. Petitioner apparently reported the Vapor Room’s “Deductible meals and entertainment” at 100% of the reported cost and then reduced the $286,885 to $285,349 (without noting so) to take into account the 50% reduction of sec. 274(n).
Petitioner filed his Federal income tax return for 2005 during the last week of September 2006. The audit was expanded at or about that time to include 2005.
Petitioner does not argue that respondent bears the burden оf proving the applicability of sec. 280E. We need not decide that issue because our resolution of that issue does not rest on which party bears the burden of proof. See Estate of Morgens v. Commissioner,
Petitioner asserts that he minimized the Vapor Room’s use of checks because he did not want his bank to know that the Vapor Room was a medical marijuana dispensary. We find that assertion incredible, especially given that petitioner informed the bank that his business was named ‘Vapor Room.”
The ledgers apparently were not available at the start of this proceeding when petitioner admitted under Rule 90 that the Vapor Room started its business in July 2004. The ledgers show sales for the Vapor Room on most (if not all) of the days from January 25 through March 13, 2004, and June 1 through October 30, 2004.
Petitioner informs us that California did not allow medical marijuana dispensaries to earn a profit for the years at issue. The need to report no profit may improperly cause a dispensary to understate gross receipts or to overstate expenditures. We are especially wary here, where petitioner by his own аdmission understated his gross receipts and took steps to disguise his cash withdrawals from his business to conceal them from his employees. We also note that petitioner in his petition challenged only respondent’s disallowance of the COGS and expenses petitioner reported on the returns and stated in the petition that he had incurred the reported expenditures in the amounts stated (without mention of any greater or additional expense amounts).
Petitioner also called Dale Gieringer, Ph.D., and Ms. Taxy to testify as experts on the medical marijuana industry and the Court recognized them as such. We similarly consider their testimony to be unreliable for similar reasons. We adopt their opinions only to the limited extent stated.
Both staff members (including petitioner) and other patrons received medical marijuana for free. The record does not disclose how much of the free marijuana actually went to “needy” individuals.
The medical marijuana petitioner gave away might arguably still qualify as an ordinary and necessary business expense under sec. 162(a). We need not decide that issue, however, because we hоld later that sec. 280E precludes any such deduction.
The largest claimed expense is wages paid in cash. Petitioner opted not to specifically identify the purported recipients of these “wages.” We are troubled with petitioner’s claimed cash transactions and doubt that any of the claimed cash wages were ever reported as income.
The parties agree that sec. 280E disallows deductions only for the expenses of a business and not for its COGS. See also Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner,
Our research reveals for information purposes that 17 States and the District of Columbia have legalized medical marijuana as of July 19, 2012. See http://medicalmarijuana.procon.org/ view.resource.php?resourceID=000881 (last visited July 19, 2012). Those States are Alaska, Arizona, California, Colorado, Connecticut, Delaware, Hawaii, Maine, Michigan, Montana, Nevada, New Jersey, New Mexico, Oregon, Rhode Island, Vermont and Washington. Id.
The underpayments also appear to be “substantial” within the statutory definition of that word. The accuracy-related penalty will also apply to the referenced portions of the underpayments if that definition is met.