Archive for the ‘Tax Court’ Category

Consulting, Gambling; There’s No Difference, Right?

Monday, February 6th, 2017

The Tax Court looked at an individual (call him “Mr. A.”) who looked like a professional poker player, appeared to have an income from poker, but was described on his tax return as a “consultant.” His tax return showed less than half the income that his W-2Gs totaled. The IRS added in a negligence penalty, and the whole dispute ended up in Tax Court.

Before I get into the meat of the case, a comment about gambling and the IRS (and the Tax Court). The IRS does not have a good understanding of the mechanics of poker tournaments. The petitioner today lost some deductions because of this (and that they didn’t explain things point by point). For example, the Court stated (in footnote 4):

The parties also stipulated the authenticity of two receipts showing that Mr. A had paid buy-ins as an “alternate” to participate in “$540 No Limit Hold’em” contests at the Bellagio on July 11 and 17, 2009. As the record does not disclose whether Mr. A in fact played–and if he did not, whether his buy-in was refunded–we conclude that petitioners have not shown that Mr. A paid these buy-ins.

That’s not how alternates in a poker tournament work. Alternates are just the people who get seated when original entrants are eliminated from the tournament. I’ve never seen or heard of an alternate not being seated. But the petitioners didn’t mention this in their briefs or testimony, so the Court used what they thought the term meant, not what really happens in poker tournaments. But I digress….

The problems began with the preparing of their 2009 return.

The return was prepared by petitioners’ accountant…who has a master’s degree in accounting and had previously prepared tax returns for professional poker players. For purposes of preparing the return, Mr. A advised the preparer that his exclusive source of income in 2009 was his poker tournament winnings. He further advised the preparer that he did not have records of the expenses he incurred in order to play in poker tournaments. The preparer concluded that Mr. A was a professional poker player on the basis that poker was his exclusive source of income. Given the absence of expense records, the preparer advised petitioners to report the net income from the gambling activity on Schedule C as gross receipts but not to report any offsetting business expenses.

Let’s look at the problems here. First, the IRS computer system was almost certain to hiccup on this return. If the W-2Gs totaled $42,000 and you report $21,000, there’s a problem. I’m certain that the petitioner received an IRS automated underreporting unit notice on this issue. The second problem deals with the preparer. Tax returns have places for expenses; they aren’t supposed to be lumped with gross receipts. Additionally, there are basic standards in preparing a return. The idea of a preparer putting down, say, $10,000 for expenses when a client says he has no records of those expenses makes no sense.

The taxpayers return showed a Schedule C—the only source of income—with $20,045 of net and gross income. The Schedule C was listed Mr. A’s occupation as “Consultant.” The IRS assumed that was the case, and saw $40,395 of wagering income to be added to the return. That was the first issue. This they won:

On the basis of Mr. A’s and his accountant’s testimony and the entire record, we agree with petitioners. Other than the reference on the Schedule C to Mr. A’s business as a “consultant”, there is no evidence that Mr. A engaged in any consulting activities for compensation during 2009. He denied doing so. When called upon to explain why Mr. A’s business was described as that of a “consultant” on the Schedule C, both he and his accountant dissembled. In the circumstances, we conclude that the business was described this way in a misguided attempt to head off the closer scrutiny of the return that would likely be triggered by a description of Mr. A’s business as “poker” or “gambling”–scrutiny that would likely unearth the inadequacies in the substantiation of Mr. A’s expenses.

The Court included gambling winnings that weren’t on W-2Gs. Yes, all income is taxable no matter if you receive a piece of paper or not. The Court noted, “On this record we find that Mr. A had poker tournament winnings of $48,686 for 2009. Given our conclusion that petitioners reported $20,045 of Mr. A’s gambling income on their return, it follows that they had unreported gains from wagering transactions of $28,641 for 2009.”

The IRS contended that the petitioner wasn’t a professional gambler. Given that the only source of income for the petitioner and his wife was his gambling, the petitioner won this argument. He also was able to deduct his losing poker tournament entries (save the “alternate” entries that the court got wrong).

The taxpayer ran into trouble with his business expenses. “Deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any deduction claimed on a return.” Mr. A. was allowed to deduct those items that he had receipts for. There were almost certainly more expenses, but a line from Tom Clancy comes to mind: If you don’t write it down it never even happened. That’s definitely the case for business expenses: Keep receipts and good records!

The IRS also asserted an accuracy-related penalty for negligence or disregarding IRS rules and regulations.

“‘[N]egligence’ includes any failure to make a reasonable attempt to comply” with the internal revenue laws. Sec. 6662(c). It connotates “a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the
circumstances…This includes “any failure by the taxpayer to keep adequate books and records or to substantiate items properly.” Sec. 1.6662-3(b)(1), Income Tax Regs. Disregard of rules or regulations includes any careless, reckless, or intentional disregard of the Internal Revenue Code, the regulations, or certain Internal Revenue Service administrative guidance.”

Respondent contends that petitioners are liable for an accuracy-related penalty on the basis of negligence. We agree. They failed to maintain records of Mr. A’s gambling activities, including the related expenses. Lacking adequate records, they filed a return that reported an estimate of their net income as if it were gross receipts. As a consequence, they significantly understated both gross receipts and net income. They also participated in a misrepresentation of Mr. A’s business as being that of a consultant rather than a professional poker player. The failure to keep records is prima facie evidence of negligence, and the misrepresentation of the nature of Mr. A’s business falls short of a reasonable effort to comply with the internal revenue laws…

Petitioners have not shown reasonable cause and good faith with regard to any portion of the underpayment. While they were advised in the preparation of their return by an accountant, the return as prepared stated a gross receipts figure that Mr. A certainly knew to be inaccurate and further identified the nature of his business in a way that both petitioners knew to be inaccurate. Petitioners have not shown that they acted with reasonable cause and in good faith with respect to any portion of the underpayment. They are liable for the negligence penalty under section 6662(a).

Some helpful hints if you want to fade into the crowd: Accurately report your gross receipts. The IRS matches things reasonably well, and if they have records that show you have $50,000 of income and your report $20,000, there’s going to be a notice sent to you. If you’re a consultant, would you note your occupation as “professional gambler?” I assume not. The converse is also true; if you’re a professional gambler, you’re not a consultant.

Second, you sign your return, and you’re expected to review it. If you’re gross income is $50,000 and you report $20,000, that you used a tax professional will not absolve you from the accuracy-related penalty.

Finally, keep good records! Every time I get a new client I emphasize with them the importance of keeping good records. An audit is an inconvenience if you have records that substantiate what’s on your tax return. If you don’t, it will be a very painful, very expensive inconvenience.

Case: Alabsi v. Commissioner, T.C. Summary Opinion 2017-5

No Gambling Log, No Problem, Right?

Tuesday, November 8th, 2016

Two married poker players worked as house players (commonly called “proposition players” or “props”) in California. They were paid wages for their work, but they had gambling winnings that they didn’t include on their tax return. They state they lost money (more than their winnings) each month with their poker playing so the winnings needn’t be included on their returns. The IRS disagreed. The dispute made its way to Tax Court.

The petitioners worked at the Hustler Casino in Gardena, California (south of downtown Los Angeles), one of the card rooms (poker clubs) in the Los Angeles metropolitan region. They were hired by the Hustler to start poker games, and fill those games until other customers came. Such house players are common, and are used at off hours or to start games.

One of the petitioners happened to be at the right place at the right time and shared in a “Bad Beat” jackpot worth $16,800 (noted on a W-2G). Because their losses exceeded their wins, the petitioners simply ignored the W-2G. Although not specified in the Tax Court’s opinion, petitioners likely received an Automated Underreporting Unit Notice (probably a CP2000) noting the missing income. Eventually a Notice of Deficiency was issued, and the case made it to Tax Court.

Petitioners didn’t note what they won or lost. From the Opinion:

Petitioners assert that initially they tried to keep track of their poker winnings and losses by writing down the amount won or lost at the end of each day, but after a while they gave up that practice because it is “bad for your psyche * * * you need to be strong mentally” when playing cards.

The Opinion goes into how gambling losses for a proposition player should be noted (whether it’s an unreimbursed employee expense or a gambling loss), but the Court first had to determine the losses.

Regardless of whether petitioners were employees or independent contractors, they were engaged in a gambling activity and are required to substantiate their reported gambling losses. Accordingly we first look to the issue of whether petitioners substantiated their reported gambling losses.

Deductions and credits are a matter of legislative grace, and taxpayers must prove entitlement to the deductions and credits claimed. Taxpayers are required to identify each deduction, show that they have met all requirements, and keep books or records to substantiate items underlying all claimed deductions. To establish entitlement to a deduction for gambling losses the taxpayer must prove the losses sustained during the taxable year. The Commissioner has suggested that gamblers regularly maintain a diary, supplemented by verifiable documentation, of gambling winnings and losses. A taxpayer’s “contention that it was too difficult for him to maintain contemporaneous records of his gambling activities is without merit.”[citations omitted]

The “bad for your psyche” defense isn’t a good one at Tax Court. The petitioners didn’t provide any evidence of their losses. They could have used a phone app to note their gambling results or pen and paper. They provided no confirmation to the Court, so the Court was left with little choice but to affirm the Notice of Deficiency.

A helpful hint for props: Keep a gambling log! It’s not hard (there are even phone apps you can use). Yes, your psyche may be damaged by a bad day at the poker table but you won’t suffer a second loss in Tax Court if you keep that log.

Case: Pham v. Commissioner, T.C. Summary 216-73

Substance Over Form

Thursday, January 7th, 2016

The Tax Court looked today at a worker in Hollywood. He thought he was a contractor; the IRS felt he was an employee. Who was correct?

Our favorite judge of the Tax Court, Judge Mark Holmes, authored the opinion so it’s very readable. The petitioner today was upset about three things that the IRS had changed with has 2009 and 2010 tax returns. First, he filed as an independent contractor in 2008 and the IRS didn’t do anything so his 2009 and 2010 returns shouldn’t be looked at. Second, he feels he was an independent contractor. Third, if he wasn’t an independent contractor he was a statutory employee. The IRS disagrees with all of these.

Judge Holmes quickly disposes of the first issue.

Each tax year stands alone, and the Commissioner may challenge in a later year what he permitted in an earlier one. The Commissioner’s failure to challenge Quintanilla’s status for the 2008 tax year doesn’t disable him from challenging that status for 2009 and 2010.

The second issue has easy law but is difficult in application. “We’ll start with the easy part: An independent contractor is one who works for another but according to his own manner and method, free from direction or right of direction in matters relating to performance of work save as to results.” The key is what did the petitioner really do, not how did he get paid.

We find that the production companies that hired Quintanilla hired him to build sets. They expected him to provide any tools he needed to complete the job. Quintanilla has an enormous collection of tools–which he stores in two 40-foot steel containers–that travels with him to jobsites. These containers are also packed with machinery that Quintanilla uses to fabricate pieces of sets on the spot…Thus, Quintanilla might be paid by the same payroll company for six months, but actually be working on 20 or more projects run by many different production companies.

But Mr. Quantanilla received some W-2s, so he must be an employee, right?

When a production company hired Quintanilla as an individual, it would generally issue him a Form W-2, Wage and Tax Statement. And the company listed on the Form W-2 as the employer was usually a payroll company. Even a tiny bit of questioning showed that his situation is much different from most taxpayers who get a W-2 from their employer, and nobody involved in this case thinks the payroll company had any control whatsoever over how Quintanilla did his work. Indeed, Quintanilla often performed different jobs for different production companies while being paid by the same payroll company. He was hired for more than 80 different jobs by production companies in 2009, but some of these production companies hired him for multiple jobs at different times throughout the year. The same was true in 2010…

We conclude that almost all these facts favor finding that Quintanilla was an independent contractor and not an employee. The most important is that Quintanilla had a large degree of control as to how to accomplish the tasks he had to do throughout the year.

That the petitioner provided his own tools was another factor in his favor. He had a risk of economic loss, another factor in his favor. The IRS tried to argue that he was employed by various payroll companies, and that was clearly not the case. The final argument that the IRS made was that the petitioner was a union member.

Quintanilla credibly explained that he and many of his peers in the industry join unions mainly to obtain health insurance and to a lesser extent to appear on call boards. His experience was typical–he was a member of a union and received his health insurance from it. That union required Quintanilla to show a minimum number of hours to receive this insurance. But neither the union contracts nor the production companies gave him vacation days or sick time. As Quintanilla credibly explained, if he wanted a vacation he would just not answer his phone. And the union contracts even excluded fixed wages and working conditions from their coverage–they expressly reserved the power of employees to cut better deals if they could. Quintanilla testified that all of his jobs came from personal connections and not one came from a union call board…

Quintanilla credibly testified that everything in Hollywood is a negotiation, and contracts are discussed daily. At times a studio even uses another studio’s stage if the price is lower than the rate for its own stage. Continual negotiations and ever-changing contracts are evidence that the studios didn’t intend to make a permanent relationship. Employers don’t negotiate with their employees daily.

So today’s petitioner, who represented himself in Tax Court, won that he was an independent contractor, not an employee. (The statutory employee issue wasn’t reached, as the petitioner won as an independent contractor.) He’s able to take his business expenses on Schedule C rather than Schedule A as he did on his tax returns.

This case was an example of a major issue in dealing with the IRS: substance versus form. I have an ongoing issue with a client who received an information return (a 1099) in error, but the IRS refuses to believe the client. All we can provide are negatives–there was no money paid to him in the year in issue. This case is going to head to Appeals soon, and we may prevail there (Appeals now looks at the chance of prevailing in Tax Court, and with information returns the burden of proof is on the IRS, and there’s no proof other than the erroneous 1099).

Here, had the IRS actually looked at what actually was happening with the petitioner, it should have realized what he was saying was true. Unfortunately, that’s a bit too much to ask for when dealing with the IRS today.

Case: Quintanilla v. Commissioner, T.C. Memo 2016-5

If a Professional Prepares Your Return, Are You Exempt from the Accuracy-Related Penalty?

Monday, December 14th, 2015

An attorney’s tax return had two major errors: $450,000 of gross receipts were left off the return and $505,417 of Contract Labor expenses were deducted as not only Contract Labor but also as Cost of Goods Sold. The return was audited, and the taxpayer agreed with the additional income and that the labor was double-deducted and pays the tax. However, he disputed the 20% accuracy-related penalty. The dispute ends up in Tax Court.

The amount of income underreported is enough where the penalty would apply if an exception doesn’t exist.

The section 6662 penalty does not apply to any portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to * * * [it]…” Reasonable cause has been found when a taxpayer selects a competent tax adviser, supplies the adviser with all the relevant information, and consistent with ordinary business care and prudence, relies on the adviser’s professional judgment as to the taxpayer’s tax obligations.

Put simply, the Court didn’t believe that the attorney used sufficient care in reviewing his return.

Petitioners contend that they reasonably and in good faith relied on their C.P.A.’s advice in the preparation of their 2010 return. We disagree. On the basis of Mr. Ogden’s testimony at trial, we find that his cursory review of petitioners’ return did not constitute proper review…

A reasonable inspection of the return by petitioners would have uncovered both the unreported gross receipts and the improperly claimed deduction. Although petitioners’ C.P.A. [firm] testified that the portion of contract labor expenses treated as COGS on petitioners’ return was hard to spot, we believe Mr. Ogden had sufficient knowledge to detect the error on the return. Because Mr. Ogden prepared the Forms 1099-MISC for the attorneys at his firm, he should have known the total amount of contract labor expenses. Even so, the amount of contract labor expenses reported on petitioners’ return did not remotely match the amount of total contract labor expenses reported on Mr. Ogden’s law firm’s Form 1096. This, combined with the fact that petitioners did not report $450,000 of income on their return, shows that more diligence was needed on their part to reasonably assess their proper tax liability. [citations omitted]

There are a couple of lessons from this decision. First, have everyone you need at the trial. While the CPA who represented the taxpayer in the audit testified at the trial, the CPA who prepared the return did not. “Petitioners did not call the C.P.A. who prepared their 2010 return as a witness, and they presented no evidence that this C.P.A. gave “advice” that they could rely on.” This didn’t sit well with the Court.

More importantly, if you’re an attorney, a CPA, or an Enrolled Agent, the Tax Court is going to expect you to know tax law. You will also be held to a higher standard on any financial disputes. (The same will be true of other financial officers, such as a controller, CFO, etc.) When you’re reviewing a tax return, do not simply take a cursory look at the return. You should want to make sure it’s accurate. If you’re signing a return with $1 million of income, isn’t it worth more than a few seconds to review it? I would certainly think so. The Tax Court definitely did.

Case: Ogden v. Commissioner, T.C. Memo 2015-241

Not a Pigg or a Turkey of a Decision

Monday, December 14th, 2015

Clarence Leland is an attorney in Mississippi. However, he bought a farm in Turkey, Texas. He entered into a crop share agreement with a Mr. Pigg. The farm didn’t make money, and Mr. Leland claimed the losses on his 2009 and 2010 tax returns stating he materially participated in the activity. The IRS didn’t allow the loss, claiming the passive activity rules prevented Mr. Leland from claiming the loss. They also added an accuracy-related penalties. The dispute made its way to Tax Court.

The passive activity rules prevent taxpayers from taking losses if they’re not materially participating in an activity. Mr. Leland didn’t maintain contemporaneous logs, but he was able to reconstruct logs that showed he worked 359.9 hours in 2009 and 209.5 hours in 2010. There was plenty of activity to be done on the farm:

Maintaining the 1,276-acre farm requires petitioner to perform a lot of long, hard work. Petitioner performs most of these tasks himself, but he sometimes has assistance from his son or a friend, Steve Coke. Aside from petitioner, Mr. Pigg, Mr. Coke, and petitioners’ son, no individuals perform any tasks on the farm. Petitioner visits the farm several times each year in order to perform necessary tasks, commuting approximately 13-16 hours each way, including the time it takes to load equipment onto his trailer. The farm has approximately 6-8 miles of perimeter roads and 18-20 miles of interior roads that must be bush hogged and disced regularly in order to remain passable. A Bush Hog is a device that is pulled behind a tractor to cut vegetation and clear land. Discing involves churning and plowing soil to uproot any existing vegetation. Trees and brush that grow near the roads must be controlled through spraying and chopping down limbs that protrude onto the roadways. Because high winds can erode soil on the roads, wheat must be planted each fall to prevent erosion on the roads and on acreage that is not part of the 130 acres planted and harvested by Mr. Pigg. Almost all of the roads have fences running parallel that must be maintained…In a year before the tax years 2009 and 2010, wild hogs ate 250,000 pounds of peanuts that petitioner and Mr. Pigg had grown on the farm. As a result, petitioner has to spend significant time controlling the wild hog population, which he accomplishes through hunting and trapping.

There are seven tests that allow one to qualify as materially participating in an activity, including “the individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year.” Mr. Pigg spent about 30 hours on the farm in 2009 and a lesser amount in 2010.

Petitioner’s reconstructed logs, his receipts and invoices related to farm expenses, and his credible testimony are all reasonable means of calculating time spent on the farming activity during tax years 2009 and 2010…We are satisfied that petitioner’s participation was not less than the participation of any other individual, including Mr. Pigg, Mr. Coke, and petitioners’ son, during tax years 2009 and 2010…Accordingly, petitioner materially participated in the farming activity during tax years 2009 and 2010, and the deductions attributable to that activity are not limited by section 469.

From a footnote, we discover that the IRS objected to the logs was that they were not contemporaneous. But that’s not required:

Respondent’s main objection to petitioner’s reconstructed logs was that they were not prepared contemporaneously with the activity. Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988), does not require contemporaneous records, and we are satisfied that petitioner has established material participation through other reasonable means. Respondent did not dispute petitioner’s inclusion of travel time in his reconstructed logs. The facts of this case establish that petitioner’s travel time was integral to the operation of the farming activity rather than incidental.

So the decision is anything but a turkey for Mr. Leland, and the farming isn’t a passive activity. Mr. Leland also wins on the accuracy-related penalties, as the returns were accurate. It’s nice to see a plaintiff win at Tax Court on passive activities; I expect we’ll be seeing a lot more cases in this area in the future (because of the new net investment tax).

Case: Leland v. Commissioner, T.C. Memo 2015-240

The 14th Time Wasn’t the Charm

Tuesday, November 24th, 2015

For most of us the saying “If you don’t succeed at first, try, try again,” is good advice. However, it’s not good to try to deduct personal expenses as business expenses on your tax return. It’s an especially bad idea to then try justifying that at Tax Court repeatedly. Of course, that happened today.

Petitioners are no strangers to this Court. This case constitutes, at the minimum, their 14th case, involving at least one of petitioners, spanning almost 30 taxable years from 1981 to 2010. Most recently they litigated the consolidated cases at docket Nos. 16195-12S, 26201-12S, and 1070-13S, which were decided by this Court’s T.C. Summary Opinion 2014-105. Those cases, like this one, addressed similar continuing issues arising primarily from petitioners’ efforts to substantiate and deduct expenses which they attribute to Mr. Boring’s Schedule C sole proprietorship d.b.a. Rambor Technology (Rambor) or his partnership Board Automation. The substantive tax disputes emanate from petitioners’ misunderstanding of the terms “ordinary” and “necessary” as used in defining deductible business expenses pursuant to section 162 and the interrelationship of that section with section 262, defining nondeductible personal expenses. [footnotes omitted]

The issues in this case were deducting expenses without backup, including what appear to be numerous personal expenses. In order to deduct business expenses, they must be both ordinary and necessary for the business.

An expense is ordinary for purposes of this section if it is normal or customary within a particular trade, business, or industry…An expense is necessary if it is appropriate and helpful for the development of the business…Section 262, in contrast, generally precludes deduction of “personal, living, or family expenses.”

The breadth of section 162(a) is tempered by the requirement that any amount reported as a business expense must be substantiated, and taxpayers are required to maintain records sufficient therefor.[citations omitted]

Put simply, almost all of the expenses that were deducted on the return were either nondeductible personal expenses or had no substantiation.

The Court goes through great detail in this case. The reason is that the Court doesn’t want to hear the 15th case dealing with the same issues.

We warn petitioners, however, that their conduct is in material noncompliance with Federal tax law. Our opinions here and in T.C. Summary Opinion 2014-105 are tailored to explain what the law requires. Petitioners have been fairly warned; consequently, any further conduct in the same vein as that considered here and in our previous cases addressing their tax liabilities and tax payments may well, under present law, result in the application of a section 6673 penalty in an amount of up to $25,000.

Section 6673 is the penalty for filing a frivolous Tax Court case. The Court ruled that the case wasn’t entirely frivolous because of one issue. On the tax return, the petitioners took the home office deduction (including mortgage interest). That deduction was denied, but the mortgage interest taken on the home office deduction should have been moved to be an itemized deduction on Schedule A. If not for that, the petitioners might not only owe the tax, penalties (they were hit with the accuracy-related penalty), and interest, but the frivolous penalty too. They somehow avoided the late filing penalty (this was noted in a footnote on the return), so they should consider themselves lucky.

Case: Boring v. Commissioner, T.C. Summary Opinion 2015-68

Time Running Out on the Miccosukee Tribe’s Battle with the IRS

Wednesday, November 4th, 2015

I have sympathy when taxpayers battle the IRS over legitimate issues. Indeed, I’m all for fighting the IRS when they’re (imho) wrong. However, fighting quixotic battles when you are wrong isn’t a good idea. The Miccosukee Tribe in Florida is in that position.

The Miccosukees operate a successful casino near Miami. The tribe itself is exempt from taxation (it’s a sovereign nation). However, the members of the tribe are not exempt from taxation when they receive income related to the casino. And therein lies the issue.

Beginning in 2012 (or perhaps even earlier) the IRS was wondering why payments to tribe members weren’t being reported (on information reporting forms) and taxes withheld. The IRS sent requests to the tribe, and eventually summonsed material from the tribe and the tribe’s financial institutions. The tribe fought the summonses claiming sovereign immunity. The tribe lost the battles, most recently with this decision in June. (It’s unclear if the tribe has since provided this information to the IRS.)

Meanwhile, approximately 20 tribe members were sent Notices of Deficiency by the IRS pertaining to distributions from 2000-2005. The tribe members filed Tax Court petitions in 2013. As best as I can tell, no case related to this has yet been decided.

Separately, the IRS issued tax, penalties and interest on the non-withholding withholding (that is, the money that the IRS thinks should have been withheld by the Miccosukee tribe). The IRS issued a lien and levy notice. The Miccosukee Tribe had a Collection Due Process hearing. When asked to provided financial information the tribe refused. The tribe lost the Collection Due Process Hearing and then filed a Tax Court petition.

The tribe disputed both the underlying liability and the collection activity (the latter, as an abuse of discretion). In May 2014 the Tax Court used an order for summary judgment against the Miccosukee tribe on the underlying liability. Because the tribe had an opportunity to dispute the underlying liability at Appeals, the Court ruled that the tribe could not dispute it in the Tax Court case.

The Tax Court held a trial in March, and ruled today that the levy was not an abuse of discretion.

It is clear from our review of the record that the SO [settlement officer] verified that the requirements of applicable law and administrative procedure were followed and that in sustaining the filing of the NFTLs and the proposed levy the SO properly balanced “the need for the efficient collection of taxes with the legitimate concern of * * * [petitioner] that any collection action be no more intrusive than necessary.” Petitioner did not raise any valid challenge to the appropriateness of the NFTL filings and the proposed levy. Furthermore, petitioner did not submit the financial information necessary for the SO to consider an installment agreement. There is no abuse of discretion when a settlement officer declines to consider collection alternatives under these circumstances…see also sec. 301.6330-1(e)(1), Proced. & Admin. Regs. (“Taxpayers will be expected to provide all relevant information requested by Appeals, including financial statements, for its consideration of the facts and issues involved in the hearing.”). Therefore, we hold that the SO’s determination to sustain the filing of the NFTLs and proceed with the proposed levy was not an abuse of discretion. [citations omitted]

While I expect the Miccouskee Tribe to file an appeal, and this will delay any IRS action for the time while an appeal is pending, it’s clear that time is running out for the Miccosukee Tribe on this matter. They may not want to provide their financial information to the IRS, but they have to. They also need to start complying with the law in regards to reporting and withholding casino income payments. Years ago, the US government ended up owning part of the Bicycle Casino. It wouldn’t surprise me that at some date in the near future that the Miccosukee’s casino is under new management.

Up In Smoke, Again

Thursday, October 22nd, 2015

A California non-profit corporation tried to find a way around Section 280E of the Tax Code at Tax Court. Would they be successful or would yet another marijuana business fall victim to the difference between federal and state law?

In 1996 California approved medical marijuana. However, federal law make marijuana a Schedule I controlled substance under Section 280E of the Tax Code. The petitioner in the case is a non-profit corporation (technically, a California mutual benefit corporation that is not for profit). The IRS had disallowed business expenses because of Section 280E of the Tax Code. The petitioner timely filed a Tax Court petition.

The problem that the petitioner faces is basically that federal law trumps state law. The Federal Drug Enforcement Administration lists marijuana as a Schedule I controlled substance. In Olive v. Commissioner, the Ninth Circuit Court of Appeals stated,

[T]he only question Congress allows us to ask is whether marijuana is a controlled substance ‘prohibited by Federal law.’ * * * If Congress now thinks that the policy embodied in § 280E is unwise as applied to medical marijuana sold in conformance with state law, it can change the statute. We may not.

The petitioner tried to argue that he was in multiple lines of businesses, so that some portion of the business expenses would be deductible. The Tax Court was having none of that:

Because of the parties’ stipulation, we find that the sale of medical marijuana was petitioner’s primary source of income and that the sale of any other item was an activity incident to its business of distributing medical marijuana. We find that petitioner was engaged in one business–the business of selling medical marijuana.

With Section 280E prohibiting deductions for business expenses, the IRS’s deficiencies were upheld. Medical marijuana might be legal under California law, and expenses are deductible on California tax returns. However, until Congress changes the law business expenses for marijuana dispensaries cannot be taken on federal tax returns.

Case: Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206

Up In Smoke…Again

Monday, August 10th, 2015

Another medical marijuana dispensary owner found himself at Tax Court today. And another marijuana dispensary owner isn’t happy with the results, though in this case much of the damage was self-inflicted.

Jason Beck owned two medical marijuana dispensaries in California (he still owns one of the two locations). He kept records, but his recordkeeping rules reminded me of something out of Get Smart!. In one episode of the 1960s classic television series, the practice of the government agency called Control was to make two copies of vital records, and then destroy them. It’s a method that works well for comedic value, but is best not practiced in accounting:

It was petitioner’s ordinary practice to shred all sales and inventory records at the end of the day or by the next day. However, petitioner was able to recover and produce some of these records.

Tapes and other records were made…but were shredded. Now, in petitioner’s defense, the legal climate regarding marijuana was very different back in 2007. However, the substantiation rules for taxes haven’t changed one iota. Even an illegal business will need records or the IRS’s allegations will be assumed to be correct.

The petitioner asked to deduct business expenses for the dispensary. While a marijuana dispensary can deduct Cost of Good Sold, it cannot deduct business expenses; Section 280E of the Tax Code prohibits business expenses for any business trafficking in a controlled substance. Marijuana is a federally controlled substance. Just one month ago the 9th Circuit Court of Appeals upheld the Tax Court on this issue.

But even if the petitioner could deduct expenses, there’s the problem of substantiation.

Where a taxpayer reports a business expense but cannot fully substantiate it, the Court generally may approximate the allowable amount. However, we may do so only when the taxpayer provides evidence sufficient to establish a rational basis upon which an estimate can be made.

Here, petitioner intentionally and routinely destroyed most documents pertaining to the operation of both dispensaries. Petitioner was able to recover and produce some records; however, those records do not reconcile with the categories or amounts reported on petitioner’s tax return. Petitioner is not entitled to deduct the Schedule C expenses because they are unsubstantiated. [citations omitted]

The Court then disallows the expenses a second time based on Section 280E.

Next, there was the matter of a raid by the Drug Enforcement Administration (DEA). The DEA in early 2007 executed a search warrant and seize marijuana and other items that the petitioner valued at $600,000. He wanted to include them in Cost of Goods Sold, or take a casualty loss on the seized marijuana.

Because of his complete failure to substantiate the value of the seized marijuana, petitioner is not entitled to claim $600,000 as part of his Schedule C COGS. Additionally, if petitioner had provided substantiation, the seized marijuana would still not be allowable as COGS because the marijuana was confiscated and not sold.

In general, section 165(a) allows a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. Sec. 165(a). However, section 280E provides that no deduction or credit (including a deduction pursuant to section 165) shall be allowed for any amount paid or incurred in connection with trafficking in a controlled substance. Therefore, petitioner is not entitled to a section 165 loss deduction for the marijuana seized by the DEA.

All-in-all, it was not a good day at Tax Court for the petitioner, especially after the accuracy-related penalty was upheld.

CASE: Beck v. Commissioner, T.C. Memo 2015-149

Where There’s Smoke…

Sunday, July 12th, 2015

Martin Olive operates “The Vapor Room,” a medical marijuana dispensary in San Francisco. His business, a sole proprietorship, was audited by the IRS for 2004 and 2005. He lost. He took that case to Tax Court. Back in August 2012 he lost (Olive v. Commissioner, 139 T.C. No. 2). He appealed that decision to the Ninth Circuit Court of Appeals. On Thursday the Ninth Circuit agreed with the Tax Court.

The issue in this case was 26 U.S.C. § 280E. That section of law prohibits a taxpayer from deducting any expenses (but not Cost of Goods Sold) related to a trade or business of trafficking in a controlled substance prohibited by Federal law. Marijuana–which may be legal under state law–is decidedly a controlled substance under Federal law.

The first argument of Mr. Olive was that he had multiple lines of businesses. The Court disagreed.

An analogy may help to illustrate the difference between the Vapor Room and the business at issue in CHAMP. Bookstore A sells books. It also provides some complimentary amenities: Patrons can sit in comfortable seating areas while considering whether to buy a book; they can drink coffee or tea and eat cookies, all of which the bookstore offers at no charge; they can obtain advice from the staff about new authors, book clubs, community events, and the like; they can bring their children to a weekend story time or an after-school reading circle. The “trade or business” of Bookstore A “consists of” selling books. Its many amenities do not alter that conclusion; presumably, the owner hopes to attract buyers of books by creating an alluring atmosphere. By contrast, Bookstore B sells books but also sells coffee and pastries, which customers can consume in a cafe-like seating area. Bookstore B has two “trade[s] or business[es],” one of which “consists of” selling books and the other of which “consists of” selling food and beverages.

Mr. Olive also argued that congressional intent and public policy should have § 280E not apply to medical marijuana.

Application of the statute does not depend on the illegality of marijuana sales under state law; the only question Congress allows us to ask is whether marijuana is a controlled substance “prohibited by Federal law.” I.R.C. § 280E. If Congress now thinks that the policy embodied in § 280E is unwise as applied to medical marijuana sold in conformance with state law, it can change the statute. We may not.

What this means for marijuana distributors and sellers is that they can deduct their Cost of Goods Sold but that they cannot deduct business expenses on their federal tax returns. It is likely, though, that on many state tax returns those business expenses will be deductible; after all, the business is selling a legal product on the state level. (This will likely depend on both the legality of marijuana under state law and the degree of conformity between the state and federal tax law in that state.)

Case: Olive v. Commissioner, No. 13-70510 (July 9, 2015)