How A Drug Dealer Then Affects Marijuana Taxation Today

 

I spent substantial time last week reviewing and researching issues related to the marijuana industry. There is one Code section – Section 280E – that overpowers almost all tax planning in this area.

That section came into the Code in 1982.

It came in response to a Tax Court decision.

Let’s talk about it.

Here is the Court setting the table:

During …, petitioner Jeffrey Edmonson was self-employed in the trade or business of selling amphetamines, cocaine, and marijuana. His primary source of controlled substances was one Jerome Caby, who delivered the goods to petitioner in Minneapolis on consignment. Petitioner paid Caby after the drugs were sold. Petitioner received on consignment 1,100,000 amphetamine tablets, 100 pounds of marijuana, and 13 ounces of cocaine during the taxable year 1974. He had no beginning inventory of any of these goods and had an ending inventory of only 8 ounces of cocaine.

What got this bus in motion was a 1961 Supreme Court decision holding that everyone who made money – whether through legal or illegal activities – had to pay taxes on that money.

Edmonson got busted.

The IRS came in with a jeopardy assessment.

The IRS was concerned about Edmonson skipping, hence the jeopardy. This assessment causes all taxes, penalties, and interest to become immediately due. This allows to IRS to exercise its Collections powers (liens, levies, not answering phone calls for extreme durations) on an expedited basis.

Edmonson might not have been too concerned about po-po, but he wasn’t about to mess with the IRS. Although he did not keep books and records (obviously), he came up with a bunch of expenses to reduce his taxable income.

The IRS said: are you kidding me?

Off they went to Tax Court.

Edmonson went green eyeshade.

·      He calculated cost of goods sold for the amphetamines, marijuana, and cocaine

·      He calculated his business mileage

·      He had business trips and meals

·      He paid packing expenses

·      He had bought a small scale

·      He used a phone

·      He even deducted an office-in-home

The IRS, on the other hand, reduced his cost of goods sold and simply disallowed all other expenses.

The Court reduced or disallowed some expenses (it reduced his office in home, for example), but it allowed many others, including his cost of goods sold.

Here is the Court:

Petitioner asserts by his testimony that he had a cost of goods sold of $106,200. The nature of petitioner’s role in the drug market, together with his appearance and candor at trial, cause us to believe that he was honest, forthright, and candid in his reconstruction of the income and expenses from his illegal activities in the taxable year 1974.

The Edmonson decision revealed an unanticipated quirk in the tax Code. This did not go over well with Congress, which closed the Edmonson loophole by passing Code section 280E in 1982:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

This Code section pretty much disallows all business deductions (marijuana is classified as a controlled substance), except for cost of goods sold. Cost of goods sold is not considered a deduction in the tax Code; rather it is a subtraction from gross receipts to arrive at gross income. Think about a business where you could not deduct (most or all) your salaries, rent, utilities, taxes, insurance and so on. That is the headwind a marijuana business faces.

Meanwhile, things around us have changed greatly since 1982. Marijuana is legal in 21 states, and medical marijuana is legal in almost twice that number. Colorado by itself has collected over $2 billion in taxes since legalizing marijuana. There are publicly traded companies in the marijuana industry. There are even ETFs should you want to invest in this sector.

And that is how we have business activity that may be legal under state law but is illegal under federal law. The federal tax Code taps into federal law – that is, the Controlled Substances Act – and that tap activates Section 280E and its harsh tax result. 

Our case this time was Edmonson v Commissioner, T.C. Memo 1981-623.

A Job, A Gig and Work Expenses

 

The case is straightforward enough, but it reminded me how variations of the story repeat in practice.

Take someone who has a W-2, preferably a sizeable W-2.

Take a gig (that is, self-employment activity).

Assign every expense you can think of to that gig and use the resulting loss to offset the W-2.

Our story this time involves a senior database engineer with PIMCO. In 2015 he reported approximately $176,000 in salary and $10,000 in self-employment gig income.  He reported the following expenses against the gig income:

·      Auto      $14,079

·      Other     $12,000

·      Office    $ 7,043

·      Travel    $ 6,550

·      Meals     $ 3,770

There were other expenses, but you get the idea. There were enough that the gig resulted in a $40 thousand loss.

I have two immediate reactions:

(1)  What expense comes in at a smooth $12,000?

(2)  Whatever the gig is, stop it! This thing is a loser.

In case you were curious, yes, the IRS is looking for this fact pattern: a sizeable (enough) W-2 and a sizeable (enough) gig loss.

In general, what one is trying to do is assign every possible expense to the gig. Say that one is financial analyst. There may be dues, education, subscriptions, licenses, travel and whatnot associated with the W-2 job. It would not be an issue if the employer paid or reimbursed for the expenses, but let’s say the employer does not. It would be tempting to gig as an analyst, bring in a few thousand dollars and deduct everything against the gig income.

It’s not correct, however. Let’s say that the analyst has a $95K W-2 and gigs in the same field for $5k. I see deducting 5% of his/her expenses against the gig income; there is next-to-no argument for deducting 100% of them.

The IRS flagged our protagonist, and the matter went to Court.

We quickly learned that the $10 grand of gig income came from his employer.

COMMENT: Not good. One cannot be an employee and an independent contractor with the same company at the same time. It might work if one started as a contractor and then got hired on, but the two should not exist simultaneously.

Then we learn that his schedule of expenses does not seem to correlate to much of anything: a calendar, a bank account, the new season release of Stranger Things.

The Court tells us that his “Travel” is mostly his commute to his W-2 job with PIMCO.

You cannot (with very limited exception) deduct a commute.

There were some “Professional Fees” that were legit.

But the Court bounced everything else.

I would say he got off well enough, all things considered. Please remember that you are signing that tax return to “the best of (your) knowledge and belief.”    

Our case this time was Pilyavsky v Commissioner.

Deducting Expenses Paid With Paycheck Protection Loans

There was a case in 1931 that is influencing a public controversy today.

Let’s talk about it.

The taxpayer (Slayton) was in the business of buying, holding and selling tax-exempt bonds. He would at times borrow money to buy or to carry tax-exempt bonds he already owned.

Slayton had tax-exempt interest income coming in. That amount was approximately $65 thousand.

Slayton was also paying interest. That amount was approximately $78 thousand.

COMMENT: On first read it does not appear that dear old Slayton was the Warren Buffett of his day.

Time came to file his tax return. He omitted the $65 grand in interest received because … well, it was tax-exempt.

He deducted the $78 grand that he was paying to carry those tax-exempt securities.

The IRS said no dice.

Off to Court they went.

Slayton was hot. He made several arguments:

(1)  The government was discriminating against owners of tax-exempt securities and – in effect – nullifying their exemption from taxation.

(2)  The government was discriminating against dealers in tax-exempt bonds that had to borrow money to carry an inventory of such bonds.

(3)  The government was discriminating in favor of dealers of tax-exempt bonds who did not have to borrow to carry an inventory of such bonds.

I admit: he had a point.

The government had a point too.

(1)  The income remained tax-exempt. The issue at hand was not the interest income; rather it was the interest expense.

(2)  Slayton borrowed money for the express purpose of carrying tax-exempt securities. This was not an instance where someone owned an insubstantial amount of tax-exempts within a larger portfolio or where a business owning tax-exempts borrowed money to meet normal business needs.

The link between the bonds and the loans to buy them was too strong in this case. The Court disallowed the interest expense. Since then, tax practitioners refer to the Slayton issue as the “double-dip.”  The dip even has its own Code section:

        § 265 Expenses and interest relating to tax-exempt income.

(a)  General rule.

No deduction shall be allowed for-

(1)  Expenses.

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Over the years the dip has evolved to include income other than tax-exempt interest, but the core concept remains: one cannot deduct expenses with too strong a tie to nontaxable income.

Let’s fast forward almost 90 years and IRS Notice 2020-32.

To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265- 1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.

I admit, it is not friendly reading.

The CARES Act is a reference to the Paycheck Protection loans. These are SBA loans created in response to COVID-19 to help businesses pay salaries and rent. If the business uses the monies for their intended purpose, the government will forgive the loan.

Generally speaking, forgiveness of a loan results in taxable income, with exceptions for extreme cases such as bankruptcy. The tax reasoning is that one is “wealthier” than before, and the government can tax that accession to wealth as income.

However, the CARES Act specifically stated that forgiveness of a Paycheck Protection loan would not result in taxable income.

So we have:

(1)  A loan that should be taxable – but isn’t - when it is forgiven.

(2)  A loan whose proceeds are used to pay salaries and rent, which are routine deductible expenses.

This sets up the question:

Are the salaries, rent and other qualified expenses paid with a Paycheck Protection loan deductible?

You see how we got to this question, with Section 265, Slayton and subsequent cases that expanded on the double dip.

The IRS said No.

This answer makes sense from a tax perspective.

This answer does not make sense from a political perspective, with Senators Wyden and Grassley and Representative Neal writing to Secretary Mnuchin that this result was not the intent of Congress.

I believe them.

I have a suggestion.

Change the tax law.

When Bidding Is Not Marketing

I was talking with a client recently. He is a real estate developer, and he was telling me about a tense run-in several years ago with the county about a proposed development. Think NIMBY (not in my backyard) and you have the context.

Believe it or not, there is a tax issue there.

Let’s set it up by discussing Hisham Ashkouri (HA).

HA was an architect. He was bidding on projects in Washington state and Utah. He was also bidding on projects in Libya and in the Republic of Tartarstan, which is in Russia.

Those last two are certainly off the beaten path.

Using different companies, he submitted development bid proposals. I am not sure what was in these bid proposals, but over three years (2009 – 2011), he deducted over $500 grand in bid expenses.

Sounds expensive.

The IRS audited the three years.

And disallowed the bid expenses.

That doesn’t sound right, thought I.

HA argued that he had deducted marketing and promotion expenses.

Then HA went foot-in-mouth:

“If any of those projects had resulted in ‘a real estate transaction …, I would be having 20 percent ownership.’”

Let’s introduce Code Section 263A. That bad boy generally deals with the acquisition of property, and its intention is to make you capitalize everything under the sun when you acquire – including constructing or developing – property. “Capitalize” is accounting-speak for depreciating something rather than deducting it immediately.

If you depreciate over one year, then I suppose the net effect is approximately the same. If you have to depreciate over 39 years, well, it is going to hurt.

HA fired off first and strong:

The deductions …"could not be capitalized as they were used for marketing and promotion with no real estate transaction." Although petitioners fail to cite any authority in support of that claim, they are correct that section 263A does not require the capitalization of "marketing, selling, advertising, and distribution costs." 

The Court however nailed the issue:

Mr. Ashkouri's testimony regarding the projects he pursued was not particularly detailed, but we take him as having acknowledged that, had he been awarded any of the projects, he would have acquired an ownership interest in the property being developed. He did not identify any project for which he claimed deductions in which he would not have received an ownership interest had he been awarded the contract.”

Every project would have resulted in the acquisition of an ownership interest. This is not marketing or promotion in a conventional sense. HA’s possible ownership interest at the end lands these transactions within the Section 263A dragnet.

So what? He did not win any of these bids, and he would get to deduct the bid costs when the contract was awarded to someone else. Granted, the deduction might be held-up a year or two – until the bid was awarded – but HA would eventually get his deduction.

Here comes the Scooby Doo mystery portion of the case:

But petitioners have not established when (if ever) the development contracts Mr. Ashkouri sought were awarded to others, when Mr. Ashkouri received written notice that no contract would be awarded, or when he abandoned his bid or proposal for each project.”

Seriously? He could not show that the bid went to someone else or was withdrawn entirely? I am not getting this at all.

The Tax Court then backed-up and ran over the body a second time – apparently to make sure that it had stopped breathing:

Even if we were to accept that the expenses in issue were not subject to deferral under section 1.263A-1(e)(3)(ii)(T), Income Tax Regs., we would still conclude that respondent properly disallowed the deductions for architectural or contract services claimed on the Schedules C for Mr. Ashkouri's proprietorship because petitioners did not adequately substantiate the expenses underlying the claimed deductions. In general, section 162(a) allows a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business". When called upon by the Commissioner, however, a taxpayer must substantiate his expenses.”

Bam! Even if HA provided evidence about the bid outcomes, the Court was still going to say “No.”

Back to my real estate guy.

What was the tax issue back when?

His transaction involved real estate development. There is no question that he would have had an ownership interest if the project went through; in fact, he would be the only owner.

Let’s say he incurred significant expenses – legal, engineering and the like – while battling the county.

Would have had to capitalize those expenses rather than deduct them right away?

Maple Trees, Blueberries and Startup Expenses

It is one of my least favorite issues in tax law. It is not a particularly technical issue; rather, it too often imitates theology and metaphysics:

When does a business begin?

For some businesses, it is straightforward. As a CPA my business starts when I take office space or otherwise offer my services to the public. Other businesses have their rules of thumb:

·        An office building begins business when it obtains a certificate of occupancy from the appropriate municipal government.

·        A restaurant begins (usually) after its soft opening; that is, when it first opens to family, friends, possibly food reviewers and critics - and before opening to the general public.

What can make the issue difficult was a 1980 change in the tax law. It used to be that start-up costs could not be immediately deducted. Rather one had to accumulate and deduct them over a 5-year period.

Unfortunate but not ruinous.

In 1980 the law changed to allow a $5,000 deduction; the balance was to be deducted over a 15-year period.

Can you imagine the potentially fraught and tense conversations between a taxpayer and the tax advisor? Rather than injecting moderate but acceptable pain, Congress introduced dispute between a practitioner and his/her client.

Let’s look at a case involving startup costs.

James Gordon Primus lived in New York and worked as an accountant at a large accounting firm. In 2011 his mother bought 266 acres in southwest Quebec on his behalf. The property contained almost 200 acres of maple trees. The trees were mature enough to produce sap, so I suppose he could start his new business of farming.

But there were details. There are always details.

He wanted to clear the brush, as that would help with production later on. He also wanted to install a collection pipeline, for the obvious reason. He also had plans for blueberry production.

He started thinning the maple brush in 2011, right after acquiring the property.

Good.

In 2012 and 2013 he started clearing for blueberry production. 

He ordered 2,000 blueberry bushes in 2014.

In 2015 he began installing the pipeline and planted the blueberry bushes.

In 2016 he readied the barn.

In 2017 he finally collected and sold maple sap.

Got it: 6 years later.

On 2012 he deducted over $200 grand for the farm.

On 2013 he deducted another $118 grand.

That caught the attention of the IRS. They saw $318 grand of startup expenses. They would spot him $5 grand and amortize the rest over 15 years.

Not a chance argued Primus.

He started clearing in 2011, and clearing is an established farming practice. He was in the trade or business of farming by 2012.

Clearing is an accepted practice, said the Court, but that does not mean that one has gotten past the startup phase. Context in all things.

Primus offered another argument: a business can start before it generates revenues.

That is correct, responded the Court, but lack of revenue does not mean that business has started.

Here is the Court:

Petitioner’s activities during 2012 and 2013 were incurred to prepare the farm and produce sap and plant blueberries. Those are startup expenses under section 195 and may not be deducted under section 162 or 212.”

The taxpayer struck out.

Get this issue wrong and the consequences can be severe.

How would one plan for something like this?

I do not pretend to be an expert in maple farming, but I would pull back to general principles: show revenues. The IRS might dismiss the revenues as inconsequential and not determinative that a startup period has ended, but one has a not-inconsequential argument.

That leads to the next principle: once one has established a trade or business, the expenses of expanding that trade or business (think blueberries in this instance) are generally deductible.

I wonder how this would have gone had Primus tapped and sold sap in 2012. I am thinking limited production but still enough to be business-consequential. Perhaps he could market it as “rare,” “local,” “artisanal” and all the buzz words.

Perhaps he could have followed the next year with another limited production. I am trying to tamp-down an IRS “not determinative” argument.

Would it have made a difference?

Driving To South Africa

Our protagonist this time is Donald Durden. He is a pastor with the Seventh Day Adventist Church, and he was based out of Columbus, Ohio for the tax year at issue. His territory included part of Maryland, Ohio, western Pennsylvania, West Virginia, and a part of Virginia.

Got it. I am guessing the case has something to do with travel expenses.

The Church reimbursed his business-related travel expenses using both an accountable and nonaccountable plan.

I guessed right.

COMMENT: The big difference between an accountable and nonaccountable plan is whether you have to provide your employer with receipts and other paperwork. If you do, the plan is accountable and the employer can leave the reimbursement off your W-2. Fail to turn in paperwork and the plan becomes nonaccountable. The reimbursement then goes on your W-2. That used to mean that one would have to itemize and claim employee business expenses. The new tax law disallows employee business expenses, meaning that – beginning with 2018 - one has income with no offsetting deduction.

Pastor Burden claimed $41,950 of unreimbursed employee expenses when he filed his 2013 tax return.

Good grief!

The IRS wanted to know what made up this number. Actually, so do I. There were all kinds of travel in there as well as vehicle expenses and other stuff, including “special shoes.”

Let’s talk about his South Africa visit.

He claimed travel expenses of $10,897. When pressed, he did not present receipts or records, opting to explain that he was away from home on ministerial duties for 100 days. At $180 per day – which he described as the “conservative high-low method” - that comes to $18,000 and was way more than he actually deducted. Why was there an issue?

Folks, it does work like that. I presume that he was referring to a per diem, but a per diem refers to hotels, meals and incidental expenses; it does not mean the air fare to get there in the first place. Additionally, one still has to substantiate the business reason for the trip and document the number of days against which to multiply the per diem. I cannot vacation for two weeks in Europe and make it deductible just by wandering into an accountants’ office one afternoon in Budapest.  

Our pastor had a receipt or two. He elaborated that he visited the Apartheid Museum, the Robben Island Museum, Nelson Mandela’s and Bishop Tutu’s residences, and the botanical gardens.

Sounds like a vacation, murmured the IRS.

Not at all, corrected the pastor. I was working.

How were you working, asked the IRS hopefully.

I said a prayer of dedication during a ceremony.

And …?

I led daily devotions with the parishioners who travelled with me. There was also a naming ceremony. I chose Chloe for my name.

Can you get to any records? Daily schedules, appointments, anything to substantiate ….

For international travel to be deductible, the primary purpose of the trip has to be business related. It is somewhat harsh, but that is the rule. If the trip is 45% business, there is no deduction. You do not get to multiply the cost of the trip by 45 percent.

It was a really good prayer, gleamed the pastor.

He also went to the Dominican Republic. Twice. Turns out his wife has family there.

Of course, sighed the IRS. Let’s go over those records. Let’s start with how you got there.

I drove there, said the pastor.

Whaa…?

I have a log. You see, right here, yeah, in January, I drove there. I left on a Sunday and returned the next Wednesday. In September I also left on a Sunday and came back eight days later.

You can’t drive to …

Ah, here it is. You see, my log shows that I drove to South Africa too. That was in December, added the pastor, squinting his eyes while remembering.

And so it continued, including other items that we cannot discuss without sounding like The Onion.

The Court bounced pretty much everything.

The Court also kept the penalty.

This time we discussed Burden and Torres v Commissioner.

It may be my favorite case so far in 2019.

The IRS Tests Deductibility Of Business Interest

You may be aware that the new tax law changed the deductibility of your mortgage interest. It used to be that you could borrow and deduct the interest on up to a million-dollar mortgage. That amount has now been further reduced to $750,000, although there is a grandfather exception for loans existing when the law changed.

COMMENT: I have never lived in a part of the country where a million-dollar mortgage would be considered routine. There was a chance years ago to relocate the CTG family near San Francisco, which might have gotten me to that rarified level. I continue to be thankful I passed on the opportunity.

There is also business interest. Let’s say you have a general contracting business. This would be the interest incurred inside the business. Maybe you have a line of credit to smooth out cash flows, or maybe you buy equipment using a payment plan. The business itself is borrowing money.

Business interest has traditionally avoided most of the revenue-rigging shenanigans of the politicians, but business interest got caught this last time. There is now a limit on the percentage-of-income that a business can deduct, and that amount is scheduled to decline as the years go by. You might see the limit referred to as the “163(j)” limitation, which is the Code section that houses it. Fortunately, you do not have to worry about “163(j)” if your sales are under $25 million. If you are over that limit (BTW related companies have to be added together to test the limit), you probably are already using a tax pro.    

Then there is investment interest. In its simplest form, it is interest on money you borrowed to buy stock in that general contracting business. The distinction can be slight but significant: it is interest on monies borrowed to own (as opposed to operate) the business.

There is a limit on the deductibility of investment interest: the income paid you as a return on investment. If the business is a corporation, as an example, that would be dividends paid you. If you do not have dividends (or some other variation of investment income), you are not deducting any investment interest expense. It will carry-over to next year when you get to try again.

I am looking at a case involving an electrical engineer and his sole-proprietor software development company. He was kicking-it out of the park, so he borrowed money to purchase two vacant lots. He also bought two steel buildings, with the intent of locating the buildings on his vacant lots and establishing headquarters for his company.

The business lost a major customer. Employees fled. He sold the steel buildings for scrap.

But he kept paying interest on the loan to buy the lots.

He deducted the interest as business interest, meaning he deducted it in full.

Oh nay-nay, said the IRS. You have investment interest and – guess what – you have no investment income. No deduction for you!

OBSERVATION: The business was still limping along, and as a proprietorship all its numbers were reported on his individual tax return.

The IRS had one principal argument: the buildings were never moved; the headquarters was never established; the land never used for its intended purpose. The “business” of business interest never happened. What he had was either investment interest or personal interest.

Let’s look at the definition of investment interest:

163(d)(5)  Property held for investment.

For purposes of this subsection –

(A)  In general. The term "property held for investment" shall include-

(i)  any property which produces income of a type described in section 469(e)(1) , and

(ii)  any interest held by a taxpayer in an activity involving the conduct of a trade or business-

(I)  which is not a passive activity, and

(II)  with respect to which the taxpayer does not materially participate.

I say we immediately throw out 163(d)(5)(A)(ii), as the taxpayer is and has been working there. I say that he is materially participating in what is left of the software company.

That leaves 163(d)(5)(A)(i) and its reference to 469(e)(1):

     469(e)  Special rules for determining income or loss from a passive activity.

For purposes of this section -

(1)  Certain income not treated as income from passive activity.

In determining the income or loss from any activity-

(A)  In general. There shall not be taken into account-

(i)  any-

(I)  gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business,

(II)  expenses (other than interest) which are clearly and directly allocable to such gross income, and

(III)  interest expense properly allocable to such gross income, and

(ii)  gain or loss not derived in the ordinary course of a trade or business which is attributable to the disposition of property-

 (I)  producing income of a type described in clause (i) , or

(II)  held for investment.

I am not clear what the IRS is dredging here, other than a circular argument that the interest was not incurred in a trade or business and was therefore held for investment.

The Court said that was an argument too far.

The Court could accept that the properties were not “used” in the trade or business, but it also accepted that the properties happened (the Court used the term “allocable”) because of the trade or business.

The Court allowed the interest as a business deduction.

Our case this time was Pugh v Commissioner.