Medical Cannabis Dispensary's Claimed Deductions Go Up In Smoke In Tax Court

(Parker Tax Publishing February 2021)

The Tax Court held that the IRS properly disallowed a medical cannabis dispensary's claimed deductions for depreciation and charitable contributions under Code Sec. 280E and upheld the imposition of a penalty on the resulting underpayment of tax. The court rejected the taxpayer's argument that depreciation is not an "amount paid or incurred during the tax year" and that its charitable contributions were not made "in carrying on" a trade or business under Code Sec. 280E, and also found that the taxpayer did not act with reasonable cause and in good faith with respect to its underpayment of taxes. San Jose Wellness v. Comm'r, 156 T.C. No. 4 (2021).

Background

San Jose Wellness (SJW) is a corporation that, during 2010, 2011, 2012, 2014, and 2015, operated a medical cannabis dispensary in San Jose, California. SJW sold cannabis to individuals who held a valid doctor's recommendation to use cannabis. SJW also sold non-cannabis items, including T-shirts, pipes, and batteries. In addition, SJW offered acupuncture and chiropractic services, as well as other "holistic" services. SJW did not charge a separate fee for membership,

acupuncture, chiropractic services, or any other services.

For each of the years at issue, SJW filed tax returns on which it claimed, among other deductions, depreciation deductions under Code Sec. 167 and charitable contribution deductions under Code Sec. 170. The IRS disallowed the deductions for depreciation and charitable contributions and determined deficiencies. The IRS also applied accuracy-related penalties for 2014 and 2015, but eventually conceded the penalty determined for 2014. SJW challenged the redeterminations and penalty in the Tax Court.

Under Code Sec. 280E, no deduction is allowed for any amount paid or incurred during the tax year "in carrying on" any trade or business if such trade or business (or the activities which comprise the trade or business) consists of trafficking in controlled substances. In N. Cal. Small Bus. Assistants Inc. v. Comm'r (NCBSA), 153 T.C. No. 4 (2019), the Tax Court rejected a medical marijuana dispensary's claimed deduction for taxes under Code Sec. 164 and depreciation under Code Sec. 167. In that case, the taxpayer argued that Code Sec. 280E limits only deductions under Code Sec. 162, but the Tax Court rejected that argument and noted that the first line of Code Sec. 280E states that "no deduction or credit shall be allowed." In Alt. Health Care Advocates v. Comm'r (AHCA), 151 T.C. No. 13 (2018) and Californians Helping to Alleviate Med. Problems, Inc. v. Comm'r (CHAMP), 128 T.C. 173 (2007), the Tax Court denied deductions for depreciation and, in AHCA, the court denied a deduction for charitable contributions as well. However, in those cases, the Tax Court did not separately analyze the application of Code Sec. 280E to Code Sec. 167 and Code Sec. 170; instead, the court denied all of the deductions at issue.

SJW argued that the depreciation deduction under Code Sec. 167(a)(1) falls outside the scope of Code Sec. 280E because depreciation is not "paid or incurred during the tax year." SJW asserted that the meaning of Code Sec. 280E is unambiguous and that its reach is limited to "deductions and credits for business expenditures." In SJW's view, the business expenditures covered by Code Sec. 280E include (but are not limited to) the expenses described in Code Sec. 162, but they do not include depreciation because depreciation is not described in Code Sec. 162 and is not an amount paid or incurred during the tax year. SJW further contended that, even if the court disallowed its depreciation deductions, its charitable contributions should be deductible because the contributions were not paid "in carrying on" a trade or business as required by Code Sec. 280E. SJW compared the text of Code Sec. 280E with that of Code Sec. 162(a) and noted that the latter provides a deduction for ordinary and necessary expenses paid or incurred during the tax year "in carrying on" any trade or business. SJW contended that the phrase "in carrying on" significantly limits the universe of expenditures to which Code Sec. 162 applies and that a similar analysis of Code Sec. 280E confirmed that it did not apply to SJW's charitable contributions.

Analysis

The Tax Court held that SJW's depreciation and charitable donation deductions were properly disallowed and sustained the imposition of the penalty. The court said that it could have ruled against SJW under the holdings of NCSBA, AHCA and CHAMP, but it proceeded to consider SJW's contentions on their merits given that SJW had advanced more nuanced textual arguments than were presented in those cases.

The court found that SJW's contention that depreciation is not paid or incurred during the tax year was foreclosed by the Code and Supreme Court precedent. The court noted that SJW used the accrual method of accounting and found that the purpose of the accrual method is to enable taxpayers to charge against income earned during the taxable period the expenses incurred in, and properly attributed to, the process of earning income during that period. The court said that the Supreme Court's decision in Comm'r v. Idaho Power Co., 418 U.S. 1 (1974) explained how these principles apply to depreciation. In that case, the Supreme Court stated that, when the consumption of an asset takes place in the construction of other assets that in the future will produce income themselves, the cost represented by depreciation does not correlate with the production of current income; rather, the cost, "although certainly presently incurred," is related to the future and appropriately allocated as part of the cost of acquiring an income-producing asset. Thus, in the view of the Tax Court, Idaho Power left no doubt that, as a cost "presently incurred," depreciation constitutes an amount paid or incurred during the tax year.

With regard to SJW's claimed charitable contribution deduction, the court found that SJW is a corporation that was engaged in a trade or business when it made the contributions, and the court saw no reason to conclude that the act of making the contributions was somehow separate from or outside the scope of SJW's business activities. The court noted that many courts have acknowledged the potential benefits to a corporation of making a charitable gift, and said that there was no indication that it should question SJW's motivations in making the contributions. The court found that SJW was correct that courts have construed Code Sec. 162(a) as inapplicable to certain categories of expenditures (for example, distributions of profits, loans, and capital expenditures). But the court explained that these exclusions were not grounded in the phrase "in carrying on" but rather relied on other requirements of Code Sec. 162(a), such as the condition that an expenditure must be an expense that is both ordinary and necessary. The court found that Code Sec. 280E, which applies to "any amount paid or incurred," has no analogous requirements. The court also agreed that the phrase "in carrying on" in Code Sec. 162(a) is narrow in the sense that it applies only to expenses incurred while conducting a trade or business, and not to expenses incurred before a business commences or after its conclusion. However, the court said, that distinction had no bearing on this case, where SJW conceded that the charitable contributions were made while it conducted business.

In upholding the penalty, the court found little evidence that SJW acted reasonably and in good faith with respect to the underpayment. While SJW treated a portion of its expenses as nondeductible, the court found that SJW advanced no argument to support such a bifurcated approach to its expenses and provided no insight into the process it followed in preparing its return. Further, the court found that SJW did not claim it relied in good faith on the advice of an independent professional in deducting the amounts at issue. With respect to SJW's claim that the law was sufficiently unsettled when it filed its 2015 return and that it reasonably reported its expenses, the court disagreed. According to the court, the text of Code Sec. 280E as well as the related caselaw, legislative history, and published guidance at the time SJW filed its returns indicated that SJW's claimed deductions would be disallowed.

For a discussion of the disallowance of deductions for expenses relating to trafficking in controlled substances, see Parker Tax ¶96,512. For a discussion of the abatement of penalties due to reasonable cause and good faith, see Parker Tax ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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