IRS found that due to poor record-keeping, lack of check registers, no physical inventory counts, incorrect Cost of good sold allocations and much more caused $78k in penalties
The Tax Court in Alterman upheld the imposition of a 20% tax penalty on the taxpayer for the underpayment of the tax liability resulting from the deductions taken. Various medical and recreational marijuana practices have been legalized in the majority of the states but the last major hurdle, the Section 280E prohibition, still keeps marijuana ultimately classified as a Schedule I controlled substance under federal law.
Attorney Henry Wykowski explains, “Nevertheless, it’s a disappointing case and illustrative of the difficulties the industry faces with many – but not all – of the judges in tax court.”
What does this mean?
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If a business is operating without keeping good records, the IRS can deny deductions for business expenses. Due to the drastic impact of this tax blow - many taxpayers of the medical marijuana industry have attempted to challenge or even just ignore the Section 280E prohibition.
Not only did Alterman have to pay taxes on taxable income in excess of actual profits - he also had to pay an additional 20% penalty fee for their initial failure to follow the 280e prohibition.
“The important facts are as follows:
The taxpayer sold marijuana and non-marijuana products. The sales of non-marijuana products were 1.4% of gross receipts in 2010 and 3.5% of gross receipts in 2011.
On the tax returns, the taxpayer reduced gross receipts by cost of goods sold. The taxpayer also deducted business expenses. It does not appear based on the findings of fact that on the original return the taxpayer disallowed any expenses pursuant to Section 280E.
It appears the amount of cost of goods sold claimed on the return was, for the most part, amounts paid for purchases of inventory and did not include production costs. At trial, the taxpayer asserted that it incurred over $100,000 of production costs each year in addition to the amounts paid for purchases of inventory.
The court found:
The sales of non-marijuana products were complementary to the sales of marijuana products and therefore, were not a separate trade or business. Even if the non-marijuana product sales were a separate trade or business, the record did not give the court any basis for determining the expenses attributable to the secondary business of sales of non-marijuana products.
The court applied Section 471 to determine cost of goods sold. Section 471 allows taxpayers to include direct and indirect production costs in cost of goods sold.
The amount of cost of goods sold conceded by the IRS, which does not appear to include production costs, was the allowable amount of cost of goods sold because the taxpayers failed to properly account for beginning and ending inventories.
The taxpayer was negligent and subject to the negligence penalty because they did not keep adequate records to compute beginning and ending inventories or adequate books and records. Further, there was no reasonable cause because the taxpayers did not seek advice regarding inventory accounting or the application of Section 280E.
Lessons and observations:
It is important that taxpayers subject to Section 280E use their best efforts to apply Section 280E when filing returns.
It is important that taxpayers subject to Section 280E properly classify costs as inventory costs when filing returns and maintain beginning and ending inventories with integrity.
It is important that taxpayers retain records needed to substantiate all accounting entries.
The substantiation issues are not unique to the marijuana industry. However, due to high audit rates and the impact of Section 280E, the cost of the failure to substantiate is uniquely burdensome. That being said, here, it is unclear how the failure to substantiate beginning and ending inventory also creates a restriction on the production costs that should be allowed. Careful documentation and preparation of returns should overcome some of these burdens.”
Make sure you understand the complex laws for your marijuana business and have accurate accounting measures in place. Let’s help Cannabis Businesses thrive together.
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