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Glen E. Frost

Attorney at Law *
Certified Public Accountant **
Certified Financial Planner®
Master of Laws in Taxation
Every Tax Problem has a Solution

10480 Little Patuxent Pkwy, Ste. 400
Columbia, MD 21044
Phone:  (410) 497-5947
Fax:      (888) 235-8405

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Permalink 04:58:43 pm, by dmerritts Email , 983 words   English (US) latin1
Categories: News

I.R.C. §280E: A Buzzkill For Those Who Keep Poor Records

By: Eli S. Noff, Partner & Mary Lundstedt

The recent Tax Court's Alterman v. Commissioner[1] decision is a lesson in Accounting 101 for Cannabisseurs. Well, technically it's a valuable lesson about record-keeping to all taxpayers who are subject to Internal Revenue Code (I.R.C.) §280E-but with the currently high audit rates for the marijuana industry, it's particularly significant for taxpayers currently in that business.

Before learning our lesson from Judge Morrison, it is helpful to briefly consider the broader legal setting in which it takes place. Currently, there are nine states in the United States that have legalized recreational marijuana and 29 states that have legalized medicinal marijuana. However, federal law maintains that marijuana is a Schedule 1 controlled substance;[2] thus, the sale of marijuana remains illegal under federal law. From the federal perspective, anyone selling is "trafficking."

Under I.R.C. §280E, the IRS disallows any deduction or credit "for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business . . . consists of trafficking in controlled substances . . . which is prohibited by Federal law or the law of any State in which such trade or business is conducted." However, I.R.C. §280E does not preclude a deduction for the cost of goods sold (COGS).[3] So, the expenses involved in purchasing or growing the marijuana inventory are deductible. Any other expenses incurred by a seller, such as utilities and wages, are disallowed under I.R.C. §280E.

With the above information in mind . . . let's get into the weeds.

What Was This Joint's Story?

During 2009 through 2011, the petitioners were married and filed joint tax returns. In 2009, one of the petitioners incorporated Altermeds, LLC, under Colorado law. Medicinal marijuana was legal under Colorado law; however, it was illegal under federal law. Soon after incorporation, Altermeds, LLC, opened a dispensary-a retail store-in Colorado.

The dispensary sold various forms of marijuana. During 2010 and 2011, the dispensary began selling products that did not contain marijuana but were used to facilitate consumption of marijuana. These non-marijuana products were purchased from third-party sellers. Services were not provided.

In 2010, legislation went into effect that required medical marijuana businesses to grow at least 70% of the marijuana sold to customers.[4] Altermeds, LLC, acted quickly to comply with the new law. It rented a warehouse and grew marijuana, while still purchasing an allowable amount from third parties. While Altermeds, LLC, clearly had employees, no records were kept that distinguished between hours worked at the growing site versus the dispensary.

Petitioners reported Altermeds, LLC, income on Schedule Cs of their 2010 and 2011 joint returns. In 2010, the sales of non-marijuana products were 1.4% of gross receipts. In 2011, 3.6% of gross receipts were the result of the sales of non-marijuana products. Furthermore, based on the findings of fact, the petitioners did not limit any deductions under I.R.C. §280E. Finally, the amount of COGS claimed was predominantly comprised of amounts paid for inventory purchases-without including production costs.

The years basically presented as follows:

The 2010 and 2011 returns were audited by the IRS. After reducing the allowable deduction for COGS in each year and denying nearly all of the business-expense deductions, the notice of deficiency resulted in the following proposed tax and penalties:

Petitioners wanted to hash this out in court, so they filed a petition with the Tax Court for redetermination of the deficiencies.

And the Arguments Went Up in Smoke

Petitioners presented different arguments in an effort to preserve the denied deductions. First, petitioners emphasized that Altermeds, LLC, sold non-marijuana merchandise. In petitioners' opinion, the sale of non-marijuana items constituted a separate business from the sale of marijuana, and as such, couldn't be subject to the limitations in I.R.C. §280E. While a similar argument persuaded the court in Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP),[5] the court here considered things differently. Rather, the court found that:

Under the circumstances, we hold that selling non-marijuana merchandise was not separate from the business of selling marijuana merchandise. First, Altermeds, LLC, derived almost all of its revenue from marijuana merchandise. Second, the types of non-marijuana products that it sold (pipes and other marijuana paraphernalia) complemented its efforts to sell marijuana."

Furthermore, according to the court, even if it agreed that there was a separate business, the "failure to properly brief the amount of deductions that would be attributable to this business would preclude us from allowing any deductions for the separate business." In other words, Altermeds, LLC's records failed to substantiate their marijuana versus non-marijuana expenses.

Next, petitioners argued that its non-deductible business expenses had been overstated and deductible COGS had been understated. Again, poor record-keeping prompted the court to state that:

Alterman and Gibson's argument for cost-of-goods-sold allowances relies entirely on purchase costs and production costs. It assumes that cost of goods sold equals purchase costs plus production costs. Thus, their method leaves out beginning inventory and ending inventory. Such a method is indeed improper.

The petitioners tried an alternate argument here, citing Cohan v. Commissioner,[6]-that the Court should estimate beginning and ending inventories. The court made it blatantly clear that the lack of proper record keeping here made that an "impossible" task. The court held that the amount of COGS conceded to by the IRS-an amount that did not include production costs-was the correct amount, because there had been no proper record-keeping.

As for the negligence penalty, the court agreed that the petitioners were negligent-again because they did not maintain proper records.

The Lesson

Dispensaries and other businesses subject to I.R.C. §280E must maintain proper records. That includes: (1) properly classifying costs as inventory costs, (2) maintaining beginning and ending inventories, (3) keeping all substantiation, and (4) overall careful preparation of returns. Otherwise, the IRS has an efficient way to kill your buzz-it will deny all of your business expense deductions that aren't COGS.

If you have tax questions related to IRC 280E, please contact Eli Noff at Frost & Associates, LLC today.

[1] TC Memo 2018-83.

[2] 21 U.S. Code §812(b).

[3] S. Rep. No. 97-494 Vol. 1, 309 (1982).

[4] Colo. Rev. Stat. sec.12-43.3-103(b)(2) (2010).

[5] 128 T.C.173, 183 (2007).

[6] 39 F.2d 540, 543-544(2d Cir. 1930).


Permalink 12:51:48 pm, by dmerritts Email , 1325 words   English (US) latin1
Categories: News

Virtual and Economic Contacts Establish Nexus for Sales Tax

By: Eli Noff, Partner & Mary Lundstedt

On June 21, 2018, the Supreme Court delivered its highly anticipated decision in South Dakota v. Wayfair, Inc., et al.[1] The 5-4 decision discards the antiquated "physical presence rule" - a rule which has allowed retailers lacking a physical presence in a state to avoid any obligation to collect and remit sales taxes. Significantly, the Court overruled the long-standing interpretation of the Commerce Clause, finding that "the physical presence rule of Quill is unsound and incorrect,"[2] and that virtual and economic contacts may indeed satisfy the necessary substantial nexus requirement.


The Commerce Clause in the U.S. Constitution empowers Congress to regulate interstate commerce;[3] however, it does not function as an express limitation on the states' ability to regulate commerce. Almost from its very beginning, the Supreme Court's interpretation of the Commerce Clause has been necessary for determining "its meaning, its reach, and the extent to which it limits state regulations of commerce."[4]

Most states have a sales tax applicable to the retail sales of goods and services. Typically, the seller must collect and remit the sales tax. As a backstop, if the seller fails in its duty, then the in-state consumers are typically supposed to pay a use tax at the same rate.

Over the years, the Supreme Court has considered various cases requiring interpretation of the Commerce Clause in the circumstance of an out-of-state retailer and its obligation, or lack thereof, to collect and remit sales tax. Throughout its decision-making, the Court has emphasized two principles that "mark the boundaries of a State's authority to regulate interstate commerce."[5] First, states may not regulate in a way that discriminates against interstate commerce. Secondly, states may not create an undue burden on interstate commerce. With these boundaries in mind, three pivotal cases culminated in the interpretation, now overruled, that only a seller with a "physical presence" in the taxing state was required to collect and remit the taxes.

In National Bellas Hess, Inc. v. Department of Revenue of Ill.,[6] the Court considered the extent to which an activity must be connected to a state, before the state has the power to tax it. The Court determined that in the case of a mail-order company, some type of physical presence (such as a solicitor or property) was required to establish a requisite "minimum contact" with the state, as required under both the Due Process Clause and the Commerce Clause. Without such minimum contact, states could not obligate an out-of-state seller to collect and remit tax.

A decade later, in Complete Auto Transit, Inc. v. Brady,[7] the Court created the four-pronged test used for deciding the sustainability of a state tax confronted with a Commerce Clause challenge. Per this test, a tax is sustained if "the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State."[8]

Subsequently, the Court definitively distinguished Bellas' "minimum contact" from Complete Auto's "substantial nexus." In Quill Corp. v. North Dakota, the Court, clarified that the Commerce Clause's "substantial nexus" prong requires something more than the "minimum contacts" requirement under the Due Process Clause.[9] In short, Quillsolidified the interpretation that "substantial nexus" requires a "physical presence" as indicated in Bellas.

Obviously, during the twenty-six-year period since Quill, the Internet dramatically changed the interstate marketplace. The combination of the expansion of e-commerce, the states' inability to tax sellers lacking a physical presence, and the impracticability of the use tax as a backstop, has caused substantial depletion to the states' revenue coffers.

Correcting the Error of Quill

Recently, South Dakota, declaring a financial "emergency" (directly tied to the loss of revenue due to the inability to compel out-of-state retailers to collect and remit taxes), enacted legislation imposing tax obligations on certain sellers lacking a physical presence in the state.[10] South Dakota sought state court validation of the legislation and an injunction requiring respondents-Wayfair and other prominent online retailers without a physical presence in the state-to comply with the act. Respondents maintained the act was unconstitutional, and eventually, the State Supreme Court agreed. The Supreme Court granted certiorari to hear the matter.

The Court carefully considered its own interpretive obligation, stating that "if it becomes apparent that the Court's Commerce Clause decisions prohibit the States from exercising their lawful sovereign powers, the Court should be vigilant in correcting the error."[11]After a thorough review of the development of the physical presence rule, the Court found Quill "flawed" for three reasons:

First, the physical presence rule is not a necessary interpretation of the requirement that a state tax must be "applied to an activity with a substantial nexus with the taxing State." Complete Auto, 430 U. S., at 279. Second, Quill creates rather than resolves market distortions. And third, Quill imposes the sort of arbitrary, formalistic distinction that the Court's modern Commerce Clause precedents disavow.[12]

As pertaining to the first reason, the Court rather summarily stated that:

The reasons given in Quill for rejecting the physical presence rule for due process purposes apply as well to the question whether physical presence is a requisite for an out-of-state seller's liability to remit sales taxes. Physical presence is not necessary to create a substantial nexus.[13]

The Court introduced its second criticism of Quill, by Citing Philadelphia v. New Jersey,[14] which reiterated the fundamental principle that the Commerce Clause was designed to prevent states from creating situations of economic discrimination. The Court further stated that "it is certainly not the purpose of the Commerce Clause to permit the Judiciary to create market distortions."[15] Noting the burdens on brick and mortar companies which remote sellers escape, the Court stated that:

In effect, Quill has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a State's consumers-something that has become easier and more prevalent as technology has advanced.[16]

The Court was also clearly concerned that Quill creates an incentive to remain remote, and it stated that "rejecting the physical presence rule is necessary to ensure that artificial competitive advantages are not created by this Court's precedents." [17]

Finally, the Court found flaw in Quill's "arbitrary" and disparate treatment of economically identical actors. The Court considered an example contrasting two furniture businesses. The Court described one business as having limited inventory in a warehouse in South Dakota. The other business used a warehouse outside of the state, but it had a website with virtual showrooms accessible in every state (including South Dakota). The Court noted that:

By reason of its physical presence, the first business must collect and remit a tax on all of its sales to customers from South Dakota, even those sales that have nothing to do with the warehouse. [Citation omitted]. But, under Quill, the second, hypothetical seller cannot be subject to the same tax for the sales of the same items made through a pervasive Internet presence. This distinction simply makes no sense.[18]

Next, the Court readily pronounced the physical presence test as "artificial" and incompatible with the realities of modern e-commerce. According to the Court, a virtual showroom can actually provide "greater opportunities for consumer and seller interaction than might be possible for local stores."[19]

The Court continued its abrogation of the physical presence rule noting that the rule is an example of "an extraordinary imposition by the Judiciary on States' authority to collect taxes and perform critical public functions." The Court also clarified that the advantage remote sellers have over competitors with a physical presence in fact limits the "States' ability to seek long-term prosperity and has prevented market participants from competing on an even playing field."

In the end, the court found the respondents' virtual and economic contacts with South Dakota sufficient to establish nexus. The door is now open for the entry of other states pursuing South Dakota's legislative goal. It remains to be seen which state will be next to enact revised sales tax legislation, but we can be certain that change is coming.

If you have any questions about sales tax issues, please feel free to contact Eli Noff at Frost & Associates, LLC today.


Permalink 12:11:21 pm, by dmerritts Email , 420 words   English (US) latin1
Categories: News

HoweyCoin—Too Good To Be True

By Mary Lundstedt

"If you’ve ever been tempted to buy into a hot investment opportunity linked with luxury travel, the Securities and Exchange Commission has a deal for you." Sound too good to be true? It is. This announcement was made in the May 16, 2018 U.S. Securities and Exchange Commission (SEC) press release which was issued to explain the SEC’s latest educational tool related to virtual currencies.

The SEC created an enticing, but entirely fake initial coin offering (ICO), in order to teach investors how to detect fraudulent ICOs. The SEC’s ICO is called "HoweyCoin"—which is cleverly derived from the 1946 U.S. Supreme Court decision, SEC v. W.J. Howey Co., where the Court established the test (commonly known as the "Howey Test") for whether a transaction is an investment contract or a security. Under the Howey Test, a transaction is an investment contract, or a security, if: (1) there is an investment of money; (2) there is an expectation of profits from such investment; (3) the money is invested in a common enterprise, and (4) any profit is the result of a promoter’s or third party’s efforts.

The SEC’s HoweyCoin website is complete with a mock white paper (which is both vague and complex), promises of guaranteed returns, a clock that counts down the time left for the "deal" and an overall professional presentation of photography and contact information. However, clicking on the website’s "Buy Coins" link will take would-be-investors to SEC educational tools and tips, rather than the deal of a lifetime. According to the SEC press release, the website was quickly constructed and shows just how easily a scam may be implemented.

The press release quotes SEC Chairman Jay Clayton as stating, ""[t]he rapid growth of the ‘ICO’ market, and its widespread promotion as a new investment opportunity, has provided fertile ground for bad actors to take advantage of our Main Street investors." Clayton continues stating that "We embrace new technologies, but we also want investors to see what fraud looks like, so we built this educational site with many of the classic warning signs of fraud. Distributed ledger technology can add efficiency to the capital raising process, but promoters and issuers need to make sure they follow the securities laws. I encourage investors to do their diligence and ask questions."

Ultimately, the SEC wanted to remind people that "a free and simple way to protect your money is to research investments and the people who sell them."

If you have questions regarding cryptocurrency and tax implications, please contact Frost & Associates, LLC today.

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* Licensed to practice in Maryland, Florida, and the District of Columbia. May represent taxpayers nationwide in IRS disputes.
** Licensed in Maryland

10480 Little Patuxent Pkwy, Ste. 400
Columbia, MD 21044
(410) 497-5947
© 2018 Glen E. Frost