On June 13, the U.S. Tax Court issued Tax Court Memo 2018-83, Alterman and Gibson v. Comm’r. Based on the way this case is being reported in the trade press, one might think that this decision portends doom and gloom for taxpayers in the cannabis industry. Such fears are not justified for anyone who maintains good records and does even basic tax planning.
The Alterman Tax Court held:
- Taxpayers selling both cannabis and paraphernalia were not carrying on a separate non-trafficking business and, therefore, could not allocate expenses between trafficking and non-trafficking businesses;
- Taxpayers failed to substantiate amounts allocable to cost of goods sold (COGS); and
- Taxpayers were subject to 20 percent accuracy-related penalties.
The doom and gloom of the holdings fade once you appreciate the relevant facts:
- Taxpayers’ non-trafficking business was limited to selling products that contained no cannabis (e.g., pipes, papers and other consumption-related items) and represented less than 5 percent of total revenue;
- Taxpayers’ kept very poor books and records;
- Taxpayers’ filed tax returns, which included facially “questionable” amounts for beginning and ending inventory, and which could not be traced to the balance sheet or general ledger;
- Taxpayers’ accountant prepared a profit and loss statement, but failed to produce supporting work-papers; and
- “The 2011 general ledger bizarrely recorded that ‘Total Inventory’ was $12,279, which was the same dollar amount recorded in the ‘Total Inventory’ entry in the 2010 ledger.”
The last point is an actual quote from the Tax Court’s findings of facts. Bad facts often result in bad law, especially when jurisprudence is summarized in the trade press where headlines attract readers and clicks. However, bad facts provide opportunities to distinguish yourself with good (or at least better) facts. So here are the key takeaways from the Aterman case that are worthy of attention:
- Taxpayers should maintain true, accurate and complete books and records; this taxpayer lost because of bad records not because the court overreached or applied Internal Revenue Code Section 280E in a particularly egregious manner;
- Alterman is a memorandum opinion that does not create new law or alter existing law;
- Taxpayers should identify and follow an inventory costing method that maximizes COGS;
- Taxpayers using a CHAMPS strategy to allocate non-COGS items between trafficking and non-trafficking businesses arguably requires some level of substance and recordkeeping — we generally recommend that clients conduct non-trafficking businesses in a separate legal entity and report on a separate income tax return;
- Taxpayers should engage competent accountants, bookkeepers and tax return preparers that understand applicable accounting methods and tax planning strategies; and
- Failing to keep accurate books and records may result in significant tax exposure and penalties.
With a little bit of luck, legislation pending in Congress will soon be enacted and henceforth relieve the state-legal industry of the unfair burden imposed by IRC Section 280E. But we can promise that no legislation will help taxpayers with shoddy record keeping.