Olive v. Commissioner

MARTIN OLIVE, PETITIONER v. COMMISSIONER OF INTERNAL
REVENUE, RESPONDENT
Docket No. 14406–08. Filed August 2, 2012.

P operates a sole proprietorship whose principal business is
the retail sale of medical marijuana pursuant to California
law. The business also provides minimal activities and serv-
ices incident to the sales. P failed to maintain sufficient
records to substantiate the business’ income or expenditures.
Held: P underreported the business’ gross receipts in amounts
R alleges in an amendment to answer. Held, further, P may
deduct cost of goods sold for the business in amounts greater
than those R allows. Held, further, I.R.C. sec. 280E precludes
P from deducting any expense related to the business in that
the business is a single business that consists of trafficking in
a controlled substance. Californians Helping to Alleviate Med.
Problems, Inc. v. Commissioner, 128 T.C. 173 (2007), distin-
guished. Held, further, P is liable for accuracy-related pen-
alties under I.R.C. sec. 6662(a) to the extent stated.

Henry G. Wykowski and Chris Wood (student), for peti-
tioner.
Daniel J. Parent, for respondent.
KROUPA, Judge: This case stems from the operation of peti-
tioner’s sole proprietorship, the Vapor Room Herbal Center
(Vapor Room). The Vapor Room’s principal business is the
retail sale of marijuana (medical marijuana) pursuant to the
California Compassionate Use Act of 1996 (CCUA), codified at
Cal. Health & Safety Code sec. 11362.5 (West 2007). 1 The
Vapor Room provides minimal activities and services as part
of its principal business of selling medical marijuana.
Respondent determined deficiencies of $367,531 and
$1,146,633 in petitioner’s Federal income tax for 2004 and
2005, respectively, after determining that petitioner failed to
substantiate any costs of goods sold (COGS) or expenses
reported for the Vapor Room. Respondent also determined for
1 Unless otherwise indicated, section references are to the applicable versions of the Internal

Revenue Code (Code), Rule references are to the Tax Court Rules of Practice and Procedure and
dollar amounts are rounded to the nearest dollar.

19

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 20 139 UNITED STATES TAX COURT REPORTS (19)

the respective years that petitioner was liable for section
6662(a) accuracy-related penalties of $73,506 and $229,327
due to substantial understatements of income tax or, alter-
natively, negligence or disregard of rules and regulations.
Respondent, in an amendment to answer, increased the defi-
ciencies to $692,501 for 2004 and $1,199,814 for 2005 to
reflect unreported gross receipts that respondent discovered
after he issued the deficiency notice. Respondent correspond-
ingly increased the accuracy-related penalties to $138,500
and $239,963.
We decide as to the Vapor Room for 2004 and 2005:
1. whether petitioner underreported gross receipts in
amounts respondent alleges in an amendment to answer. We
hold he did;
2. whether petitioner may deduct COGS in amounts greater
than those respondent allows. 2 We hold he may to the extent
stated;
3. whether petitioner may deduct his claimed expenses. We
hold he may not; and
4. whether petitioner is liable for the accuracy-related pen-
alties. We hold he is to the extent stated.

FINDINGS OF FACT

I. Preliminaries
The parties submitted stipulated facts and exhibits. We
incorporate the stipulated facts and exhibits by this ref-
erence. Petitioner is a high school graduate who resided in
California when he filed the petition. He filed Federal income
tax returns for 2004 and 2005 and included in each return
a Schedule C, Profit or Loss From Business (Sole Proprietor-
ship), reporting the Vapor Room’s gross receipts, COGS and
expenses for the corresponding year. He reported that the
Vapor Room’s ‘‘principal business’’ is ‘‘Retail Sales’’ and that
its product is ‘‘Herbal.’’

2 COGS is not a deduction within the meaning of sec. 162(a) but is subtracted from gross re-

ceipts in determining a taxpayer’s gross income. See Max Sobel Wholesale Liquors v. Commis-
sioner, 69 T.C. 477 (1977), aff ’d, 630 F.2d 670 (9th Cir. 1980); sec. 1.162–1(a), Income Tax Regs.
We refer to COGS as a deduction for convenience.

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 (19) OLIVE v. COMMISSIONER 21

II. CCUA
The State of California’s voters approved the CCUA as a
ballot initiative in 1996. The CCUA is intended to ensure that
‘‘seriously ill Californians’’ (recipients) can obtain and use
marijuana if physicians recommend marijuana as beneficial
to recipients’ health. Numerous medical marijuana
dispensaries were formed in California to dispense medical
marijuana to recipients. 3 Medical marijuana, however, is a
controlled substance under Federal law.
III. Petitioner Forms the Vapor Room
Petitioner, while pursuing a college degree in arts and edu-
cation, became involved in the medical marijuana industry
by volunteering at a medical marijuana dispensary in San
Francisco, California. The dispensary had a single business,
the dispensing of medical marijuana. Petitioner learned that
an approximately 1,250-square-foot room in his low-income
neighborhood of San Francisco was available to rent at a
minimal cost and he decided to abandon his college studies
during his second year and establish a medical marijuana
dispensary in the room. He sought the help of local friends
and marijuana suppliers and, on January 25, 2004, began
operating an unlicensed medical marijuana dispensary as a
sole proprietorship. 4 He named his dispensary the Vapor
Room. 5 He established the Vapor Room so that its patrons,
almost all of whom were recipients (including some with ter-
minal diseases such as cancer or HIV/AIDS) could socialize and
purchase and consume medical marijuana there. 6
Petitioner designed the Vapor Room with a comfortable
lounge-like, community center atmosphere, placing couches,
chairs and tables throughout the premises. He placed vapor-
izers, games, books and art supplies on the premises for
patrons to use at their desire. He set up a jewelry-store-like
3 Approximately
50 medical marijuana dispensaries were located in California in 2004.
4 Petitioner
was oblivious to the licensing requirement for his medical marijuana dispensary.
He received the requisite license from San Francisco in or about July 2004.
5 A vaporizer is an expensive apparatus that extracts from marijuana its principal active com-

ponent and allows the user to inhale vapor rather than smoke. Petitioner chose the name of
his business to publicize that the Vapor Room had the requisite equipment to allow patrons to
vaporize marijuana there.
6 We say ‘‘almost all’’ because patrons also included designated caregivers of the recipients,

who were entitled to receive medical marijuana for recipients. We use the term ‘‘patrons’’ to in-
clude only recipients.

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 22 139 UNITED STATES TAX COURT REPORTS (19)

glass counter with a cash register on top and jars of the
Vapor Room’s medical marijuana inventory displayed under-
neath and behind the counter.
IV. Operation of the Vapor Room
The Vapor Room was generally open for business (except
on some holidays) on weekdays from 11 a.m. to 8:30 p.m.,
and on weekends from noon to 8 p.m. The Vapor Room sold
nothing but medical marijuana (in three different forms) and
its patrons went to the Vapor Room primarily to consume
marijuana, knowing that it was readily available there. 7
Patrons also frequented the Vapor Room to socialize with
each other incident to consuming marijuana. Petitioner
required that each patron possess either a doctor’s rec-
ommendation to use medical marijuana or a similar certifi-
cate the San Francisco government issued. This documenta-
tion contained the person’s picture and identification
number, but not his or her name. Patrons came to know at
least the first name of the other patrons who regularly fre-
quented the Vapor Room.
The Vapor Room’s staff members (collectively, staff mem-
bers) were petitioner and a few other individuals (four
working as employees and an undisclosed number working as
volunteers) and all staff members qualified under the CCUA
to receive and consume medical marijuana. Neither the staff
members nor the other patrons paid petitioner a stated fee
to frequent the Vapor Room. Nor did petitioner require that
any patron purchase medical marijuana from him to frequent
the Vapor Room or to take part in its activities or services.
Patrons had access to all of the activities and services that
the Vapor Room provided and marijuana was routinely
passed throughout the room for consumption without cost to
patrons who wanted to partake.
The Vapor Room’s sole source of revenue was its sale of
medical marijuana and patrons did not specifically pay for
anything else connected with or offered by the Vapor Room.
Petitioner purchased for cash (or sometimes received for free)
the Vapor Room’s medical marijuana inventory from sup-
pliers, each of whom was eligible under the CCUA to receive
7 The medical marijuana in the Vapor Room’s inventory was in the following three forms: (1)

dried marijuana, (2) food (e.g., bakery goods, butter and candy) laced with marijuana and (3)
a concentrated version of the principal active component of marijuana.

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 (19) OLIVE v. COMMISSIONER 23

and consume marijuana. Petitioner typically purchased high-
quality marijuana to dispense to the patrons and he allowed
them to consume the marijuana virtually anywhere on the
premises. Petitioner sold to the patrons for cash 93.5% of the
marijuana that he received and he gave the rest to patrons
(including himself and the other staff members) for free. One
to three staff members monitored the counter in the Vapor
Room and they explained to patrons the attributes and
effects of the different types of medical marijuana in the
Vapor Room’s inventory. Petitioner set each patron’s cost for
the medical marijuana according to the quantity desired, the
quality of the marijuana and the amount petitioner decided
the patron should pay. Petitioner sometimes gave patrons
medical marijuana for free. Petitioner and the other staff
members occasionally sampled the medical marijuana inven-
tory for free and they would regularly ‘‘hang out’’ at the
Vapor Room after business hours and consume marijuana.
Staff members and other patrons sometimes consumed med-
ical marijuana together. 8
Petitioner provided regular activities at the Vapor Room,
such as yoga classes, chess and other board games and
movies (with complimentary popcorn and drinks). Patrons
sometimes consumed medical marijuana while participating
in these activities. The Vapor Room regularly offered chair
massages with a therapist. Patrons sometimes consumed
medical marijuana before or after a massage. Patrons, while
at the Vapor Room, regularly drank complimentary tea or
water and they occasionally ate complimentary snacks or
light food such as pizza and sandwiches.
Staff members explained to patrons the promoted benefits
of vaporizing marijuana (as opposed to smoking it). The staff
members also helped patrons understand how to operate a
vaporizer and the staff members helped patrons operate
a vaporizer upon request. Petitioner did not require that a
patron buy medical marijuana from the Vapor Room as a
condition of using one of the Vapor Room’s vaporizers and
patrons sometimes consumed in a vaporizer (or elsewhere in
8 Petitioner was not forthcoming with the specific prices at which he sold his marijuana or

the specific amount of medical marijuana that was consumed for free. Nor does the record con-
tain a formula for the price that petitioner charged a patron for medical marijuana or reveal
whether any discount price had a set floor such as the Vapor Room’s cost. Petitioner, during
2004, sold approximately 32% of the marijuana (inclusive of the portion he dispensed for free)
for less than what would otherwise have been the sale price.

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 24 139 UNITED STATES TAX COURT REPORTS (19)

the room) marijuana they obtained elsewhere. Staff members
sometimes delivered medical marijuana to terminally ill
patrons at locations other than the Vapor Room and joined
those patrons in consuming marijuana at those other loca-
tions. The Vapor Room’s staff members lived near the Vapor
Room.
Patrons discussed with other patrons (sometimes one-on-
one) their illnesses and their lives in general and they coun-
seled one another on various personal, legal or political mat-
ters related to medical marijuana. Staff members (or other
persons the Vapor Room retained) educated patrons or mem-
bers of the public on medical marijuana and about using
medical marijuana responsibly. The Vapor Room had a pro-
gram through which patrons wrote letters to individuals who
were incarcerated for distributing medical marijuana.
V. Vapor Room’s Gross Receipts, COGS and Reported Income
A. Reported Income
Petitioner’s tax returns for 2004 and 2005 reported that
the Vapor Room’s net income was $64,670 and $33,778,
respectively. 9 The net income was calculated as follows:

2004 2005
Gross receipts $1,068,830 $3,131,605
COGS 993,377 2,812,478

Gross income 75,453 319,127
Expenses:
Advertising -0- 660
Bank fees -0- 790
Deductible meals and entertain-
ment -0- 3,072
Depreciation -0- 11,506
Internet services and fee 1,605 -0-
Legal and professional services -0- 46,900
Office -0- 13,337
Payroll fees -0- 1,353
Postage and delivery -0- 13
Printing and reproduction -0- 1,952
Rent 4,000 14,300
Repairs and maintenance 730 3,505
Security services 750 412
Supplies 2,922 -0-
9 Petitioner used the cash method to compute the Vapor Room’s net income. Respondent does

not challenge petitioner’s use of that method. We discuss it no further.

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 (19) OLIVE v. COMMISSIONER 25

2004 2005
Taxes and licenses -0- 8,750
Telephone -0- 965
Travel 776 10
Utilities -0- 3,426
Wages -0- 175,934

Total 10,783 1 285,349

Net profit 64,670 33,778
1 The expenses in this column actually total $286,885, or $1,536
more than $285,349. Petitioner apparently reported the Vapor Room’s
‘‘Deductible meals and entertainment’’ at 100% of the reported cost
and then reduced the $286,885 to $285,349 (without noting so) to take
into account the 50% reduction of sec. 274(n).

B. Gross Receipts
Staff members noted the amount of the Vapor Room’s sales
for each business day as shown on the cash register tape and
counted the cash in the register. The total daily sales as
ascertained by the cash register tape and by the daily count
were recorded in a book (recording book).
Petitioner’s Schedules C for 2004 and 2005 reported gross
receipts of $1,068,830 and $3,131,605, respectively. The gross
receipts reported on the Schedule C for 2004, however, did
not include any gross receipts received before July 14, 2004.
C. COGS
Petitioner’s Schedules C for 2004 and 2005 reported that
the Vapor Room’s COGS were $993,337 and $2,812,478,
respectively. These amounts were calculated as follows:

2004 2005

Purchases less cost of items with-
drawn for personal use -0- $2,796,724
Cost of labor $88,209 -0-
Materials and supplies 905,168 15,754

COGS 993,377 2,812,478

The labor amounts represent petitioner’s payments to mari-
juana growers in return for marijuana that they grew.

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 26 139 UNITED STATES TAX COURT REPORTS (19)

D. Expenses
Petitioner paid the Vapor Room’s expenses by using cash
from the cash register or by using a check or a debit card
drawn on a bank account that petitioner opened as a sole
proprietor ‘‘DBA Vapor Room.’’ Petitioner opened this account
on July 6, 2004, and he regularly deposited funds into the
account to cover the draws from the account.
Petitioner paid the Vapor Room’s employees through a pay-
roll service. Petitioner paid the employees (who were the
same individuals in both 2004 and 2005) wages of $37,588
and $96,965. Petitioner reported those wages to the Internal
Revenue Service for Federal employment tax purposes. None
of the employees had a specific job at the Vapor Room and
each employee at one time or another performed all required
jobs.
Respondent concedes that petitioner paid the following
ordinary and necessary business expenses during 2004 and
2005:
Expense 2004 2005
Advertising -0- $650
Bank and payroll (Paychex) fees $557 1,271
Bottled water -0- 473
Employment taxes 3,002 7,609
Garbage -0- 317
Office expense and supplies 2,992 13,337
Phone and Internet 681 784
Postage -0- 13
Rent 12,000 12,300
Repairs and maintenance -0- 2,297
Security alarm monitoring 361 413
Security system/locksmith -0- 11,506
Utilities 748 1,731
Wages 37,588 96,965

Total 57,929 149,666

The items underlying the office expense and supplies for
2004 include office supplies (e.g., labels), paper cups, a step
ladder, a shredder, zip bags, glass canisters, a degreaser,
marijuana rolling papers and lighters. The advertising
expense for 2005 relates to advertisements aimed at medical
marijuana audiences. The items underlying the office
expense and supplies for 2005 include paper towels, mari-
juana-related calendars, magazines and books, marijuana

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 (19) OLIVE v. COMMISSIONER 27

rolling papers, zip bags, vaporizer bags, lighters, brown
paper bags, containers and storage jars.
E. Petitioner’s Withdrawals
Petitioner regularly took cash from the cash register to use
personally, including to pay for personal trips to New York,
New York, to Barcelona, Spain, to Amsterdam, the Nether-
lands, to Venice, Italy, to Cabo San Lucas, Mexico, and to the
British Virgin Islands. He coded these withdrawals in the
recording books so that the Vapor Room’s employees would
not know the amount of money he was taking from the busi-
ness.
VI. Audit
Respondent began auditing petitioner’s 2004 tax return in
April 2006 and respondent’s revenue agent met with peti-
tioner (accompanied by his independent accountant/tax pre-
parer William Ehardt and an attorney) on July 6, 2006. 10
The revenue agent requested the Vapor Room’s bank state-
ments and substantiation for COGS and petitioner gave the
revenue agent two documents Mr. Ehardt had prepared: a
document entitled ‘‘Vapor Room Profit and Loss January
through December 2004’’ (Ehardt P&L) and a document enti-
tled ‘‘Vapor Room General Ledger As of December 2004’’
(Ehardt GL). The Ehardt GL reports that the Vapor Room’s
first sale occurred on July 14, 2004. The Ehardt P&L and the
Ehardt GL each report that the Vapor Room’s total income
for 2004 was $1,068,830, which corresponds to the amount of
gross receipts reported on the Federal income tax return for
2004. Many (but not all) of the expenditures shown on the
Ehardt P&L and the Ehardt GL were reported on the return
for 2004.
The revenue agent next met with Mr. Ehardt in August
2006 (the second and last meeting that the revenue agent
had with petitioner or his representatives) and was informed
that petitioner had ‘‘ledgers’’ showing cash received for sales
and cash paid for purchases, but no further documents. Peti-
tioner did not tender any ledgers at that time.
10 Petitioner filed his Federal income tax return for 2005 during the last week of September

2006. The audit was expanded at or about that time to include 2005.

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 28 139 UNITED STATES TAX COURT REPORTS (19)

VII. Deficiency Notice
Respondent issued the deficiency notice to petitioner. The
deficiency notice states that petitioner may not deduct any of
the reported COGS on account of lack of substantiation. Peti-
tioner, after the deficiency notice was issued, provided
respondent’s counsel with $25,776 in receipts for COGS for
2004 and $27,370 in receipts for COGS for 2005. Respondent
concedes that petitioner may deduct those respective
amounts as COGS for 2004 and 2005.
The deficiency notice also states that petitioner may not
deduct any of the reported expenses on account of lack of
substantiation. Respondent later conceded that petitioner
substantiated the $57,929 and $149,666 of expenses pre-
viously mentioned but asserts that section 280E precludes
any deduction of these expenses. Respondent’s revenue agent
had relied upon sections 280E and 6001 during the audit to
disallow all of the Vapor Room’s reported expenses, but the
deficiency notice does not specifically say that. Respondent
formalized the applicability of section 280E in a second
amendment to answer.
VIII. Ledgers
Petitioner gave respondent five ledgers (collectively,
ledgers) during this proceeding. The credible evidence in the
record fails to establish when the ledgers were prepared. The
ledgers, however, do not appear to be (and we do not find
that they are) the same as the recording books.
The ledgers purport to show the Vapor Room’s receipts and
cash disbursements (not including payments through the
Vapor Room’s bank account) for January 25 through March
13, 2004; June 1 through October 30, 2004; November 1,
2004, through April 25, 2005; April 26 through October 8,
2005; and October 9, 2005, through February 18, 2006,
respectively. Petitioner has never produced a ledger (or
recording book) for the 79-day period from March 14 through
May 31, 2004.
The ledgers show categories of cash received and expendi-
tures made during each business day in a total figure for
each category and they list few (and in some cases no) spe-
cifics on the components of the categories. The ledgers some-

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 (19) OLIVE v. COMMISSIONER 29

times contain no identification for an expenditure. Petitioner
cannot definitively identify some of the entries in the ledgers.
The ledgers (as respondent adjusted for 2004 to reflect the
missing 79-day period) report that the Vapor Room’s gross
receipts for 2004 and 2005 were $1,967,956 and $3,301,898,
respectively.

OPINION

I. Overview
California law allows petitioner to dispense medical mari-
juana to the recipients through the Vapor Room. Federal law
prohibits taxpayers, however, from deducting any expense of
a trade or business that consists of the trafficking of a con-
trolled substance such as marijuana. See sec. 280E. We are
asked to decide whether the Vapor Room, a medical mari-
juana dispensary permitted by California law, may deduct
any of its expenses. We also are asked to decide whether
petitioner underreported the Vapor Room’s gross receipts,
whether petitioner overreported the Vapor Room’s COGS and
whether petitioner is liable for an accuracy-related penalty.
We first discuss the burden of proof and our perception of
the witnesses. We then decide the referenced issues.
II. Burden of Proof
Petitioner bears the burden of proving that respondent’s
determination of the deficiencies set forth in the deficiency
notice is incorrect. See Rule 142(a)(1); Welch v. Helvering,
290 U.S. 111, 115 (1933). Section 7491(a) sometimes shifts
the burden of proof to the Commissioner, but that section
does not apply where a taxpayer fails to satisfy the record-
keeping and substantiation requirements. See sec.
7491(a)(2)(A) and (B). Petitioner has failed to satisfy those
requirements. Respondent bears the burden of proof only
with respect to the increased deficiencies pleaded in the
amendment to answer. 11 See Rule 142(a)(1).

11 Petitioner does not argue that respondent bears the burden of proving the applicability of

sec. 280E. We need not decide that issue because our resolution of that issue does not rest on
which party bears the burden of proof. See Estate of Morgens v. Commissioner, 133 T.C. 402,
409 (2009), aff ’d, 678 F.3d 769 (9th Cir. 2012); see also Knudsen v. Commissioner, 131 T.C. 185,
186–189 (2008).

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 30 139 UNITED STATES TAX COURT REPORTS (19)

III. Witness Testimony
We determine the credibility of each witness, weigh each
piece of evidence, draw appropriate inferences and choose
between conflicting inferences in finding the facts of a case.
The mere fact that one party presents unopposed testimony
on that party’s behalf does not necessarily mean that we will
find the elicited testimony to be credible. We will not accept
the testimony of witnesses at face value to the extent we per-
ceive the testimony to be incredible or otherwise unreliable.
See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43,
84 (2000), aff ’d, 299 F.3d 221 (3d Cir. 2002); see also Ruark
v. Commissioner, 449 F.2d 311, 312 (9th Cir. 1971), aff ’g per
curiam T.C. Memo. 1969–48; Clark v. Commissioner, 266
F.2d 698, 708–709 (9th Cir. 1959), aff ’g in part and
remanding T.C. Memo. 1957–129.
Petitioner’s testimony and the testimony of his other wit-
nesses were rehearsed, insincere and unreliable. We do not
rely on petitioner’s testimony to support his positions in this
case, except to the extent his testimony is corroborated by
reliable documentary evidence. We also do not rely on the
uncorroborated testimony of petitioner’s other witnesses,
three of whom are (or were) patrons of the Vapor Room and
all of whom are closely and inextricably connected with the
medical marijuana industry and with a desired furtherance
of that movement.
IV. Unreported Gross Receipts
We start our analysis of the substantive issues by deter-
mining the amount of the Vapor Room’s gross receipts. Peti-
tioner reported that the Vapor Room’s gross receipts were
$1,068,830 for 2004 and $3,131,605 for 2005. Respondent did
not adjust those amounts in the deficiency notice. Petitioner
later, however, gave respondent the ledgers that revealed
that the Vapor Room’s gross receipts were greater than the
reported amounts. Respondent then computed the Vapor
Room’s gross receipts using the ledgers. Respondent first
totaled the cash that petitioner recorded in the ledgers for
each year as sales receipts ($1,513,370 and $3,301,898,
respectively). Respondent then extrapolated from the ledgers’
recording of the sales receipts for 2004 that the Vapor
Room’s total sales during the missing 79-day period were

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 (19) OLIVE v. COMMISSIONER 31

$454,586. Respondent concluded that the Vapor Room’s gross
receipts for 2004 and 2005 were $1,967,956 ($1,513,370 +
$454,586) and $3,301,898, respectively, and asks the Court to
find the same.
Petitioner does not dispute that he underreported the
Vapor Room’s gross receipts for 2004 and 2005 (including
that he failed to report any gross receipts received before
July 14, 2004). He asks the Court, however, to find that the
Vapor Room’s gross receipts for the respective years totaled
$1,969,331 and $3,264,798 (i.e., $1,375 more and $37,100 less
than the respective amounts respondent determined). He
supports his proposed finding with citations to profit and loss
statements that his current accountant, Marlee Taxy, C.P.A.,
prepared for the respective years. One statement reports
without further explanation that the Vapor Room’s ‘‘Sales (as
per Ledger)’’ for 2004 were $1,948,882 (inclusive of a
$450,904 adjustment to reflect the 79 missing days) and that
its total income for 2004 also included a $20,448 upward
adjustment for ‘‘Actual to agree with cash in Ledger’’
($1,948,882 + $20,448 = $1,969,331). The other statement
reports without further explanation that the Vapor Room’s
‘‘Sales (as per Ledger)’’ for 2005 were $3,308,328 and that its
total income for 2005 also included a $43,530 downward
adjustment for ‘‘Actual to agree with cash in Ledger’’
($3,308,328 – $43,530 = $3,264,798). Neither petitioner nor
any of his witnesses explained the calculation of the numbers
in those statements.
Petitioner’s reporting in the ledgers of the Vapor Room’s
sales is reliable evidence of the amount of the Vapor Room’s
gross receipts for 2004 and 2005. Respondent and Ms. Taxy
calculated the Vapor Room’s gross receipts using those
ledgers. They arrived at slightly different totals for each
year. We place more weight on respondent’s calculations.
They were accompanied by sufficient detail. We accept
respondent’s computation as the more accurate calculation of
the Vapor Room’s gross receipts for 2004 and 2005. We hold
that the Vapor Room’s gross receipts for the respective years
were $1,967,956 and $3,301,898. We note that petitioner in
his answering brief sets forth no objection to respondent’s
request in his opening brief that the Court find that the
ledgers (as adjusted for the missing period) stated that the

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 32 139 UNITED STATES TAX COURT REPORTS (19)

Vapor Room’s sales during the respective years were in the
amounts that respondent calculated.
V. COGS
We now turn to the parties’ dispute as to the Vapor Room’s
COGS. Petitioner argues that respondent arbitrarily deter-
mined the Vapor Room’s COGS in the deficiency notice
because the notice states that the Vapor Room’s COGS were
zero for 2004 and 2005. Petitioner argues that the burden of
proof is therefore upon respondent. See Helvering v. Taylor,
293 U.S. 507, 515 (1935); Palmer v. United States, 116 F.3d
1309, 1312 (9th Cir. 1997). We disagree that respondent’s
determination of the Vapor Room’s COGS was arbitrary so as
to shift the burden of proof on that issue to respondent.
A cash method taxpayer like petitioner may generally
deduct all ordinary and necessary expenses of the business
upon payment of those expenses. See sec. 162(a). Deductions
are strictly a matter of legislative grace, however, and peti-
tioner must prove he is entitled to deduct the Vapor Room’s
claimed amounts of COGS (as well as the Vapor Room’s
claimed amounts of expenses). See Rule 142(a)(1); New Colo-
nial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Goldsmith
v. Commissioner, 31 T.C. 56, 62 (1958); Hahn v. Commis-
sioner, 30 T.C. 195, 198 (1958), aff ’d, 271 F.2d 739 (5th Cir.
1959); see also Briggs v. Commissioner, T.C. Memo. 2000–
380; King v. Commissioner, T.C. Memo. 1994–318, aff ’d with-
out published opinion, 69 F.3d 544 (9th Cir. 1995); Whatley
v. Commissioner, T.C. Memo. 1992–567, aff ’d without pub-
lished opinion, 21 F.3d 1119 (9th Cir. 1994). Petitioner is
required to maintain sufficient permanent records to
substantiate the Vapor Room’s deductions. See sec. 6001; see
also Briggs v. Commissioner, T.C. Memo. 2000–380; sec.
1.6001–1(a), (d), Income Tax Regs. Respondent’s determina-
tion in the notice of deficiency of the Vapor Room’s COGS as
zero reflects that petitioner failed to produce credible records
supporting any greater deductions of COGS. Petitioner, in
fact, concedes in his posttrial brief that he ‘‘freely admitted’’
to the revenue agent that he had no receipts for COGS.
Petitioner argues nonetheless that the ledgers alone are
sufficient substantiation for taxpayers operating in the med-
ical marijuana industry because, he states, that industry

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 (19) OLIVE v. COMMISSIONER 33

‘‘shun[s] formal ‘substantiation’ in the form of receipts.’’ We
disagree with petitioner that the ledgers standing alone are
sufficient substantiation. The ledgers did not specifically
identify the marijuana vendors or reflect any marijuana that
was received or given away. The ledgers neither were
independently prepared nor bore sufficient indicia of reli-
ability or trustworthiness. The substantiation rules require a
taxpayer to maintain sufficient reliable records to allow the
Commissioner to verify the taxpayer’s income and expendi-
tures. See sec. 6001; sec. 1.6001–1(a), Income Tax Regs.; see
also Obot v. Commissioner, T.C. Memo. 2005–195. Neither
Congress nor the Commissioner has prescribed a rule stating
that a medical marijuana dispensary may meet that substan-
tiation requirement merely by maintaining a self-prepared
ledger listing the amounts and general categories of its
expenditures. It is not this Court’s role to prescribe the spe-
cial substantiation rule that petitioner desires for medical
marijuana dispensaries and we decline to do so.
Petitioner seeks to strengthen the probative value of the
ledgers through his and Ms. Taxy’s testimony. He testified
that he contemporaneously recorded in the ledgers all of the
Vapor Room’s purchases of marijuana and Ms. Taxy testified
that she totaled the Vapor Room’s COGS for the respective
years at $1,651,554 and $2,713,128. Respondent rebuts that
petitioner has failed to substantiate that the amount of the
Vapor Room’s COGS exceeded $25,776 for 2004 or $27,370 for
2005. Respondent concludes that the Vapor Room’s COGS are
limited to the amounts petitioner was able to substantiate to
respondent’s satisfaction. We disagree with both parties.
The Vapor Room’s sales for the respective years were
$1,967,956 and $3,301,898. We consider it unreasonable to
conclude that the Vapor Room’s COGS totaled the small
amounts that respondent asks us to find. We also consider it
unreasonable, however, to conclude that the Vapor Room’s
COGS are those amounts set forth in the ledgers. We do not
believe that the COGS entries set forth in the ledgers are
entirely accurate and we decline to rely upon those entries
in their entirety. Petitioner consciously chose to transact the
Vapor Room’s business primarily in cash. He also chose not
to keep supporting documentation for the Vapor Room’s

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 34 139 UNITED STATES TAX COURT REPORTS (19)

expenditures. He did so at his own peril. 12 The mere fact
that we rely on the ledgers to determine the amounts of the
Vapor Room’s gross receipts is not necessarily inconsistent
with our refusing to rely upon the ledgers to determine the
amount of the Vapor Room’s COGS (or expenses). Nor are the
ledgers necessarily accurate as to COGS (and expenses)
simply because petitioner recorded more sales receipts in the
ledgers than he did in the Federal income tax returns he
filed for the years at issue. We find the expenditure entries
in the ledgers vague and incomplete in many instances.
Moreover, we seriously doubt that they were recorded
contemporaneously or accurately with the expenditures. 13
We also doubt that petitioner made each recorded expendi-
ture in the amount and for the purpose (if any) stated. 14
We are left to ascertain the Vapor Room’s COGS on the
basis of the record. The evidence is not satisfactory for this
purpose. We nevertheless must do our best with the mate-
rials at hand. ‘‘Absolute certainty in such matters is usually
impossible and is not necessary; * * * [we] make as close an
approximation as * * * [we] can, bearing heavily * * * upon
the taxpayer whose inexactitude is of his own making.’’
Cohan v. Commissioner, 39 F.2d 540, 543–544 (2d Cir. 1930);
accord Edelson v. Commissioner, 829 F.2d 828, 831 (9th Cir.
1987) (stating that ‘‘a court should allow the taxpayer some
deductions [under the Cohan rule] if the taxpayer proves he
[or she] is entitled to the deduction but cannot establish the
full amount claimed’’), aff ’g T.C. Memo. 1986–223; see also
Lollis v. Commissioner, 595 F.2d 1189, 1190 (9th Cir. 1979),
12 Petitioner asserts that he minimized the Vapor Room’s use of checks because he did not

want his bank to know that the Vapor Room was a medical marijuana dispensary. We find that
assertion incredible, especially given that petitioner informed the bank that his business was
named ‘‘Vapor Room.’’
13 The ledgers apparently were not available at the start of this proceeding when petitioner

admitted under Rule 90 that the Vapor Room started its business in July 2004. The ledgers
show sales for the Vapor Room on most (if not all) of the days from January 25 through March
13, 2004, and June 1 through October 30, 2004.
14 Petitioner informs us that California did not allow medical marijuana dispensaries to earn

a profit for the years at issue. The need to report no profit may improperly cause a dispensary
to understate gross receipts or to overstate expenditures. We are especially wary here, where
petitioner by his own admission understated his gross receipts and took steps to disguise his
cash withdrawals from his business to conceal them from his employees. We also note that peti-
tioner in his petition challenged only respondent’s disallowance of the COGS and expenses peti-
tioner reported on the returns and stated in the petition that he had incurred the reported ex-
penditures in the amounts stated (without mention of any greater or additional expense
amounts).

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 (19) OLIVE v. COMMISSIONER 35

aff ’g T.C. Memo. 1976–15; Goldsmith v. Commissioner, 31
T.C. at 62.
We are aided, in small part, by the testimony of Henry C.
Levy, C.P.A. Petitioner called Mr. Levy as an expert on the
medical marijuana industry and the Court recognized him as
such. Having said that, we generally found Mr. Levy to be
unreliable. He was unreliable in that he was not sufficiently
independent of petitioner and his cause (e.g., Mr. Levy is
petitioner’s current bookkeeper and accountant and has
approximately 100 other medical marijuana dispensaries as
clients). See Neonatology Assocs., P.A. v. Commissioner, 115
T.C. at 86–87. In addition, his testimony improperly con-
sisted mainly of legal opinions and conclusions. 15 See Gibson
& Assocs., Inc. v. Commissioner, 136 T.C. 195, 229–230
(2011); Alumax, Inc. v. Commissioner, 109 T.C. 133, 171
(1997), aff ’d, 165 F.3d 822 (11th Cir. 1999); see also United
States v. Scholl, 166 F.3d 964, 973 (9th Cir. 1999).
We have broad discretion to evaluate the cogency of an
expert’s analysis. We may adopt only those parts of an
opinion we consider to be reliable. See Helvering v. Nat’l Gro-
cery Co., 304 U.S. 282, 294–295 (1938); Neonatology Assocs.,
P.A. v. Commissioner, 115 T.C. at 85–86; IT & S of Iowa, Inc.
v. Commissioner, 97 T.C. 496, 508 (1991). Mr. Levy opined
that the average COGS of three of his medical marijuana
dispensary clients was 75.16% of their sales for 2005 and
that part of his opinion comports with Dr. Gieringer’s opinion
that the COGS of medical marijuana dispensaries ranged from
70 to 85% of sales during the years at issue. We consider
75.16% of sales to be a reasonable measure of the Vapor
Room’s COGS. We therefore adopt that percentage of sales as
a measure of the Vapor Room’s COGS for each year at issue.
This does not mean, however, that the Vapor Room’s COGS
equals 75.16% of its gross receipts. We are mindful that this
is not the right percentage because petitioner gave some of
the Vapor Room’s inventory to patrons for free and the par-
ties dispute whether the Vapor Room’s cost of that portion of
the medical marijuana is includable in the Vapor Room’s
15 Petitioner also called Dale Gieringer, Ph.D., and Ms. Taxy to testify as experts on the med-

ical marijuana industry and the Court recognized them as such. We similarly consider their tes-
timony to be unreliable for similar reasons. We adopt their opinions only to the limited extent
stated.

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 36 139 UNITED STATES TAX COURT REPORTS (19)

COGS. Petitioner argues that these costs are so includable.
We disagree.
Petitioner did not sell the marijuana underlying these
costs and he did not hold all the marijuana out for sale.
These costs, therefore, hardly reflect the cost of the goods
that petitioner sold. See Fuller v. Commissioner, 20 T.C. 308,
316 (1953), aff ’d, 213 F.2d 102 (10th Cir. 1954). Petitioner
acknowledges that inventory withdrawn for personal use is
not included in a COGS calculation and petitioner withdrew
the referenced medical marijuana from the Vapor Room’s
inventory of marijuana for sale. He personally consumed
some of it and gave the rest to his selected patrons for free.
Petitioner’s claim that he gave the marijuana to needy
patrons out of compassion, even if true (which we need not
decide), does not dictate a different result. 16 Inventory that
is given to a qualified charitable organization may receive
special treatment. The recipients of petitioner’s gratuities,
however, were not qualified charitable organizations. Nor
does the record or caselaw support petitioner’s characteriza-
tion of the free medical marijuana distributions as rebates to
customers. We conclude that the Vapor Room’s COGS for each
year at issue equals 75.16% of the Vapor Room’s gross
receipts for the year, as further adjusted to take into account
our finding that petitioner gave away 6.5% of the Vapor
Room’s purchases. 17 We therefore hold that the Vapor
Room’s COGS for 2004 and 2005 are $1,382,973 ($1,967,956 ×
75.16% × 93.5%) and $2,320,396 ($3,301,898 × 75.16% ×
93.5%), respectively.
VI. Expenses
A. Overview
We turn now to decide the parties’ dispute on the deduct-
ibility of the Vapor Room’s expenses. Respondent argues that
petitioner failed to substantiate expenses in amounts greater
than $57,929 for 2004 and $149,666 for 2005. Respondent
also argues that section 280E precludes petitioner from
16 Both staff members (including petitioner) and other patrons received medical marijuana for

free. The record does not disclose how much of the free marijuana actually went to ‘‘needy’’ indi-
viduals.
17 The medical marijuana petitioner gave away might arguably still qualify as an ordinary and

necessary business expense under sec. 162(a). We need not decide that issue, however, because
we hold later that sec. 280E precludes any such deduction.

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 (19) OLIVE v. COMMISSIONER 37

deducting any of those amounts notwithstanding that the
amounts were substantiated. Petitioner argues that he is
entitled to deduct the Vapor Room’s expenses in full. Peti-
tioner asserts that the Vapor Room’s expenses are as fol-
lows: 18
Expense 2004 2005
Advertising $1,466 $5,902
Bank fees 724 1,271
Charity -0- 7,810
Donations 683 3,330
Internet services and fee 2,219 784
Legal and professional services 390 36,670
Other 12,787 24,596
Payroll taxes 2,876 7,418
Rent 14,369 12,300
Repairs and maintenance 1,328 11,486
Security services 827 5,988
State -0- 1,547
Supplies 26,649 31,401
Taxes and licenses 195 2,500
Travel and meals and entertainment 2,549 3,602
Utilities 973 2,248
Wages:
Paid in cash 133,071 161,751
Paid through Paychex 37,588 96,965

Total 1 236,502 417,569
1 This column totals $238,694. Petitioner does not explain how his
total differs.

Petitioner asserts that section 280E, if applicable, which he
argues it is not, precludes deductions for the years at issue
of only $12,636 and $20,748 of expenses. He calculates those
amounts on the basis of his reading of our Opinion in
Californians Helping to Alleviate Med. Problems, Inc. v.
Commissioner (CHAMP), 128 T.C. 173 (2007). We disagree
with petitioner’s reading of our Opinion in CHAMP and fur-
ther find that the factual settings of CHAMP and this case
are distinguishable.
B. Substantiation
Petitioner has failed to maintain required permanent
records. He also has failed to substantiate the Vapor Room’s
18 The largest claimed expense is wages paid in cash. Petitioner opted not to specifically iden-

tify the purported recipients of these ‘‘wages.’’ We are troubled with petitioner’s claimed cash
transactions and doubt that any of the claimed cash wages were ever reported as income.

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 38 139 UNITED STATES TAX COURT REPORTS (19)

expenses with the exception of those expenses respondent
concedes. We decline to attempt to estimate any of his
expenses pursuant to Cohan v. Commissioner, 39 F.2d 540,
because, as discussed below, we hold that section 280E pre-
cludes any deduction of the Vapor Room’s expenses. See also
Lewis v. Commissioner, 560 F.2d 973, 977 (9th Cir. 1977)
(stating that the Cohan rule may not be applied to certain
expenses), rev’g on other grounds T.C. Memo. 1974–59; San-
ford v. Commissioner, 50 T.C. 823, 827–828 (1968) (same),
aff ’d, 412 F.2d 201 (2d Cir. 1969). We hold that petitioner
may not deduct any expense other than the expenses that
respondent concedes. Those conceded expenses, however,
must still fall outside section 280E to be deductible.
C. Section 280E
We now turn to section 280E. A taxpayer may not deduct
any amount for a trade or business where the ‘‘trade or busi-
ness (or the activities which comprise such trade or business)
consists of trafficking in controlled substances * * * which is
prohibited by Federal law.’’ 19 Sec. 280E. We have previously
held, and the parties agree, that medical marijuana is a con-
trolled substance under section 280E. See CHAMP, 128 T.C.
at 181; see also Gonzalez v. Raich, 545 U.S. 1 (2005); United
States v. Oakland Cannabis Buyers’ Coop., 532 U.S. 483
(2001).
Petitioner argues that he may deduct the Vapor Room’s
expenses notwithstanding section 280E because, he claims,
the Vapor Room’s business did not consist of the illegal traf-
ficking in a controlled substance. He argues that the illegal
trafficking in controlled substances is the only activity cov-
ered by section 280E. We disagree that section 280E is that
narrow and does not apply here. We therefore reject peti-
tioner’s contention that section 280E does not apply because
the Vapor Room was a legitimate operation under California
law. We have previously held that a California medical mari-
juana dispensary’s dispensing of medical marijuana pursuant
to the CCUA was ‘‘trafficking’’ within the meaning of section
280E. See CHAMP, 128 T.C. at 182–183. That holding
applies here with full force.
19 The parties agree that sec. 280E disallows deductions only for the expenses of a business

and not for its COGS. See also Californians Helping to Alleviate Med. Problems, Inc. v. Commis-
sioner, 128 T.C. 173, 178 n.4 (2007).

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 (19) OLIVE v. COMMISSIONER 39

Petitioner asserts that the Vapor Room provided caregiving
services in addition to dispensing medical marijuana. He
invites the Court to reinterpret section 280E more narrowly
than we did in CHAMP to reach only those illegal under-
ground businesses that have a single business of drug traf-
ficking. We decline to do so. The taxpayer in CHAMP was a
legitimate (under State law) operation that had a second
business (providing caregiving services) and we applied sec-
tion 280E there. The dispensing of medical marijuana, while
legal in California (among other States), 20 is illegal under
Federal law. Congress in section 280E has set an illegality
under Federal law as one trigger to preclude a taxpayer from
deducting expenses incurred in a medical marijuana dispen-
sary business. This is true even if the business is legal under
State law.
Petitioner argues alternatively that he may deduct all of
the Vapor Room’s expenses attributable to the Vapor Room’s
caregiving business. He asserts that he trafficked marijuana
only during the short time it took for the staff members to
pass the medical marijuana to the patrons in exchange for
payment and that the rest of the Vapor Room’s business was
providing caregiving services. He compares his business to
the medical marijuana dispensary in CHAMP. We found
there that the taxpayer had two businesses (one the dis-
pensing of medical marijuana and the other the providing of
caregiving services). Petitioner asserts that the Vapor Room’s
overwhelming purpose was to provide caregiving services,
that the Vapor Room’s expenses are almost entirely related
to the caregiving business and that the Vapor Room would
continue to operate even if petitioner did not sell medical
marijuana. We disagree. The record does not establish these
assertions. Moreover, as previously stated, all of the testi-
mony from petitioner and from his other witnesses was
rehearsed, not impartial and not credible. We find instead
that petitioner had a single business, the dispensing of med-
ical marijuana, and that he provided all of the Vapor Room’s
services and activities as part of that business.
20 Our research reveals for information purposes that 17 States and the District of Columbia

have legalized medical marijuana as of July 19, 2012. See http://medicalmarijuana.procon.org/
view.resource.php?resourceID=000881 (last visited July 19, 2012). Those States are Alaska, Ari-
zona, California, Colorado, Connecticut, Delaware, Hawaii, Maine, Michigan, Montana, Nevada,
New Jersey, New Mexico, Oregon, Rhode Island, Vermont and Washington. Id.

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 40 139 UNITED STATES TAX COURT REPORTS (19)

The record establishes that the Vapor Room is not the
same type of operation as the medical marijuana dispensary
in CHAMP that we found to have two businesses. The dif-
ferences between the operations are almost too numerous to
list. The dispensary there was operated exclusively for chari-
table, educational and scientific purposes and its income was
slightly less than its expenses. See CHAMP, 128 T.C. at 174,
176–177. The director there was well experienced in health
services and he operated the dispensary with caregiving as
the primary feature and the dispensing of medical marijuana
(with instructions on how to best consume it) as a secondary
feature. See id. at 174–175. Seventy-two percent of the
CHAMP dispensary’s employees (18 out of 25) worked exclu-
sively in its caregiving business and the dispensary provided
its caregiving services regularly, extensively and substan-
tially independent of its providing medical marijuana. See id.
at 175–176, 178, 183, 185. It rented space at a church for
peer group meetings and yoga classes and the church did not
allow marijuana on the church’s premises. See id. at 176. It
provided its low-income members with hygiene supplies and
with daily lunches consisting of salads, fruit, water, soda and
hot food. See id. at 175. Its members, approximately 47% of
whom suffered from AIDS, paid a single membership fee for
the right to receive caregiving services and medical mari-
juana from the taxpayer. See id. at 174–175. The names of
the dispensaries are even diametrically different. The name
of the dispensary there, ‘‘Californians Helping To Alleviate
Medical Problems,’’ stresses the dispensary’s caregiving mis-
sion. The name of the dispensary here, ‘‘The Vapor Room
Herbal Center,’’ stresses the sale and consumption (through
vaporization) of marijuana.
Petitioner essentially reads our Opinion in CHAMP to hold
that a medical marijuana dispensary that allows its cus-
tomers to consume medical marijuana on its premises with
similarly situated individuals is a caregiver if the dispensary
also provides the customers with incidental activities, con-
sultation or advice. Such a reading is wrong. A business that
dispenses marijuana does not necessarily consist simply of
the act of dispensing marijuana, just as a business that sells
other goods does not necessarily consist simply of the passing
of those goods.

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 (19) OLIVE v. COMMISSIONER 41

All facts and circumstances must be taken into account to
ascertain the parameters of a business. Two activities can be
separated or aggregated for tax purposes depending on the
‘‘degree of organizational and economic interrelationship
* * *, the business purpose which is (or might be) served by
carrying on the various undertakings separately or together
in a trade or business * * *, and the similarity of * * * [the]
undertakings.’’ Sec. 1.183–1(d)(1), Income Tax Regs.; see also
Tobin v. Commissioner, T.C. Memo. 1999–328 (listing certain
factors to consider in deciding whether a taxpayer’s
characterization of two or more undertakings as a single
activity for purposes of section 183 is unreasonable). The
Commissioner usually will accept a taxpayer’s characteriza-
tion of several undertakings either as a single activity or as
separate activities. See sec. 1.183–1(d)(1), Income Tax Regs.
The Commissioner will reject the characterization, however,
if it is artificial and cannot be reasonably supported under
the facts and circumstances of the case. See id. A taxpayer,
to be engaged in a trade or business for purposes of section
162, must be involved in the activity with continuity and
regularity and the taxpayer’s primary purpose for engaging
in the activity must be for income or profit. See Commis-
sioner v. Groetzinger, 480 U.S. 23, 35 (1987).
The facts here persuade us that the Vapor Room’s dis-
pensing of medical marijuana and its providing of services
and activities share a close and inseparable organizational
and economic relationship. They are one and the same busi-
ness. Petitioner formed and operated the Vapor Room to sell
medical marijuana to the patrons and to advise them on
what he considered to be the best marijuana to consume and
the best way to consume it. Petitioner provided the addi-
tional services and activities incident to, and as part of, the
Vapor Room’s dispensing of medical marijuana. Petitioner
and the Vapor Room’s employees were already in the room
helping the patrons receive and consume medical marijuana
and the entire site of the Vapor Room was used for that pur-
pose. The record does not establish that the Vapor Room paid
any additional wages or rent to provide the incidental serv-
ices and activities. Nor does the record establish that the
Vapor Room made any other significant payment to provide
the incidental activities or services. Petitioner also oversaw
all aspects of the Vapor Room’s operation and the Vapor

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 42 139 UNITED STATES TAX COURT REPORTS (19)

Room had a single bookkeeper and a single independent
accountant for its business. These facts further support our
conclusion that the Vapor Room had only one trade or busi-
ness. See Tobin v. Commissioner, T.C. Memo. 1999–328.
That petitioner may have sometimes overcharged patrons
for marijuana to subsidize the cost of the Vapor Room’s lim-
ited services or activities does not change our view. Peti-
tioner’s payment of the Vapor Room’s expenses to dispense
medical marijuana allowed the Vapor Room to fulfill its busi-
ness purpose of selling medical marijuana that in turn
allowed the Vapor Room to offer its incidental services and
activities in support of that purpose. Moreover, the Vapor
Room’s only revenue was from patrons’ purchase of mari-
juana. The Vapor Room would not have had any revenues at
all (and could not have operated) if none of the patrons had
purchased marijuana from petitioner. The Vapor Room did
not spawn a second business simply by occasionally providing
the patrons with snacks, a massage, or a movie, or allowing
the patrons to play games in the room and to talk there to
each other.
Petitioner also has not established that the Vapor Room’s
activities or services independent of the dispensing of med-
ical marijuana were extensive. He tried to establish that they
were but failed. His counsel, at trial, repeatedly asked peti-
tioner’s patrons/witnesses to describe ‘‘caregiving’’ services
that petitioner provided at the Vapor Room. The witnesses
strained to come up with any such service, other than
through their rehearsed statements that fell short of estab-
lishing caregiving services of the type and extent described
in CHAMP, 128 T.C. at 175–176. Petitioner’s actions spoke
loudly when he filed the tax returns for 2004 and 2005,
reporting that the Vapor Room’s principal business was the
retail sale of ‘‘herbal’’ (which we understand to be mari-
juana). We perceive his claim now that the Vapor Room actu-
ally consists of two businesses as simply an after-the-fact
attempt to artificially equate the Vapor Room with the med-
ical marijuana dispensary in CHAMP so as to avoid the dis-
allowance of all of the Vapor Room’s expenses under section
280E. We conclude that section 280E applies to preclude
petitioner from deducting any of the Vapor Room’s claimed
expenses.

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 (19) OLIVE v. COMMISSIONER 43

VII. Accuracy-Related Penalty
We now turn to decide whether petitioner is liable for an
accuracy-related penalty under section 6662(a). A taxpayer
may be liable for a 20% penalty on any underpayment of tax
attributable to negligence or disregard of rules or regulations
or any substantial understatement of income tax. See sec.
6662(a) and (b)(1) and (2). ‘‘Negligence’’ includes any failure
to make a reasonable attempt to comply with the provisions
of the Code and includes ‘‘any failure by the taxpayer to keep
adequate books and records or to substantiate items prop-
erly.’’ Sec. 6662(c); sec. 1.6662–3(b)(1), Income Tax Regs.
Negligence has also been defined as a lack of due care or
failure to do what a reasonable person would do under the
circumstances. See Allen v. Commissioner, 925 F.2d 348, 353
(9th Cir. 1991), aff ’g 92 T.C. 1 (1989). ‘‘Disregard’’ includes
any careless, reckless or intentional disregard of rules or
regulations. See sec. 6662(c); sec. 1.6662–3(b)(2), Income Tax
Regs. An individual’s understatement of income tax is
substantial if the understatement exceeds the greater of 10%
of the tax required to be shown on the return or $5,000. See
sec. 6662(d)(1)(A). An accuracy-related penalty does not
apply, however, to any portion of an underpayment for which
there was reasonable cause and where the taxpayer acted in
good faith. See sec. 6664(c)(1).
Respondent bears the burden of production to establish
that it is appropriate to impose the accuracy-related penalty.
See sec. 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446
(2001). The burden of proof is then upon petitioner (except
for the increased portions of the accuracy-related penalty
raised in the amendment to answer) if and once respondent
meets his burden of production. See Higbee v. Commissioner,
116 T.C. at 447, 449. Respondent bears the burden of proof
as to the increased portions of the accuracy-related penalty
raised in the amendment to answer. See Rule 142(a)(1).
Respondent argues that petitioner is liable for the
accuracy-related penalty to the extent he has understated
the Vapor Room’s gross receipts and failed to substantiate
the Vapor Room’s COGS and expenses. Petitioner’s sole argu-
ment in brief is that the penalty does not apply because, he
states, any inaccuracy underlying an understatement was
‘‘accidental, not substantial, and/or not negligent on the part

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 44 139 UNITED STATES TAX COURT REPORTS (19)

of the taxpayer.’’ Petitioner asserts that the Vapor Room was
his first business and that he was not instructed on the
proper way to keep the books and records of a business.
We agree with respondent that the accuracy-related pen-
alty applies in this case but disagree that it applies to the
full amounts of the underpayments. Respondent concedes
that petitioner substantiated $57,929 and $149,666 of the
Vapor Room’s reported expenses for 2004 and 2005, respec-
tively. We nonetheless disallowed the deduction of those
expenses under section 280E. The application of section 280E
to the expenses of a medical marijuana dispensary had not
yet been decided when petitioner filed his Federal income tax
returns for 2004 and 2005. The accuracy-related penalty does
not apply, therefore, to the portion of each underpayment
that would not have resulted had petitioner been allowed to
deduct his substantiated expenses. Cf. Van Camp & Bennion
v. United States, 251 F.3d 862, 868 (9th Cir. 2001) (‘‘Where
a case is one ‘of first impression with no clear authority to
guide the decision makers as to the major and complex
issues,’ a negligence penalty is inappropriate[.]’’ (quoting
Foster v. Commissioner, 756 F.2d 1430, 1439 (9th Cir. 1985),
aff ’g in part and vacating as to an addition to tax for neg-
ligence 80 T.C. 34 (1983))).
The accuracy-related penalty does apply, however, to the
remainder of each underpayment because those portions of
the underpayments are attributable to negligence. 21 Peti-
tioner consciously opted not to keep adequate books and
records and that action was in reckless or conscious dis-
regard of rules or regulations. See Higbee v. Commissioner,
116 T.C. at 449. He also did not record or report any of the
Vapor Room’s gross receipts for approximately the first six
months of its business. He also initially gave respondent’s
revenue agent one set of documents (the Ehardt GL and the
Ehardt P&L) that does not correspond with the ledgers he
now relies upon. Our decision to find petitioner liable does
not change even though the Vapor Room may have been peti-
tioner’s first business or he was not ‘‘instructed’’ on the
proper way to keep books. The Code requires that taxpayers
who decide to go into business for themselves maintain suffi-
21 The underpayments also appear to be ‘‘substantial’’ within the statutory definition of that

word. The accuracy-related penalty will also apply to the referenced portions of the underpay-
ments if that definition is met.

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 (19) OLIVE v. COMMISSIONER 45

cient records to substantiate their income and expenditures.
A reasonable person would have sought to comply with this
requirement. We sustain respondent’s determination (as
supplemented through the amendment to answer but as we
modify) that petitioner is liable for the penalty for each year.
VIII. Epilogue
We have considered all arguments that the parties made
and have rejected those arguments not discussed here as
without merit.
To reflect the foregoing,
Decision will be entered under Rule 155.

f

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