T.C. Memo. 2017-211
UNITED STATES TAX COURT
NEIL FEINBERG AND ANDREA E. FEINBERG, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
KELLIE MCDONALD, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 10083-13, 10084-13. Filed October 23, 2017.
James D. Thorburn and Richard A. Walker, for petitioners.
Luke D. Ortner, Matthew A. Houtsma, and Michael W. Lloyd, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
KERRIGAN, Judge: Petitioners in these consolidated cases are Neil
Feinberg (N. Feinberg) and Andrea E. Feinberg (together, Feinbergs), and Kellie
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[*2] McDonald (K. McDonald). For K. McDonald respondent determined
deficiencies of $13,369, $63,641, and $12,262 for tax years 2009-11, respectively.
For the Feinbergs respondent determined deficiencies of $47,203 and $35,809 for
2010 and 2011, respectively. Most of the deficiencies are attributable to income
adjustments for Total Health Concepts, LLC (THC).
After concessions the issues for consideration are whether petitioners have
substantiated that they should be allowed costs of goods sold (COGS) greater than
those allowed in respondent’s examination report for THC and whether respondent
properly disallowed business expense deductions pursuant to section 280E.
Unless otherwise indicated, all section references are to the Internal Revenue Code
in effect for the tax years in issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
FINDINGS OF FACT
The stipulation of facts and the attached exhibits are incorporated herein by
this reference. Petitioners resided in Colorado when they timely filed their
petitions.
THC’s Business Activity
THC was a limited liability company organized under the laws of the State
of Colorado. Articles of organization for THC were filed with the Colorado
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[*3] secretary of state on October 12, 2009. K. McDonald was a shareholder of
THC for tax years 2009-11. N. Feinberg was a shareholder for tax years 2010-11.
The State of Colorado licensed THC to grow and sell medical marijuana,
and THC’s operating agreement stated that its purpose was to “promote the
cultivation and sale of medical marijuana products.” Its business operations began
in December 2009. During the tax years in issue it held licenses to operate at least
two medical marijuana dispensaries. THC leased a separate warehouse facility,
for which it held a license to operate a cultivation premises.
Tax Reporting
For the tax years in issue THC elected to be treated as an S corporation for
Federal income tax purposes and filed Forms 1120S, U.S. Income Tax Return for
an S Corporation. It reported ordinary business losses of $105,478, $295,321, and
$54,231 for tax years 2009-11, respectively. Each year THC calculated its total
income by subtracting COGS from gross receipts.
THC claimed deductions from total income for ordinary and necessary
business expenses (below-the-line deductions). It claimed below-the-line
deductions for salaries and wages, repairs and maintenance, rents, depreciation,
advertising, and “other deductions”, which it detailed on attached statements. It
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[*4] claimed total below-the-line deductions for business expenses of $110,405,
$687,093, and $498,723 for the tax years in issue, respectively.
Petitioners did not receive any compensation from THC. They reported
passthrough losses from THC on Schedules E, Part II, Income or Loss From
Partnerships and S Corporations, attached to their respective income tax returns.
The Feinbergs filed joint income tax returns for 2010-11.
Respondent’s Determination
On December 6, 2012, respondent issued THC an examination report for its
tax returns for the tax years in issue. The examination report proposed
adjustments to taxable income based on respondent’s determination that section
280E applied to THC. The report also made adjustments to COGS.
Respondent reclassified as COGS a number of THC’s expenses that were
claimed originally as below-the-line deductions. For both 2010 and 2011
respondent’s net adjustments allowed greater COGS than THC had actually
claimed on its original returns. However, respondent disallowed deductions for all
other business expenses not reclassified as COGS. The adjustments increased
THC’s taxable income for the tax years in issue by $104,051, $630,835, and
$375,442, respectively.
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[*5] On February 6, 2013, respondent issued K. McDonald and the Feinbergs
notices of deficiency that reflected the adjustments determined for THC. The
notices of deficiency reflected K. McDonald’s shares from THC as $52,025,
$157,708, and $93,861 for tax years 2009-11, respectively, and N. Feinberg’s
shares as $223,946 and $114,030 for 2010 and 2011, respectively.
OPINION
I. Burden of Proof
Generally, the taxpayer bears the burden of proving that the Commissioner’s
determinations set forth in the notice of deficiency are erroneous. Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). The taxpayer likewise bears the
burden of proving his or her entitlement to deductions and of substantiating the
amounts of items underlying claimed deductions. INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a), Income Tax Regs. At a
minimum petitioners must produce business records or other evidence
substantiating the amounts and the purpose of the deductions that they assert
respondent improperly disallowed. Higbee v. Commissioner, 116 T.C. 438, 440
(2001). Under section 7491(a) in certain circumstances the burden of proof may
shift from the taxpayer to the Commissioner. Petitioners have not claimed or
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[*6] shown that they meet the requirements of section 7491(a) to shift the burden
of proof to respondent as to any relevant factual issue.
II. Evidentiary Issues
During the trial petitioners produced no contemporaneous records or any
other business records pertaining to THC’s operations. Instead they rely
exclusively on an expert report.
In accordance with the Court’s standing pretrial order and Rule 143(g),
petitioners exchanged and submitted the expert report of Jim Marty, C.P.A., whom
they contend is an expert in cost accounting, with an emphasis in the marijuana
industry. In his report Marty opines on COGS for medical marijuana businesses in
Colorado during the tax years in issue. Petitioners contend that the report
establishes that the COGS respondent allowed THC for the tax years in issue were
incorrect.
Before trial respondent filed a motion in limine, asserting that the Marty
report should be excluded on the following grounds:
(1) Admitting the report is improper where petitioners have refused to
comply with any discovery requests; (2) the report is an attempt to
usurp the Court’s own role insofar as it attempts to substitute Mr.
Marty’s legal conclusions and unsupported factual assertions for the
Court’s role in applying the law to the facts of this case; and (3) the
report’s factual conclusions are not reliable.
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[*7] At the trial the Court deferred ruling on respondent’s motion in limine
because of the substantial effect on the case of eliminating petitioners’ primary
evidence. The Marty report was marked, and the related testimony of petitioners’
expert was heard solely as an offer of proof. Whether the report and testimony
will be received in evidence and considered in determining THC’s COGS for tax
years 2009-11 depends on application of principles expressed in Daubert v.
Merrell Dow Pharms., Inc., 509 U.S. 579 (1993), and rule 702 of the Federal Rules
of Evidence.
Respondent contends the Marty report reaches a number of speculative
conclusions regarding the amount of allowable COGS based wholly on his
“unscientific, unprincipled opinion”. Respondent further contends that there is no
analysis or reliable data for figures in the report. Petitioners contend that Daubert
does not apply to a bench trial.
Rule 702 of the Federal Rules of Evidence provides:
A witness who is qualified as an expert by knowledge, skill,
experience, training, or education may testify in the form of an
opinion or otherwise if:
(a) the expert’s scientific, technical, or other specialized
knowledge will help the trier of fact to understand the evidence or to
determine a fact in issue;
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[*8] (b) the testimony is based on sufficient facts or data;
(c) the testimony is the product of reliable principles and
methods; and
(d) the expert has reliably applied the principles and methods to
the facts of the case.
In Daubert, 509 U.S. at 592, the Supreme Court stressed the trial court’s role
as a “gatekeeper” in excluding at the outset evidence that is unreliable or
irrelevant. The trial judge must make “a preliminary assessment of whether the
reasoning or methodology underlying the testimony is scientifically valid and of
whether that reasoning or methodology properly can be applied to the facts in
issue.” Id. at 592-593. The reliability and relevancy standards are embodied in
rule 702 of the Federal Rules of Evidence, and they apply equally to expert
testimony that is not “scientific”. Kumho Tire Co. v. Carmichael, 526 U.S. 137,
148 (1999). Although special considerations apply to jury trials, the Daubert
analysis applies to bench trials as well as jury trials. Boltar, L.L.C. v.
Commissioner, 136 T.C. 326, 334 (2011) (citing Att’y Gen. of Okla. v. Tyson
Foods, Inc., 565 F.3d 769, 779 (10th Cir. 2009)).
The Marty report is brief and summary, and its content is unreliable.
Multiple statements in the report refer to no underlying source of information. For
other statements that do cite an underlying source, Marty has failed to include the
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[*9] information or data on which he relied. In many instances the report does not
reference or provide sufficient information or data for us to conclude that the
opinions expressed are based on anything other than his own conjecture.
The report states that during the tax years in issue the average wholesale
purchase price for medical marijuana remained between $2,000 and $3,000 per
pound. The report later posits an average purchase price of $2,500 per pound and
reconstructs an income and expense schedule for THC “assuming” that COGS
equaled 55% of gross sales. The report does not explain how or on what basis
Marty determined these sales figures, and the exhibits do not include any sales
records or other documents that would support them. The report asserts that tax
returns Marty’s firm prepared show that “actual” COGS for medical marijuana
businesses during the tax years in issue was between 66% and 100% (or more) of
gross sales.
The conclusions in the Marty report are an attempt to present reconstructed
income tax returns as evidence of petitioners’ correct tax liabilities. The report is
not based on personal knowledge of THC’s business. To determine the correct
COGS for THC, substantiation of THC’s expenses is necessary. A reconstructed
income tax return based on industry averages does not take the place of
substantiation and does not help determine a fact in issue.
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[*10] By relying on returns that Marty and his firm prepared for other businesses,
the Marty report provides the Court with legal conclusions as to which types of
expenses may be treated as COGS. Expert testimony about what the law is or that
directs the finder of fact on how to apply the law does not assist the trier of fact.
Stobie Creek Invs., LLC v. United States, 81 Fed. Cl. 358, 364 (2008). Expert
opinions on law are inadmissable. Fed. R. Evid. 702(a); see Hosp. Corp. of Am. v.
Commissioner, 109 T.C. 21, 59 (1997).
For the reasons stated above, we conclude that the Marty report is not
admissible under rule 702 of the Federal Rules of Evidence because is it is not
helpful in understanding evidence or in determining a fact and it includes legal
conclusions.
During the trial respondent offered Exhibits 32-R and 34-R through 39-R.
All were offered in relation to the Marty report, and the ruling on these exhibits
was reserved. These exhibits are not admitted because the Marty report was
excluded.
III. Cost of Goods Sold
A taxpayer engaged in manufacturing or merchandising can subtract
COGS from gross receipts to arrive at gross income. See secs. 1.61-3(a), 1.162-
1(a), Income Tax Regs.; see also Rodriguez v. Commissioner, T.C. Memo. 2009-
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[*11] 22, slip op. at 6. COGS is not a deduction but an offset to income for the
purpose of calculating gross income and is subtracted from gross income to arrive
at taxable income. See Kazhukauskas v. Commissioner, T.C. Memo. 2012-191,
slip op. at 24; Rodriguez v. Commissioner, slip op. at 6-7.
Petitioners must show that they are entitled to COGS for THC above and
beyond those respondent allowed. See Kazhukauskas v. Commissioner, slip op. at
24. The substantiation rules require a taxpayer to maintain sufficient reliable
records to allow the Commissioner to verify the taxpayer’s income and
expenditures. See sec. 6001; sec. 1.6001-1(a), Income Tax Regs.; see also Olive
v. Commissioner, 139 T.C 19, 32 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015).
COGS is determined under section 471 and the accompanying regulations.
See secs. 1.471-3(c), 1.471-11(c), Income Tax Regs. Petitioners contend we
should allow the COGS in THC’s income tax returns under the Cohan rule. See
Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). Petitioners further contend
that they should be able to subtract an amount for COGS based on industry
standards for the medical marijuana industry during the tax years in issue.
Respondent allowed COGS that were substantiated and also recharacterized
below-the-line expenses as COGS to the extent allowable under section 471.
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[*12] Petitioners produced no evidence to substantiate COGS higher than those
which respondent allowed.
The Court may estimate the amount of a deductible expense if a taxpayer
establishes that an expense is deductible but is unable to substantiate the precise
amount. See Cohan v. Commissioner, 39 F.2d at 543-544; Vanicek v.
Commissioner, 85 T.C. 731, 742-743 (1985). This principle is often referred to as
the Cohan rule. See, e.g., Van Dusen v. Commissioner, 136 T.C. 515, 537 n.39
(2011). The Cohan rule also applies to COGS. See Goldsmith v. Commissioner,
31 T.C. 56, 62 (1958).
In Cohan v. Commissioner, 39 F.2d at 544, the Court of Appeals for the
Second Circuit held that this Court should in some cases make “as close an
approximation as it can” with respect to a taxpayer’s deductible expenses,
“bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own
making.” The Court of Appeals for the Second Circuit stated that “to allow
nothing at all appears to us inconsistent with saying that something was spent.”
Id.
During the tax years in issue THC held licenses for selling medical
marijuana in Colorado. We will proceed as if THC was in the business of selling
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[*13] medical marijuana. However, there is not enough evidence in the record to
make a finding of fact that THC sold medical marijuana.
Respondent did allow for some COGS. Under the Cohan rule there must be
sufficient evidence in the record to provide a basis upon which an estimate can be
made. Vanicek v. Commissioner, 85 T.C. at 742-743. There is no evidence to
support higher COGS for THC. We sustain respondent’s allowances for COGS.
IV. Business Expenses
Deductions are a matter of legislative grace, and a taxpayer must prove his
or her entitlement to deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. at
84; New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Section 162(a)
permits a taxpayer to deduct ordinary and necessary expenses incurred during the
taxable year in carrying on a trade or business. Section 261 provides that “no
deduction shall in any case be allowed in respect of items specified in this part.”
“[I]tems in this part” refers to part IX of subchapter B of chapter 1, entitled “Items
Not Deductible”, and this includes section 280E, “Expenditures in Connection
With the Illegal Sale of Drugs”. See Californians Helping to Alleviate Med.
Problems, Inc. v. Commissioner, 128 T.C. 173, 180 (2007). Section 280E
provides:
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[*14] No deduction or credit shall be allowed for any amount paid or
incurred during the taxable year in carrying on any trade or business
if such trade or business (or the activities which comprise such trade
or business) consists of trafficking in controlled substances (within
the meaning of schedule I and II of the Controlled Substance Act)
which is prohibited by Federal law or the law of any state in which
such trade or business is conducted.
We do not need to address whether section 280E applies because petitioners
have failed to substantiate any expenses for which respondent disallowed
deductions. Petitioners did not produce any business records or any other
supporting documents. They have not met their burden of proving respondent’s
determinations in the notices of deficiency are incorrect. Respondent’s
determinations will be sustained.
To reflect the foregoing,
Decisions will be entered
for respondent.