The Use of Expert Testimony in Tax Court, Part I

The IRS is very aggressive in its audits of marijuana businesses, doing “random audits” of nearly everyone in the industry – particularly if their operations are large and profitable. A recent case involving the owners of a Colorado medical marijuana dispensary highlights the devastating impact of federal tax law on cannabusinesses and the limits of using expert testimony in Tax Court.

More audits and higher taxes for marijuana businesses

After completing a round of Form 8300 audits of cannabis companies, the IRS turned its attention in 2016 to 26 U.S. Code §280E, which disallows deductions and credits for ordinary and necessary business expenses to businesses that deal in controlled substances prohibited under federal or state law.

Since only the cost of goods sold (COGS) is deductible for marijuana businesses, they obviously pay higher taxes than other businesses. While tax planning techniques such as classifying as many expenses as possible as COGS can help, a recent case shows that trying to use expert witness testimony instead of producing records that justify your expenses can backfire. The case also provides important information on what an expert’s report should contain for it to be admissible (and useful) in Tax Court.

Feinberg vs. Commissioner of Internal Revenue

After operating at a loss for many years, the owners of Total Health Concepts, a small medical marijuana dispensary, closed their doors for business. Following an audit of the dispensary’s tax returns from 2009 through 2011, the IRS adjusted the dispensary’s ordinary and necessary business deductions and cost of goods sold, disallowed certain business expenses, and issued a tax bill for roughly $300,000.

The case went to litigation. Note that IRS demands for records involving marijuana sales are generally opposed by the industry – here, the owners’ initial attempts at circumventing discovery were unsuccessful and they were compelled by the Tax Court to provide documents requested by the IRS.

The owners either refused or were unable to submit that documentation, and instead produced a report drafted by a CPA who was supposedly an expert in marijuana industry cost accounting. The CPA’s report was intended to substantiate the taxpayer’s COGS allowance in excess of what the IRS had allocated.

This course of action was detrimental to their case.

We continue discussion on the use of expert testimony in tax court in Part II