In Part I, we introduced the Feinberg vs. Commissioner of Internal Revenue case, which demonstrates the financial challenges faced by marijuana businesses due to their inability to deduct ordinary and necessary business expenses under 26 U.S. Code §280E. It also provides us with guidance as to the limits of expert testimony in Tax Court.
The Feinbergs (the owners of Total Health Concepts, a medical marijuana dispensary) submitted only one piece of evidence to substantiate their COGS allowance in excess of what the IRS had allocated following an audit of the dispensary – a report by a CPA who was supposedly an expert in marijuana industry cost accounting.
Inadmissible report leaves taxpayers with no evidence
The Tax Court ruled that the report was inadmissible for the following reasons:
- Many statements made in the report failed to reference their underlying source of information,
- Statements that did cite the underlying source of information did not include the data on which the CPA relied, and
- The report was not based on personal knowledge of the taxpayer’s business (the CPA attempted to reconstruct the taxpayer’s income tax returns based on industry averages, and used those figures in his opinion of their tax liability).
In short, the report did not include sufficient information or data to support its conclusions – the Tax Court could not determine that the expert’s opinions were “based on anything other than his own conjecture.” To add insult to injury, the expert’s report also included legal conclusions about which expenses may be treated as COGS –that is the job of the Tax Court, not of an expert witness!
By ruling that the report was inadmissible, the Tax Court removed all of the taxpayer’s evidence since the taxpayers did not present any of their other business records. The Court therefore also unable to determine whether other evidence might support a higher cost of goods sold.
How marijuana businesses should prepare for an audit
The result of Feinberg vs. Commissioner of Internal Revenue demonstrates that owners of marijuana businesses should prepare for audits in basically the same way that everyone else should – maintain records that validate the amount of income reported and that substantiate the deductions you took on your tax returns, and provide that information to the IRS if requested.
Don’t expect to get away with withholding information from the IRS by having a CPA present a reconstruction of your sales and activities based on industry averages. If you are being audited by the IRS, contact a member of Moskowitz, LLP’s experienced Cannabis Law Group today.