Back to Basics: Laurel Alterman and William A. Gibson v. Commissioner of Internal Revenue

In the rapidly growing industry of cannabis, there are several important concepts for owners to understand. One of the most popular topics would be Internal Revenue Code (“IRC”) Section (“§”) 280E; passed in 1982, this code section prohibits companies that traffic Schedule I and II controlled substances from deducting ordinary and necessary business expenses when computing taxable income.

A constraint such as §280E has a direct impact on the profitability of a company. It is imperative for owners and investors to understand the importance and impact that segregation of plant-touching and non-plant-touching activities can have on their businesses; however, there is no concept more important to understand than the need for appropriate documentation & good record keeping.

In addition to the restrictions that §280E causes, business owners need to be aware of the accuracy related penalties that can be imposed. Internal Revenue Code (“IRC”) Section (“§”) Section 6662(a) states that an additional penalty of an amount equal to 20 percent of the underpayment can be added on top of the tax required if negligence, disregard of rules and regulations occurs, or other various attributions exist that are outlined and defined within the code section.

In a recent court case, Altermeds, LLC, which is a Colorado medical marijuana dispensary owned solely by Laurel Alterman (“Petitioner”), contested a notice of deficiency that was issued by the Internal Revenue Service (“IRS”) for tax years 2010 and 2011. See Laurel Alterman and William A. Gibson V. Commissioner of Internal Revenue.

The notice of deficiency contained the following adjustments to both tax years:

• Denial of ordinary and necessary business expenses
• Reduction of Cost of Goods Sold (“COGS”)
• Accuracy-related penalties

The Petitioner claimed that the business expenses were attributable to the non-marijuana merchandise. This argument was denied since 95 percent of revenue was derived from marijuana sales, and the petitioner was unable to prove segregation of business activities. Whether the outcome would have been different is unknown but the lack of records to show segregation of business activities certainly does not help when disputing these notices.

A notice of deficiency put the burden of proof on the taxpayer. Petitioner’s claims for additional COGS were denied based on failure to follow § 1.471-1, which states, “[i]n order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.” Review of the tax returns and records for the years in question revealed that beginning inventory was reported as zero, and no record of physical inventory could be produced.

Substantial accuracy-related penalties were upheld on the premise of negligence. No proof that advice specific to the cannabis industry was ever sought and the failure to keep inventory records showed a lack of interest by the petitioner in complying with the federal tax laws. The negligence or failure to make a reasonable attempt claim was upheld.

In a growing industry, it could be easy to be blinded by the potential upside. Obtaining a sound understanding of the industry and having the appropriate framework in place from the beginning can make all the difference. Had Altermeds, LLC kept more complete and detailed books and records, the outcome may have been different.

The cannabis industry is exploding, and because of this, government legislation will continue to evolve. As businesses continue to cultivate their brands, it is critical that they balance their dedication to a high-quality product with proper documentation and record-keeping. Altermeds, LLC, is just one example where missing and incomplete records caused a negligence to make a reasonable attempt claim to be upheld. In a more recent court case, Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center V. Commissioner of Internal Revenue, the IRS increased the level of scrutiny when reviewing the separation of business activities to determine the impact of §280E, and stated that using the Uniform Capitalization (UNICAP) rules under IRC §263A in the COGS calculation is not recommended. The failure to calculate COGS correctly could cause a business to be liable for additional accuracy-related penalties, as shown in this case. Please be on the lookout for more details regarding the impact of Harborside Health Center V. Commissioner of Internal Revenue in future releases.

Greg Pelucacci is a senior associate at CohnReznick. He can be reached at 301-280-1824 or Greg.Pelucacci@CohnReznick.com.

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