On March 29, 2021, the U.S. Tax Court issued a ruling in favor of the IRS that should serve as a potent reminder of the importance of record-keeping for the cannabis industry. The case is Purple Heart Patient Ctr. v. Comm’r.
Purple Heart was a licensed medical cannabis dispensary operating in Oakland, California. Keith Stephenson was its sole director. Its business consisted of selling medical cannabis and accessories to patients. Purple Heart also offered free health counseling services to help its patients select and use cannabis products.
Purple Heart bought all of its inventory of cannabis and accessories with cash. Patients also paid in cash.
Purple Heart used cash registers to record sales of cannabis and accessories. Purple Heart used the…”tapes that those cash registers produced (Z-tapes) to log purchases and sales in a general ledger.” Mr. Stephenson reviewed the general ledger to ensure that the proper information was recorded.
Once Mr. Stephenson paid the California sales and use taxes he destroyed the Z-tapes. Once he paid the Federal taxes he destroyed the general ledger and related documents. The bottom line is that Purple Heart did not keep the general ledger, Z-tapes or other documents permanently.
The reason Mr. Stephenson destroyed the documents is that he was worried the information they contained would be used by the Federal government to prosecute him criminally.
Purple Heart engaged the services of a CPA to assist in the preparation of its tax returns. The Court noted, however, that while Purple Heart did provide documents for rent and security to the CPA it did not provide the CPA with …”any source documents for its sales and purchases [of cannabis and accessories].”
The IRS conducted an audit of Purple Heart for the years 2010, 2011, 2012, 2015 and 2016. The IRS determined that there were deficiencies in taxes paid, additions to tax, and penalties to be assessed against Purple Heart.
Because Purple Heart was unable to provide any books and records to the IRS, the IRS used a bank deposits and cash expenditure analysis to determine taxable income.
In addition, the IRS disallowed all of the cost of goods sold (COGS) deductions that Purple Heart claimed in its tax returns. The IRS noted that COGS or other claimed expenses would not be allowed because Purple Heart had failed to prove them and because Section 280E disallows expenses incurred in the operation of a medical marijuana dispensary.
The IRS also assessed underpayment penalties based on negligence or substantial understatement of income tax.
Burden of Proof
The Court stated that the burden of proof shifts to the IRS if the taxpayer presents “…credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer…”
Reasoning that Purple Heart had not provided arguments or evidence to shift the burden to the IRS, the Court decided that all of the burden was on Purple Heart to prove its case.
Purple Heart relied on the written report of an expert to support its position. The Court rejected the testimony of the expert because the report did not explain the facts or data upon which it relied.
The facts and data in question were the returns of other medical cannabis dispensaries. The likely reasons why they were not provided by the expert was the potential audit exposure and risk of Federal criminal prosecution.
The Court stated that taxpayers are responsible for maintaining accurate books and records to prove their income.
When a taxpayer fails to keep accurate books and records, then the “…Commissioner [IRS] is authorized to compute the taxpayer’s income by any method that, in the Commissioner’s opinion, clearly reflects income.”
The Court approved the IRS’ calculations of taxable income, the methods used to calculate it and the disallowance of any deductions for COGS.
The Court also approved the penalty imposed by the IRS because it held that Purple Heart’s tax returns reflected a substantial understatement of income tax. Mr. Stephenson’s destruction of records was enough to convince the Court that he did not act with “…reasonable cause and in good faith…”
Cannabis companies must keep accurate books and records if they want to effectively defend themselves in an IRS audit or tax court case.
Companies that do maintain accurate books and records have a much higher chance of success against the IRS in both an audit and tax court setting.
If expert testimony is used by a cannabis company in its defense, it must be supported by facts or data including, in this case, information about other medical marijuana dispensaries which in turn may create IRS audit and Federal criminal prosecution risks for those named dispensaries.
Finally, the IRS will continue to aggressively pursue audits of cannabis companies knowing that most of the targets will not have the books and records necessary to mount a successful defense.