On April 11, 2017, we discussed what constitutes Tax Reform. On April 24, 2017, we explored the process by which Tax Reform will likely be created by lawmakers. In our May 3, 2017 blog post, we focused on the likely timing for Tax Reform. In this blog post, we look at what Tax reform may look like.
Like one of my favorite things in this world, namely ice cream, Tax Reform also likely comes in different flavors. For starters, we have President Trump’s campaign comments on Tax Reform. Next, we have the Republican leaders’ from the U.S. House of Representatives initial draft of a Tax Reform package. Lastly, we have the White House’s April 26, 2017 one-page memorandum that broadly outlines the President’s current vision of Tax Reform.
Let’s break Tax Reform into three broad categories, namely:
- Estate & Gift Tax
- Individual Income Tax
- Corporate Income Tax
As a general rule, in accordance with IRC § 162(a), taxpayers are allowed to deduct, for federal income tax purposes, all of the ordinary and necessary expenses they paid or incurred during the taxable year in carrying on a trade or business. There are, however, numerous exceptions to this general rule. One exception is found in IRC § 280E. It provides:
“No deduction or credit shall be allowed for any payment 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 Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.”
Congress enacted IRC § 280E as part of the Tax Equity and Fiscal Responsibility Act of 1982, in part, to support the government’s campaign to curb illegal drug trafficking. Even though several states have now legalized medical and/or recreational marijuana, IRC § 280E may come into play. The sale or distribution of marijuana is still a crime under federal law. The impact of IRC § 280E is to limit the taxpayer’s business deductions to the cost of goods sold.
On October 22, 2015, the U.S. Tax Court issued its opinion in Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206. In that case, Judge Haines was presented with a California taxpayer that is in the business of selling medical marijuana, an activity that is legal under California law.
The facts of this case are interesting. Bryan and Lanette Davies, facing significant financial setbacks and hefty educational costs for their six (6) children, turned to faith for a solution. After “much prayer,” Mr. Davies concluded that God wanted him to start a medical marijuana business. Unfortunately, it does not appear that he consulted with God or a qualified tax advisor about the tax implications of this new business before he and his wife embarked upon the activity.
The good news for the Davies is that their business blossomed. In fact, they employ ten (10) people in the business and have enjoyed financial success. They timely filed state and federal income tax returns, reported income and paid, what they believed, was the proper amount of taxes. The bad news for the Davies is the fact that the IRS did not agree with their computation of the tax liability.
The IRS issued a notice of deficiency. Not able to resolve the matter at IRS appeals, the Davies found themselves in the U.S. Tax Court. The sole issue in the case was whether the taxpayers’ business deductions were properly disallowed by the Service under IRC § 280E.
To no avail, the Davies presented numerous arguments as to why marijuana should no longer be a controlled schedule I substance. They also asserted that their new business created employment opportunities for others, cured their family’s financial woes, and allowed them to participate in civic and charitable activities.
Judge Haines quickly dismissed the Davies’ arguments, concluding the sale of marijuana is prohibited under federal law—marijuana is a schedule I controlled substance. Accordingly, IRC § 280E prevents taxpayers from deducting the expenses incurred in connection with such activity (other than the cost of goods sold).
Faced with a tax assessment exceeding $800,000, the Davies argued that their business does more than sell marijuana. In fact, it sells books, shirts and other items related to medical marijuana. Citing other cases, they argued that their expenses should be apportioned among the various activities (i.e., the sale of medical marijuana and the sale of other items), and that they should be able to deduct the expenses related to the sale of the non-marijuana items.
The court explained that, where a taxpayer is involved in more than one distinct trade or business, it may be able to apportion its ordinary, necessary and reasonable expenses among the different trades or businesses. Unfortunately for the Davies, they could not show that they operated two (2) or more trades or businesses. In this case, the facts indicated that the sale of shirts, books and other items was merely incidental to the sale of medical marijuana. There was not more than one (1) trade or business.
PRACTICE ALERT: Whether more than one (1) trade or business exists is a question of facts and circumstances. Under CHAMP v. Commissioner, 128 T.C. 182 (2007), if a taxpayer operates more than one (1) distinct trade or business, it may be allowed to apportion its expenses among the trades or businesses. If only one (1) of the businesses is impacted by IRC § 280E, only the expenses relating thereto should be denied. The key is establishing that more than one (1) trade or business exists, and reasonably be able to apportion the expenses among those trades or businesses. Keeping separate books and records, and accounting for business expenses in a separate manner, is likely the best approach. The more separation and distinction among the businesses the better the chances of showing more than one (1) trade or business exists. Maintaining separate entities or business names for each activity may be warranted.
The Davies lost the case and are now faced with a hefty tax bill. Unless IRC § 280E is amended, taxpayers involved in the sale of medical and/or recreational marijuana, despite state legalization, will be presented with the same dilemma faced by the Davies in Canna Care, Inc. v. Commissioner.
Trugman v. Commissioner, 138 T.C. 22 (2012) exemplifies one of many reasons why you do not put real estate in a corporation, especially your personal residence.
The Trugmans were the sole shareholders of Sanstu corporation, an S corporation. Over the years, the S corporation acquired rental real estate all across the country. The Trugmans likely did not utilize professional tax advisors.
In 2009, for some reason, the Trugmans awoke from a deep sleep and started thinking about tax planning. To avoid tax on the income from their stock portfolio, they moved to Nevada which has no state income tax.
That same year, the Trugmans caused Santsu to purchase a single family dwelling they could occupy as their home. Santsu contributed about 98% of the purchase price; and the Trugmans put in the other 2% or about $7500 toward the purchase. The deed to the property listed Santsu as the sole owner.
Since they had not been homeowners in over three years, the Trugmans claimed a first-time homebuyer credit on their 2009 joint individual tax return under now expired IRC Section 36.
The Service audited the Trugmans and disallowed the credit on the ground the credit was only available to individuals. The statute is clear; the credit only applies to individuals.
The Trugmans, rather than give up on the $8000 refundable tax credit, appealed. After losing at appeals, they marched pro se into the US Tax Court.
The issue, a matter of first impression for the US Tax Court, was whether an individual may claim a credit under Section 36 for a principal residence that was actually purchased and owned by his or her wholly owned S corporation.
Judge Kroupa, who has the patience of a saint, gently told the Trugmans that they lost the battle – an S corporation is not an individual. Consequently, since the Corporation owned the home, it could not claim the credit. Likewise, the Trugmans, because they were not the owners of the home, could not claim the credit. The saga ends.
What happens if the Trugmans keep the home in the S corporation; the real estate market in Nevada recovers; and the corporation sells the home at a significant profit this year? Under Judge Kroupa’s ruling, no IRC Section 121 exclusion is available – the IRC Section 121 exclusion is only available to individuals since it applies to the sale of personal residences; Judge Kroupa pointed out to the Trugmans that only individuals have personal residences; corporations may have a place of organization; they do not have personal residences.
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "Entity Classification – Another Look at the Check-the-Box Regulations," New York University Summer Institute in TaxationNew York, NY, 7.27.17
- New York, NY, 10.22.17-10.27.17
- San Francisco, CA, 11.12.17-11.17.17