On August 2, 2012, the U.S. Tax Court issued its decision in the case of Martin Olive vs. Commissioner of the Internal Revenue Service.  Martin Olive, a young man unconcerned with the normal formalities of operating a business, owns a relatively well known medical marijuana dispensary in San Francisco, California, called the Vapor Room Herbal Center that used to operate in a 1,250 square foot store in a low income neighborhood.  The Tax Court said that Mr. Martin “consciously opted not to keep adequate books and records and that action was in reckless or conscious disregard of rules or regulations.”  The Vapor Room was in the news recently because it announced that it was going out of business.

Martin Olive started the Vapor Room in 2004 and operated it as a sole proprietorship rather than through an entity that would protect him from the debts and liabilities of the business.  Martin operated the business as a cash business and apparently did not keep records of any kind other than journals written by him that contained income and expense information.  The IRS assessed deficiencies against Martin Olive of $692,501 for 2004 and $1,199,814 for 2005 plus accuracy-related penalties to $138,500 for 2004 and $239,963 for 2005. On his federal income tax returns Martin Olive reported that the Vapor Room’s “principal business” is “Retail Sales” and that its product is “Herbal.”

The court ruled:

• Martin Olive under-reported his gross income.
• He could deduct his cost of goods sold (COGS) in an amount greater than the IRS allowed.
• Section 280E of the Internal Revenue Code prevented the deduction of any of his business expenses because his only business was selling marijuana.
• Martin Olive is liable for the accuracy-related penalties.

The Tax Court was not impressed by witnesses who testified on behalf of the Vapor Room.  The Court said:

“Petitioner’s testimony and the testimony of his other witnesses was rehearsed, insincere and unreliable. We do not rely on petitioner’s testimony to support his positions in this case, except to the extent his testimony is corroborated by reliable documentary evidence. We also do not rely on the uncorroborated testimony of petitioner’s other witnesses, three of whom are (or were) patrons of the Vapor Room and all of whom are closely and inextricably connected with the medical marijuana industry and with a desired furtherance of that movement.”

The Court found that Martin Olive’s gross receipts for the were $1,967,956 om 2004 and $3,301,898 in 2005.

Cost of Goods Sold

The case is a road map for how medical marijuana dispensaries should not conduct their businesses.  For example, the self-prepared journals in which Martin Olive wrote his income and expenses were ignored by the Court as proof of any expenses.  The Court said:

“Petitioner argues nonetheless that the ledgers alone are sufficient substantiation for taxpayers operating in the medical marijuana industry because, he states, that industry “shun[s] formal ‘substantiation’ in the form of receipts.” We disagree with petitioner that the ledgers standing alone are sufficient substantiation.  The ledgers did not specifically identify the marijuana vendors or reflect any marijuana that was received or given away. The ledgers neither were independently prepared nor bore sufficient indicia of reliability or trustworthiness. The substantiation rules require a taxpayer to maintain sufficient reliable records to allow the Commissioner to verify the taxpayer’s income and expenditures. . . .

Neither Congress nor the Commissioner has prescribed a rule stating that a medical marijuana dispensary may meet that substantiation requirement merely by maintaining a self-prepared ledger listing the amounts and general categories of its expenditures. It is not this Court’s role to prescribe the special substantiation rule that petitioner desires for medical marijuana dispensaries and we decline to do so. . . .

Petitioner consciously chose to transact the Vapor Room’s business primarily in cash. He also chose not to keep supporting documentation for the Vapor Room’s expenditures. He did so at his own peril. . . . Petitioner asserts that he minimized the Vapor Room’s use of checks because he did not want his bank to know that the Vapor Room was a medical marijuana dispensary. We find that assertion incredible, especially given that petitioner informed the bank that his business was named ‘Vapor Room’. . . .

Petitioner informs us that California did not allow medical marijuana dispensaries to earn a profit for the years at issue. The need to report no profit may improperly cause a dispensary to understate gross receipts or to overstate expenditures. We are especially wary here, where petitioner by his own admission understated his gross receipts and took steps to disguise his cash withdrawals from his business to conceal them from his employees”

Martin Olive did win one big victory.  Despite lacking any records of the cost of goods sold and saying it didn’t believe his expert witnesses, the Court accepted the testimony of Henry C. Levy, C.P.A. that the average COGS of a medical marijuana dispensary is 75.16% of its gross receipts despite stating that “we generally found Mr. Levy to be unreliable” and “his testimony improperly consisted mainly of legal opinions and conclusions.”

Section 280E

Section 280E of the Internal Revenue Code provides that a taxpayer may not deduct any amount for a trade or business where the “trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances.  Selling marijuana is a controlled substance for the purposes of Section 280E.  Martin Olive argued that the Vapor Room that in addition to selling marijuana the Vapor Room operated the separate business of “care-giving.”  Unlike the Tax Court case of Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP), where the Court found that CHAMP did operate a separate business and allowed deductions for expenses of that business, the Court in this case found no evidence that Martin Olive had any business other than selling marijuana.

The Court’s discussion of why it found that CHAMP operated two businesses and the Vapor Room did not is instructive for all medical marijuana dispensaries.

“The record establishes that the Vapor Room is not the same type of operation as the medical marijuana dispensary in CHAMP that we found to have two businesses. The differences between the operations are almost too numerous to list.  The dispensary there was operated exclusively for charitable, educational and scientific purposes and its income was slightly less than its expenses. . . . The director there was well experienced in health services and he operated the dispensary with caregiving as the primary feature and the dispensing of medical marijuana (with instructions on how to best consume it) as a secondary feature. . . . Seventy-two percent of the CHAMP dispensary’s employees (18 out of 25) worked exclusively in its caregiving business and the dispensary provided its caregiving services regularly, extensively and substantially independent of its providing medical marijuana. . . . It rented space at a church for peer group meetings and yoga classes and the church did not allow marijuana on the church’s premises. . . . It provided its low-income members with hygiene supplies and with daily lunches consisting of salads, fruit, water, soda and hot food. . . . Its members, approximately 47% of whom suffered from AIDS, paid a single membership fee for the right to receive caregiving services and medical marijuana from the taxpayer. . . . The names of the dispensaries are even diametrically different.  The name of the dispensary there, ‘Californians Helping To Alleviate Medical Problems,’ stresses the dispensary’s caregiving mission. The name of the dispensary here, ‘The Vapor Room Herbal Center,’ stresses the sale and consumption (through vaporization) of marijuana.”

The opinion does not state how much Martin Olive owes for 2004 and 2005, but it must be a big number.  Also unmentioned is whether the IRS audited Martin Olive for years after 2005.  I suspect that it did because of what it found in its 2004 and 2005 audits.

For more on this case read “Tax deductions for medical pot business go up in smoke, court rules” and “Bad News for Medical Marijuana Dispensaries (and Especially for the Vapor Room).”