Opinion
30991-21
01-02-2024
ESTATE OF RONALD E. VAN STEYN, DECEASED, HOLLY A. COOK, PERSONAL REPRESENTATIVE, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Ronald L. Buch Judge
Mr. Van Steyn owned two businesses in Colorado that trafficked in marijuana. During the examination of those businesses, they did not substantiate their costs of goods sold. Section 280E prohibits taxpayers from taking credits or deductions from income earned from the trade or business of trafficking in controlled substances prohibited by either federal or state law. And of course, taxpayers are required to substantiate what they report on their returns. Section 6001.
Unless otherwise indicated, statutory references are to the Internal Revenue Code, Title 26 U.S.C., in effect at all relevant times, and Rule references are to the Tax Court Rules of Practice and Procedure.
Pending before the Court is petitioner's Motion for Partial Summary Judgment filed November 9, 2023, seeking partial summary judgment on two separate issues. First, it asks us to conclude that the Commissioner's enforcement of the plain language of section 280E violates the Administrative Procedures Act. The Motion further asks us to conclude that the Commissioner's disallowance of costs of goods sold for lack of substantiation was arbitrary. Because the plain language of section 280E applies to the trafficking in marijuana, the Administrative Procedure Act is not implicated. And because taxpayers are required to substantiate their tax reporting, the Commissioner's disallowance of items for lack of substantiation was not arbitrary.
Background
Mr. Van Steyn owned two marijuana dispensaries that operated in Colorado. The businesses, Herbal Alternatives, LLC and REVS and Associates, LLC, were sole proprietorships operating through Colorado limited liability companies.
Although Colorado has decriminalized the sale of marijuana, it continues to be a controlled substance at the federal level. 21 U.S.C. § 812. Colorado decriminalized the sale of marijuana for medical purposes in 2000 and for recreational use in 2012. Colo. Const. art. XVIII, §§ 14, 16. The federal government still categorizes marijuana as a Schedule I controlled substance. 21 U.S.C. § 812.
Mr. Van Steyn reported these businesses on his individual tax return for 2014 and 2015, but he died before filing his tax return for 2016. According to the parties,he reported both businesses on Schedule C, Profit or Loss from Business, on his tax returns for 2014 and 2015. For 2015, for example, Mr. Van Steyn reported gross receipts of $2,760,853, cost of goods sold of $2,448,108, and business expenses of $125,294 for Herbal Alternatives, LLC.
The moving papers do not contain Schedules C for both business for both years.
The Commissioner issued two notices of deficiency to Mr. Van Steyn, one for 2014 (issued to him and his wife) and the other for 2015 and 2016 (issued only to Mr. Van Steyn). For 2014 and 2015, the Commissioner allowed cost of goods sold to the extent Mr. Van Steyn substantiated them. The Commissioner disallowed all business expenses pursuant to section 280E. In the notice of deficiency for 2014, the Commissioner explained:
Expenses are limited by I.R.C. section 280E, and no deductions or credits are allowable. I.R.C. section 280E does not disallow costs of goods sold. To the extent the item has been substantiated as allowable in costs of goods sold, it has been allowed under that category. Alternatively, the claimed amounts were not substantiated.
The notice of deficiency for 2015 and 2016 contained nearly identical passages as to each year.
Mr. Van Steyn's estate filed a timely Petition challenging the Commissioner's determinations as to each year. And on November 9, 2023, the estate filed the pending Motion for Partial Summary Judgment.
Discussion
I. Summary Judgment
We may grant summary judgment when there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law. Rule 121(b); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 (7th Cir. 1994). The moving party bears the burden of showing that there is no genuine dispute as to any material fact. Sundstrand Corp., 98 T.C. at 520. When a motion for summary judgment is properly made and supported, an opposing party may not rest on mere allegations or denials. Rule 121(d). Rather, the party's response, by affidavits or declarations, or as otherwise provided in Rule 121, must set forth specific facts showing there is a genuine factual dispute for trial. Rule 121(d). In deciding whether to grant summary judgment, we view the facts and make inferences in the light most favorable to the nonmoving party. Sundstrand Corp., 98 T.C. at 520.
II. Calculation of Taxable Income
Gross income means all income from whatever source derived, including income derived from business. I.R.C. § 61(a); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 432 n.11 (1955). Congress has the constitutional and statutory authority to tax gross income. Id. at 429-30. To ensure taxation of income rather than sales, "cost of goods sold" is a mandatory exclusion from the calculation of a taxpayer's gross income. Alpenglow Botanicals, LLC v. United States, 894 F.3d 1187, 1199 (10th Cir. 2018); see Sullenger v. Commissioner, 11 T.C. 1076, 1077 (1948); see also Treas. Reg. § 1.61-3(a) ("[G]ross income means the total sales, less the cost of goods sold.").
Taxable income is the taxpayer's "gross income minus the deductions allowed" by statute. I.R.C. §63(a). Deductions are specifically authorized by statute, and "Congress has unquestioned power to condition, limit, or deny deductions from gross income in arriving at the net which is to be taxed." Commodore Mining Co. v. Commissioner, 111 F.2d 131, 133-34 (10th Cir. 1940). An otherwise allowable deduction may be disallowed if a business engages in a federally prohibited conduct. See e.g. I.R.C. § 280E.
III. Federal Tax Law's Treatment of Income from Trafficking in Marijuana
Section 280E prohibits any deduction or credit for any amount paid or incurred during the taxable year in connection with any trade or business trafficking in controlled substances. I.R.C. § 280E. These substances include those within the meaning of schedule I and II of the Controlled Substances Act as well as any substances banned by state law. Id. The statute does not make an exception for controlled substances at the federal level that may have been decriminalized at the state level.
Historically, taxpayers could not take deductions from income earned in the course of a trade or business that defied sharply defined public policy. See Commissioner v. Heiniger, 320 U.S. 467, 473 (1943); see also Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 33 (1958). In general, the Tax Court has held similarly. See Holt v. Commissioner, 69 T.C. 75, 81 (1977) (holding that petitioners could not claim deductions against income earned from the sale of marijuana because it defied sharply defined public policy), aff'd, 611 F.2d 1160 (5th Cir. 1980).
Congress codified this public policy when enacting section 280E, disallowing deductions or credits for amounts paid in the trafficking of controlled substances. Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, § 351(a), 96 Stat. 324, 640. Controlled substances are those within the meaning of schedule I or II of the Controlled Substances Act. See I.R.C. § 280E; 21 U.S.C. § 812. Before state decriminalization, trafficking in marijuana was illegal at both the federal and state level.
When first enacted, the Commissioner applied section 280E to disallow deductions or credits following a criminal conviction. See e.g. Bender v. Commissioner, T.C. Memo. 1985-375, 50 T.C.M. (CCH) 538.
The Commissioner changed his approach in 1996, after states began decriminalizing marijuana. See Californians Helping to Alleviate Med. Probs, Inc. v. Commissioner, 128 T.C. 173, 182-83 (2007). California and Arizona were the first states to decriminalize marijuana in 1996. See Proposition 215, the Compassionate Use Act of 1996, codified at Cal. Health & Safety Code sec. 11362.5 (West 2007); see also Proposition 200, codified as Arizona. Rev. Stat. Ann. § 13-901.01. At the direction of the President, the Office of National Drug Control Policy developed a coordinated strategy in response to state decriminalization. As it relates to the Internal Revenue Service, that policy stated in part, "To the extent that state laws result in efforts to conduct sales of controlled substances prohibited by Federal law, the IRS will disallow expenditures in connection with such sales to the fullest extent permissible under existing Federal tax law." Administration Response to Arizona Proposition 200 and California Proposition 215, 62 Fed.Reg. 6164 (Feb. 11, 1997).
IV. The Estate's Arguments
The estate argues that the Commissioner's change in enforcement amounts to legislative rulemaking by the Treasury subject to rulemaking procedures set forth in the Administrative Procedure Act (APA). The estate argues that the Commissioner should have adopted regulations that would, in effect, restate the words of the statute, arguing, "The Commissioner has failed to comply with the Administrative Procedures Act by failing to adopt regulations determining that state-legal marijuana sales constitute unlawful drug trafficking pursuant to 26 U.S.C. Sec. 280E." The estate further argues that the Commissioner's enforcement of the plain language of the statute requires rulemaking under the Administrative Procedures Act, arguing, "The Commissioner cannot enforce its rule that sec. 280E includes state-legal marijuana, as this is a legislative rule requiring both notice and comment." He contends the failure to promulgate regulations renders the Commissioner's application of the plain language of section 280E procedurally invalid.
Separately, the estate argues that the Commissioner improperly disallowed cost of goods sold. The Commissioner recharacterized some items that were reported as cost of goods sold as business expenses and applied section 280E to disallow those reclassified expenses. The Commissioner also disallowed cost of goods sold for lack of substantiation.
V. Plain language of Section 280E applies
Section 7805(a) authorizes the Commissioner to prescribe "all needful rules and regulations for the enforcement of [Title 26], including all rules and regulations." The APA imposes rules regarding the promulgation of rules and regulations. See 5 U.S.C. § 553(b)-(c). It requires, for example, that a notice of proposed rulemaking as well as time for public comment generally precede the publication of a final rule. Id. But this requirement does not apply to interpretive rules or rules of agency practice or procedure. Id. at § 553(b)(4)(A). But here, no rulemaking occurred nor was any required.
The plain language of section 280E applies. The Commissioner may disallow deductions or credits from income reported from a trade or business trafficking in controlled substances. I.R.C. § 280E. Controlled substances refers to those substances listed under schedule I or II of the Federal Controlled Substances Act or any substance prohibited at the state level. Id. Marijuana is a Schedule I controlled substance. 21 U.S.C. § 812. Because we consider facts in the light most favorable for the nonmoving party, we find for the purpose of this Motion that Mr. Van Steyn reported income from a trade or business trafficking in marijuana. Therefore, the plain language of section 280E applies to disallow deductions or credits against any income derived from that trade or business.
VI. Genuine Disputes of Material Fact Remain
The Commissioner allowed costs of goods sold to the extent they were substantiated. In general, the Commissioner's determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving otherwise. Rule 142(a). Summary judgment requires us to view all facts in the light most favorable to the nonmoving party. Sundstrand Corp., 98 T.C. at 520. To the extent the estate is characterizing the Commissioner as having disallowed cost of goods sold, the Commissioner's notice of deficiency is explicit that such costs were allowed to the extent substantiated. To claim cost of goods sold, a taxpayer must substantiate them. Section 6001. The disallowance was not arbitrary. To the extent there is a dispute as to whether certain items are, in fact, cost of goods sold or have been adequately substantiated, these are disputes of material facts. And, of course, genuine disputes of material fact cannot be resolved on summary judgment. Sundstrand Corp., 98 T.C. at 520.
Conclusion
The plain language of the section 280E applies to the trafficking of schedule I and II controlled substances. The APA is not applicable to the application of the plain language of a statute. Furthermore, genuine issues of material fact remain, therefore we cannot grant the estate's Motion for Partial Summary Judgment. To reflect the foregoing, it is
ORDERED that Mr. Van Steyn's Motion for Partial Summary Judgment filed November 9, 2023, is denied.