Jesse M. Loughman & Desa C. Loughman v. Commissioner , 2018 T.C. Memo. 85 ( 2018 )

T.C. Memo. 2018-85UNITED STATES TAX COURT
JESSE M. LOUGHMAN AND DESA C. LOUGHMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21464-15. Filed June 18, 2018.
Rachel K. Gillette and Kirstin M. Jahn, for petitioners.
Luke D. Ortner, for respondent.
MEMORANDUM OPINION
KERRIGAN, Judge: The petition in this case was filed in response to a
notice of deficiency dated May 27, 2015. Respondent determined deficiencies in
petitioners’ Federal income tax and penalties as follows:
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[*2] Penalty
Year Deficiency sec. 6662(a)
2010 $20,922 $4,184
2011 55,825 11,165
2012 72,110 14,422
After concessions the remaining issues for our consideration are (1) whether
deductions for wages not attributable to costs of goods sold (COGS) paid to
petitioners by Palisades Health Care IN (Palisades) for tax years 2010-12 (years in
issue) should be disallowed pursuant to section 280E and (2) whether petitioners
are entitled to relief under the Revenue Act of 1978, Pub. L. No. 95-600, sec. 530,
92 Stat. at 2885, as amended (section 530). The amounts in issue are as follows:
Year Disallowed deduction
2010 $28,945
2011 23,274
2012 43,307
Unless otherwise indicated, all section references are to the Internal Revenue Code
(Code) in effect for the tax years in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure. All monetary amounts are rounded to the
nearest dollar.
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[*3] Background
This case was fully stipulated pursuant to Rule 122. The stipulation of facts
and the attached exhibits are incorporated in our findings by this reference.
Petitioners resided in Colorado when they timely filed their petition.
Palisades’ Business Activity
Palisades, also known as Colorado Alternative Health Care LTD, is an S
corporation organized under the laws of Colorado. Petitioners were the sole
owners of Palisades and also served as its officers during the years in issue.
Colorado licensed Palisades to grow and sell medical marijuana.
Tax Reporting
For the years in issue Palisades elected to be treated as an S corporation for
Federal income tax purposes and filed Forms 1120S, U.S. Income Tax Return for
an S Corporation. For the years in issue it reported ordinary business income of
$16,188, $190,778, and $243,561, respectively.
Palisades claimed deductions from total income for ordinary and necessary
business expenses (below-the-line deductions). It claimed below-the-line
deductions for items such as compensation of officers, wages, repairs and
maintenance, rents, taxes and licenses, interest, depreciation, advertising,
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[*4] employee benefit programs, and “other deductions”, which it detailed on
attached statements.
Petitioners filed joint income tax returns for the years in issue. They
received compensation from Palisades, both as passthrough income and as officer
compensation. Petitioners reported passthrough income from Palisades of
$15,101, $190,778, and $227,219, respectively, on their Schedules E,
Supplemental Income and Loss, Part II, Income or Loss From Partnerships and S
Corporations, attached to their income tax returns for the years in issue.
Petitioners reported wages they received from Palisades of $46,458 and
$173,228 for tax years 2011 and 2012, respectively, on their Forms 1040, U.S.
Individual Income Tax Return. Petitioners did not report any wages from
Palisades on their Form 1040 for 2010. They have conceded that some of the
wages they received from Palisades for 2010 should have been reported.
Petitioners included the wage payments they received from Palisades as a part of
Palisades’ expenses in its section 162 deductions.
Respondent’s Determinations
Respondent examined Palisades’ returns for the years in issue. Respondent
made flowthrough adjustments to petitioners’ taxable income as a result of the
application of section 280E, along with other adjustments and corresponding
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[*5] computational adjustments. Respondent determined that Palisades’ below-
the-line deductions should be disallowed, but allowed Palisades’ COGS to the
extent substantiated. The parties agree that some of petitioners’ wages are not
COGS pursuant to section 471 and section 1.471-11, Income Tax Regs.
Discussion
I. Burden of Proof
Generally, the taxpayer bears the burden of proving that the Commissioner’s
determinations set forth in the notice of deficiency are erroneous. Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). The taxpayer likewise bears the
burden of proving his or her entitlement to deductions and of substantiating the
amounts of items underlying claimed deductions. INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a), Income Tax Regs.
Under section 7491(a) in certain circumstances the burden of proof may shift from
the taxpayer to the Commissioner. Petitioners have not claimed or shown that
they meet the requirements of section 7491(a) to shift the burden of proof to
respondent as to any relevant factual issue.
II. Section 162
Deductions are a matter of legislative grace, and a taxpayer must prove his
or her entitlement to deductions. INDOPCO, Inc. v. Commissioner, 503 U.S.
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[*6] at 84. Section 162(a)(1) allows taxpayers to deduct “ordinary and necessary
expenses”, including a “reasonable allowance for salaries or other compensation
for personal services actually rendered”. Thus, compensation is deductible only if
(1) reasonable in amount and (2) paid or incurred for services actually rendered.
See sec. 1.162-7(a), Income Tax Regs. COGS is not a deduction within the
meaning of section 162(a) but is subtracted from gross receipts in determining a
taxpayer’s gross income. See Max Sobel Wholesale Liquors v. Commissioner, 69
T.C. 477 (1977), aff’d, 630 F.2d 670 (9th Cir. 1980); sec. 1.162-1(a), Income Tax
Regs.
The parties dispute whether Palisades may deduct the wages that it paid to
petitioners to the extent that respondent disallowed the deductions. They agree
that these disallowed wage deductions cannot be characterized as COGS and that
in disallowing any of the wage deductions, petitioners’ flowthrough income from
Palisades increases.
III. Section 280E
Section 261 provides that “no deduction shall in any case be allowed in
respect of items specified in this part.” “[I]tems specified in this part” refers to
part IX of subchapter B of chapter 1, entitled “Items Not Deductible”, and this
includes section 280E, “Expenditures in Connection With the Illegal Sale of
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[*7] Drugs”. See Californians Helping to Alleviate Med. Problems, Inc. v.
Commissioner, 128 T.C. 173, 180 (2007). Section 280E precludes taxpayers from
deducting any expense related to a business that consists of trafficking in a
controlled substance. See Olive v. Commissioner, 139 T.C. 19, 29 (2012), aff’d,
792 F.3d 1146 (9th Cir. 2015). Section 280E disallows deductions only for the
expenses of a business and does not preclude petitioners from taking into account
Palisades’ COGS. See Californians Helping to Alleviate Med. Problems, Inc. v.
Commissioner, 128 T.C. at 178 n.4.
We have previously held that medical marijuana is a controlled substance.
Id. at 180-181; see also Gonzalez v. Raich, 545 U.S. 1 (2005); United States v.
Oakland Cannabis Buyers’ Coop., 532 U.S. 483 (2001). The dispensing of
medical marijuana, while legal in Colorado, is illegal under Federal law. See
Olive v. Commissioner, 139 T.C. at 39; see also Colo. Const. art. XVIII, sec. 16.
Congress in section 280E has set an illegality under Federal law as one trigger to
preclude a taxpayer from deducting expenses incurred in a medical marijuana
dispensary business. Olive v. Commissioner, 139 T.C. at 39. This is true even if
the business is legal under State law. Id.Petitioners contend that the application of section 280E results in
discriminatory treatment of S corporation owners of marijuana businesses in
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[*8] violation of subchapter S. They argue that respondent’s treatment of
petitioners’ wage income as an expense subject to section 280E causes the same
income to be taxed twice, once as wages, and a second time as S corporation
income. They contend that this results in the disallowed officer wages attributable
to trafficking being included in Palisades’ earnings, which flowthrough to
petitioners without any deduction for the wages. Petitioners contend that this
treatment is contrary to the purpose and legislative intent of subchapter S.
Petitioners contend that discriminatory treatment results from an S
corporation’s being required to pay a reasonable wage as a salary to its officers
pursuant to sections 3111, 3121, 3301, and 3306, as other entities are not subject
to this reasonable wage requirement. The Code sections which petitioners refer to
apply to the administration of employment taxes. The parties are not disputing the
reasonableness of the wages. Rather, petitioners are contending that this
reasonable wage requirement results in double taxation.
Petitioners’ argument of double taxation assumes that there is no distinction
between gross income from wages and passthrough income from the ownership of
an S corporation. The economic considerations for these two items of income
differ, as do their tax treatments.
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[*9] Subchapter S was designed to create a passthrough taxation system under
which income is subjected to only one level of taxation. See Gitlitz v.
Commissioner, 531 U.S. 206, 209 (2001). Section 1366(a) provides that income,
losses, deductions, and credits of an S corporation are passed through pro rata to
its shareholders on their individual tax returns. The character of each item of
income is determined as if it were directly from the source from which the
corporation realized it or incurred in the same manner as it was by the corporation.
Sec. 1366(b). A shareholder’s gross income includes his or her pro rata share of
the S corporation’s gross income. Sec. 1366(c). Thus Palisades’ income passes
through to petitioners, and they must report it on their individual tax returns.
Separately, and in addition to Palisades’ passthrough income, petitioners
must report the wage compensation they received as officers of Palisades as a part
of their gross income on their individual returns. Section 61(a) provides that gross
income includes “all income from whatever source derived”. See Commissioner
v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955). This includes compensation for
services, such as wages, salaries, and bonuses. See sec. 61(a)(1). Accordingly,
petitioners must include in their gross income not only their pro rata shares of
Palisades’ income, but also their wages separately received for providing services
to Palisades.
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[*10] Petitioners’ contention that the application of section 280E results in
disparate treatment is misplaced. An S corporation subject to section 280E
remains a flowthrough entity with one tax imposed at the shareholder level, as
prescribed by subchapter S. Gitlitz v. Commissioner, 531 U.S. at 209; see also
Bufferd v. Commissioner, 506 U.S. 523, 525 (1993). This can be illustrated by
example. If petitioners had hired a third party to perform the officer duties that
they performed, and they paid that third party an amount equal to that included as
wages in petitioners’ gross income, petitioners’ gross income would not include
the third party’s wages from Palisades. Petitioners would ultimately have less
income, but they would not owe Federal income tax on the wages paid to the third
party. However, section 280E would still disallow Palisades’ wage expense
deductions not attributable to COGS. Petitioners’ flowthrough income would be
the same. The application of section 280E to deny Palisades’ wage expense
deductions is not discriminatory; it applies equally, regardless of whether
petitioners themselves or a third party receives the wages.
To the extent that petitioners believe they received disparate tax treatment
as a result of organizing their marijuana business as an S corporation, petitioners
were free to operate as any business entity and in other trades. Petitioners chose to
operate Palisades as an S corporation in the marijuana business. Petitioners are
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[*11] responsible for the tax consequences of their decision. See Higgins v.
Smith, 308 U.S. 473, 477 (1940).
IV. Section 530 Relief
Section 530 may afford a taxpayer relief from employment taxes even if the
relationship between the taxpayer and the worker would otherwise require
payment of those taxes. Charlotte’s Office Boutique, Inc. v. Commissioner, 121
T.C. 89, 106 (2003), aff’d, 425 F.3d 1203 (9th Cir. 2005). Section 530(a)(1)
provides relief if the taxpayer satisfies the following requirements: (1) the
taxpayer has not treated the worker as an employee for any period; (2) the taxpayer
has consistently treated the worker as not being an employee on all tax returns for
periods after December 31, 1978; and (3) the taxpayer had a reasonable basis for
not treating the worker as an employee. Joseph M. Grey Pub. Accountant, P.C. v.
Commissioner, 119 T.C. 121, 130 (2002), aff’d, 93 F. App’x 473 (3d Cir. 2004).
Petitioners contend that they are entitled to section 530 relief to exempt the
trafficking-related officer wages from the reasonable wage requirement because
they have a reasonable basis, which is to eliminate tax disparity. Section 530
relief is limited to controversies regarding the employment tax status of service
providers under the common law and does not apply with respect to statutory
employees, such as corporate officers. Joseph M. Grey Pub. Accountant, P.C. v.
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[*12] Commissioner, 119 T.C. at 131-132. Section 530(a)(1)(B) applies only
when the taxpayer has not already classified the individuals in question as
employees and the Government attempts to retroactively classify them as
employees. Further, the petition in this case was filed in response to a notice of
deficiency and not in response to a notice of determination of worker
classification. See sec. 7436(a). Section 530 is inapplicable to this case.
We have considered all of the arguments made by the parties, and to the
extent we did not mention them above, we conclude that they are moot, irrelevant,
or without merit.
To reflect the foregoing,
Decision will be entered under
Rule 155.