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- Written by: Adam Fayne, JD
Marijuana is quickly becoming legal across the country – albeit not federally legal. Dozens of states have legalized medical marijuana and some allow the recreational use of marijuana. Investors are quick to jump into marijuana investments. Some invest in grow operations. Some invest in retail operations. And some invest in vertically integrated operations (grow and retail). After representing a number of investors in various states, and entities seeking licensure nationwide, I have seen financial models of existing operations and pro-forma models for future operations. The most overlooked item in all these financial models is Internal Revenue Code (“IRC”) Section 280E. In fact, most financial models do not even account for Section 280E, which in my opinion is a mistake. Section 280E is an extremely important consideration when owning or operating a marijuana endeavor, or investing in one. Anybody in the marijuana space cannot truly model out their investment without serious consideration of Section 280E, yet it is the most overlooked consideration in all the models I have seen. The most likely reason not knowing how to apply Section 280E and understanding its impact.
Internal Revenue Code Section 280E – Expenditures in connection with the illegal sale of drugs:
“No deduction or credit shall be allowed for any amount 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.”
Despite the language of the Internal Revenue Code, the Senate made clear that businesses subject to Section 280E are allowed to deduct its Cost of Goods Sold (“COGS”). This is the saving grace and where the creativity comes in. A taxpayer is generally required to report inventory on the accrual method under IRC Section 471. Under this accrual method, the taxpayer must capitalize the costs to acquire or produce the inventory and only deduct these costs when the merchandise is sold (as COGS). While it was widely believed IRC Section 263A added value to the available COGS deduction by capitalizing those pro-rata attributable expenses (marketing, training, transportation, meals and entertainment, etc) within the COGS, a recent (2015) Chief Counsel Advice Memorandum held that since 263A specifically states that the available deductions therein cannot run contrary to the Internal Revenue Code, no additional items were to be added to the COGS amount beyond what is allowed under Section 471. Specifically, IRC Section 263A(a)(2), states: “any cost which could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.”
By way of example, take a marijuana operation with $750,000 of gross revenue, $375,000 of COGS without any Section 263A expenses, and $200,000 of other expenses (payroll, rent, insurance, storage, etc.). Then let us assume that $100,000 of these other expenses are attributable to the inventory costs by way of Section 263A. The operator would be able to reduce its taxable income accordingly: $750,000-$375,000-$100,000 = $275,000 of taxable income. Absent the Section 263A allocation, the taxable income would be: $750,000-375,000 = $375,000 of taxable income.
An important item to note is that this Chief Counsel Advice is not legally binding. It is only the Internal Revenue Service’s interpretation of the Internal Revenue Code. It does not necessarily mean it is the right interpretation. If you take a strict reading of this interpretation, then a grower may only include the following direct and indirect costs (must be “incidental and necessary for production”) in its COGS:
- Seeds
- Direct labor costs – those costs associated with planting, cultivating, harvesting, etc.
- Indirect costs such as quality control, utilities, maintenance, supplies, fertilizer, certain insurance, accounting and attorney fees.
While it is more challenging for a retailer, there are a number of strategies to reduce the tax bill for a grower or a retailer. For example, providing ancillary services at a marijuana retail establishment (i.e. yoga) may allow allocating certain expenses to this segment of the business without the limitations of Section 280E. There are also a number of other strategies to limit the harsh tax impact. It remains to be seen how the IRS will treat various allocations and capitalization structures, but there is no doubt it is a very fluid practice today and will be flushed out in the years to come.
Adam Fayne is a partner with the law firm of Arnstein & Lehr LLP. Fayne was an attorney with the IRS Office of Chief Counsel. He may be reached at 312-876-7883 or
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- Written by: Kathleen Lach
An IRS notice of examination of a tax return brings great anxiety to our clients. It also takes us to the great unknown as to how the process will play out. We have all worked with aggressive revenue agents, agents that move at the pace of molten lava, and efficient agents simply trying to get their job done. As Congress reduces the IRS budget, revenue agents are asked to do more with less. In this scenario, beware of an increase in allegations of civil fraud, which if upheld, keep the statute of limitation for proposed adjustments to tax open indefinitely.
Statute of Limitations
IRC §6501 states:
“(a) General rule.--Except as otherwise provided in this section, the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed…”
“(c) Exceptions.--
(1) False return.--In the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time.
(2) Willful attempt to evade tax.--In case of a willful attempt in any manner to defeat or evade tax imposed by this title (other than tax imposed by subtitle A or B), the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time.”
If you can show that your case does not fall under any of the exceptions in Section 6501, the IRS is barred from adjusting a taxpayer’s tax liability after three years, or six years if there is an alleged “substantial understatement” of income.1 One key is a taxpayer’s cooperation with the agent throughout the audit process, including the extent of the documentation provided. This cooperation helps avoid willful intent to evade tax, which the IRS must prove in order to make the fraud penalty stick, and keep the statute open.
Wilfull Intent to Defraud
If the three or six year statute of limitations time frame has expired, the only avenue left for the IRS to pursue additions to tax against a taxpayer is by assertion of the civil fraud penalty under IRC §6663. Otherwise, the statute of limitations has run. In a Tax Court proceeding, the IRS must prove by clear and convincing evidence that a taxpayer acted with willful intent to evade taxes, for each year of proposed adjustments. If it fails, no adjustments may be made due to the expiration of the statute of limitations. When multiple years are involved, fraud must be established for each year.2
Fraud may be proven by an underreporting of income or an overstating of deductions where there is an absence of an alternative explanation for the taxpayer's conduct such as reasonable cause or merely willful neglect.3 IRS evidence must do more than merely raise the suspicion of fraud, it must establish its existence clearly and convincingly.4 Even though a taxpayer's conduct with respect to the keeping of proper business records and the preparation of returns may be clearly negligent, perhaps even grossly so, such negligence is not the equivalent of fraud.5 There are cases where although a taxpayer underreported income and maintained poor records, the Service did not prove by clear and convincing evidence that the taxpayer had the requisite fraudulent intent.6
The U.S. Tax Court has found that “circumstantial evidence which may give rise to a finding of fraudulent intent includes: (1) Understatement of income; (2) inadequate records; (3) failure to file tax returns; (4) implausible or inconsistent explanations of behavior; (5) concealment of assets; (6) failure to cooperate with tax authorities; (7) filing false W–4's; (8) failure to make estimated tax payments; (9) dealing in cash; (10) engaging in illegal activity; and (11) attempting to conceal illegal activity.”7 An analysis of these factors in any case will give you an indication of whether the IRS has met its burden of proving the requisite willful intent to evade taxes.
Burden of Proof
In Tax Court, the burden of proving the false or fraudulent-return exception to three-year limitations period (or six-year under certain circumstances) for assessing tax falls to the IRS to establish by clear and convincing evidence that a taxpayer filed false and fraudulent returns with the intent to evade tax.8 The IRS must prove the taxpayer intended to commit fraud in the preparation of these returns.9 If the Service satisfies its burden of proving that a portion of an underpayment is attributable to fraud, the burden of proof then shifts to the taxpayer to show otherwise.10 The burden of proof upon the Service and taxpayers is different, however. If the burden shifts to the taxpayers, their standard of proof is a preponderance of the evidence.11 Under the clear and convincing standard, the evidence presented by a party during the trial must be more highly probable to be true than not. Under the preponderance of evidence standard, a party need only to show that there is sufficient evidence to make it more likely than not that the facts it seeks to prove are true.
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The IRS has a stiff burden of proof in asserting a civil fraud penalty against a taxpayer. In situations where such a penalty may be in play, a practitioner should undertake a detailed analysis of the factors considered before succumbing to this burdensome exposure.
1. 26 U.S.C.A. §6501(e)
2. Gleis v. Commissioner, 24 T.C. 941, 1955 WL 784 (T.C. 1955), acq., 1956-2 C.B. 4 and decision aff'd, 245 F.2d 237.
3. Bozied v.Commissioner, T.C. Memo. 1969-142.
4. Id.
5. Id.
6. Gagliardi v. U.S., 81 Fed. Cl. 772, 101 A.F.T.R.2d 2008-2257 (2008).
7. Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).
8. 26 U.S.C.A. §§6501(c)(1), 6663, 7454(a); Tax Court Rule 142(b); Harlan v. Commissioner, 116 T.C. 31, 39, 2001 WL 40098 (2001).
9. Niedringhaus, at 210; Beaver v. Commissioner, 55 T.C. 85, 1970 WL 2247 (1970); Griffiths v. Commissioner, 50 F.2d 782, 10 A.F.T.R. (P-H) P 106 (7th Cir. 1931).
10. Sclafani v. Commissioner, T.C. Memo. 1963-298, 1963 WL 1529 (T.C. 1963).
11. IRC §7454; Niedringhaus v. Commissioner, 99 T.C. 202, 1992 WL 190129 (1992).
Kathleen Lach is a Partner in the Tax and Litigation Departments of Arnstein & Lehr LLP. She represents clients before a variety of different tax authorities, including the Internal Revenue Service, the Illinois Department of Revenue, and the Illinois Department of Employment Security.
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- Written by: T. Steel Rose, CPA, ACS Editor
Tommye Barie, a partner with Mauldin & Jenkins LLC, is the new chair of the board of directors of the American Institute of CPAs. Barie said accounting is in her family’s DNA, since her father was an accountant and her brother is a CPA. Yet it was her mother, the founder of two small businesses, who got Barie hooked on numbers at age 12 by enlisting her help with bookkeeping.
In her acceptance speech, Barie, 53, compared the nimbleness and strength required in kiteboarding–one of her favorite sports–with the skills CPAs must wield in an increasingly competitive global economy.
“External forces change the landscape seemingly overnight, and we ride that constantly changing wind.”
An accounting graduate of Stetson University, Barie is focused on audit and consulting services for governmental entities and not-for-profit organizations. We discussed Barie’s views on the small firms’ role over the next five years.
Barie commented that a CPA’s role is, “constantly evolving, we will have to develop whole new skill sets. The core skill set will remain intact.” She sees growth in the health care area, valuation and forensics, which attracts new CPAs, “it has a mystery around it,” she noted.
Concerning auditing Barie said, “small firms may not want to deal with the risk, and don’t want to deal with the peer review and quality control standards. Some enjoy [audits] and focus on their area of interest.
“This is a time of big changes for small firms. There are opportunities to specialize, use technology to compete with larger firms and to adopt more flexible work policies that make it easier to connect with clients and have a rewarding life outside of your career. But at the same time, many small firms run the risk of being squeezed out if they don’t adapt to changing client expectations.
“Automation, globalization and other trends all play into this. I worked in a smaller firm for many years, and never thought I’d have to get up to speed on IFRS and other international accounting issues. But I had two clients that did work overseas, so I adapted. Many practitioners at smaller firms will have to develop whole new skill sets, but that’s part of the evolution of our profession.”
Naturally, our discussion led to the Statement on Standards for Accounting and Review Services No. 21 (SSARS No. 21), which takes effect for financial statements dated on or after Dec. 15, 2015 – although, early implementation is permitted.
“We needed to modernize the ‘trigger’ for when CPAs apply the compilation standard, and that’s being addressed through SARS 21,” Barie said. “In today’s environment, the old model of ‘submission’ no longer works. Additionally, in today’s technology environment, many CPAs collaborate in real-time with clients through financial cloud applications, so the question of who prepared the financial statements can be muddy. SSARS No. 21 takes the current climate into account, and requires a CPA to apply the compilation and new preparation standards when an accountant is actually engaged to perform specific work.”
Concerning the case brought against the IRS by the AICPA about the new RTRP replacement, Barie said, “As far as the lawsuit is concerned, we’re disappointed by the ruling and are analyzing it in order to evaluate our options. For tax-preparing CPAs, nothing really changes. We believe CPAs continue to offer the best advice and expertise for clients on tax matters. One of the issues with the IRS program is the CPA is educated far in excess of the new IRS voluntary Annual Filing Season Program (AFSB).”
“If the CPA has the credential, they get the additional resources,” Barie said. “Like the tax section, we are enhancing the value, increasing the overlap of what the tax preparing CPA needs.”
Barie has been athletic all her life. Besides kiteboarding, she spends her free time paddle boarding, golfing and training in Pilates. Barie tried kiteboarding on vacation and liked it. Learning the sport requires more leg strength than upper body strength to ride that constantly changing wind.
“You can’t control the wind, but you can ride it,” Barie said.
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- Written by: Philip Panitz
By: Philip Panitz, Tax Attorney | When one reads the title of this piece, it is probably a natural assumption to think of little green men. Did some space alien make a wrong turn at Pluto and end up in the pine forest in Flagstaff?1 This article would probably be a lot more interesting and exciting if it were. However, we are talking about tax concepts here, something much more mundane; unless you happen to be here from another country, of course.
A person from a foreign country who is permitted to live in the United States typically falls into one of three categories. They are here legally as a resident alien, they have passed rigorous examinations about our culture and history to become citizens, or they are here illegally. Since this is a tax article, we will omit any political discussion related to who should be allowed privileges of citizenship and stick to the tax ramifications. If the resident alien or newly minted citizen is going through the process or has just been through the process, it is very likely that they know more about our culture and history at this moment than some of our own children. Unfortunately, the one thing they are not informed of is their rights and obligations under our extensive and complicated tax system.
Many Americans who have investments overseas or foreign bank accounts have been informed about the requirement to disclose these accounts. This has been covered in the news media, the Internet, and the newspapers. What is not being covered is the obligation that resident aliens and new citizens have in relation to money that they earned while living in their native land. Too often I have met with new clients who have been referred to me by a CPA because the client was from a foreign country, and failed to disclose accounts, homes, assets that are left behind in their native land. Once the CPA ultimately ascertains that the individual has not disclosed these accounts or foreign assets, the ramifications are so frightening that the referral is made immediately to a tax attorney like myself.
The first meeting goes something like this: “I earned the money in France. I was not a United States citizen at the time. Why would the United States get to tax that money?” The answer is: The United States taxes you on your world-wide income when you become a resident alien or a U.S. Citizen, just like it taxes people that were born here. So, if you have 500,000 Euros in a Swiss Bank Account when you become a resident alien or U.S. Citizen, it is a logical assumption that the money is not sitting in a non-interest bearing account. Typically, the alien is earning interest, or if invested in some type of pension, is earning dividends or capital gain upon sales. Once the alien becomes a resident alien (not a little green man but a green card holding taxpayer); or a U.S. Citizen, than taxes must be paid upon that earned income even if the principal was never earned in the United States.
But wait, it gets worse. Not only did the alien have to report the income earned upon becoming a resident alien or citizen, but they also must separately report the amounts in accounts or assets held. The income is reported on a regular tax return, due on April 15 each year, with extensions through October 15th. The assets are reported on a foreign bank account form called an FBAR. The FBAR is not a taxing event, it is simply a reporting event, and is due June 30th each year. There are no extensions. The FBAR puts the government on notice of what assets are held by the alien overseas. The income earned on those assets is fully taxable on the alien’s personal tax return. Many aliens inherit property from family and friends from their native land. These assets must be reported on the FBAR as well. Reporting the income on the tax return is fine, but failing to report the assets that earned the income by not filing an FBAR can be a catastrophe.
The penalties for non-compliance are very onerous, and this writer would add the adjective “confiscatory.” Intentional misrepresentation could lead to criminal prosecution. For example, willful failure to file the FBAR allows for fines up to $250,000 and five years in jail or both. For civil penalties, they fall into different categories. For each account not disclosed in the FBAR there is a $10,000 penalty. Additionally, civil penalties for willful failure to file can be the greater of $100,000 or 50% of the amounts in the accounts. Obviously, this can be fairly shocking to the alien when they were never informed of this legal requirement as part of their admission. The 50% penalty is the top tier, it can be argued down depending upon whether the failure to file the FBAR was not based on willfulness, but mere negligence.
In response to the outcry from both aliens and U.S. Citizens to this new and unexpected trap for the unwary, and also to encourage people to come in from the cold, Congress initiated the OVDP program (Offshore Voluntary Disclosure Program.) This was like an amnesty with teeth. The OVDP, unlike the failure to file FBAR penalties, had a sliding scale of penalties, from 27.5% down to 12.5% down to 5% depending upon the gravity of the omissions. However, the penalties are imputed back for eight years! The good news about submitting under the OVDP is if there is a voluntary disclosure, it is supposed to take all potential criminal charges off the table. Of course, if the alien is being audited, it is too late to seek amnesty.
The problem with this entire tax regime is the inherent unfairness to aliens who have earned or inherited their money overseas, prior to becoming resident aliens or citizens of the United States. The confiscatory penalty regime was really enacted by Congress in response to Americans who were hiding money overseas, avoiding the tax man. Aliens are, with a few exceptions, not in that category. Most of the aliens I have encountered were ignorant of the requirements, and made assumptions that only money earned here in the United States should be taxable here. This was not an unreasonable assumption, since most countries in the world tax their citizenry exactly that way, only upon money earned in the country. It is even a greater trap for the unwary alien that they have additional reporting requirements related to disclosing assets on a separate form and on a separate due date, with outrageous penalties for failing to disclose. Unfortunately, I have seen all too many aliens when confronted with this financial nightmare, climb back into their spaceships and fly home.
Philip Garrett Panitz is a tax attorney and a certified tax specialist, and has an LL.M. in taxation from New York University. He litigates tax court cases against the IRS nationwide. In 1995, he argued the landmark tax case Williams v. United States to the United States Supreme Court, leading to a victory that changed the way the IRS can seize properties from third parties. For more information, please call 805-379-1667.
1 This writer expresses no opinion as to why Flagstaff seems to be the capital of alien abductions.
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- Written by: T. Steel Rose, CPA
By: T. Steel Rose, CPA | This past September, the investment firm SecondMarket created the Bitcoin Investment Trust (BIT) to participate in the biggest bitcoin explosion in history. Bitcoin4biz spoke with Robert Cho, vice president of SecondMarket and the one who spearheads their bitcoin trading efforts.
“The fund is modeled after the SPDRS Gold (GLD) ETF. The BIT, launched as a vehicle for institutional investors to get into bitcoin,” Cho said.
Shares in the Trust edged along for around two weeks after its inception on 26th September. Following this, they began creeping up, before beginning their meteoric rise on November 4th. The net asset value (NAV) per share peaked a month later, before falling back. In short, the NAV of the BIT has tracked bitcoin’s own price movements very closely. The fund stood at $61.1m (67,300 BTC) net asset value on Friday the 13th, this December, 2013.
“BIT investment has been from a wide demographic, with interest from technologists and the [traditional] Wall Street audience,” said Cho.
The fund is bridging the gap in understanding on these investments. Although institutions are not investing, family offices are investing for their clients. BIT is the first US based fund to invest in bitcoins.
“It [the BIT] benefits the investors who can invest without worrying about cold storage or volatility,” said Cho.
The CEO of SecondMarket, Barry Silbert, introduced the idea of a bitcoin investment trust to the trading desk. The JOBS Act, which Silbert helped get passed according to Cho, relaxed requirements to advertise BIT to accredited investors. When this portion of the JOBS Act became effective on September 23, the BIT fund was ready to launch.
“Silbert saw the opportunity,” said Cho.
Investors are required to be accredited to invest in the fund through a self directed IRA. Some investors use self-directed IRAs to do early-stage investing. PENSCO, EnTrust, Equity Institutional, and Millennium Trust, list the BIT as an investment option. Clarifying the Fidelity Investments was allowing certain IRA clients to invest in bitcoin, SecondMarket said in a statement:
“The Bitcoin Investment Trust was previously approved by Fidelity as an eligible investment for accredited clients in their self-directed IRA accounts and investments began closing last week. We understand that Fidelity has decided to reevaluate this decision.”
The private aspect is what differentiates the BIT from the proposed Winklevoss twins’ EFT which is a public fund. Cho explained that March or April 2014 will be the redemption period for investors in the trust. Rather than sell them on the public exchanges, you could trade the fund shares on SecondMarket. SecondMarket is an alternative trading system (ATS) registered with the SEC. Therefore, the possibility of a large amount of bitcoin being sold on the public market may be mitigated; so it does not destabilize the market any more than it has been of late.
“SecondMarket is one of the largest liquidity providers for bitcoin which purchases bitcoin daily on exchanges, but mostly from private owners. People feel more comfortable dealing with SecondMarket which has been around before bitcoin began,” Cho said. “The most important factor benefitting SecondMarket being registered is their knowledge of AML and KYC (anti-money laundering and Know Your Customer).”
However, the BTC is volatile and a risky play. With the minimum investment being $25,000, you could either lose all your money or do very well. The risk/return profile is tremendous. The return is uncapped and unforeseen.
“One thing we do well is work within the proper regulatory guidelines,” said Cho.
The interest level from day one was surprising.
“When the bitcoin price escalated from $200ish to $600 to $800, along with media coverage, people got excited,” recounted Cho. “It is something we believe in.”
SecondMarket, Inc. (member FINRA/SIPC/MSRB) (SecondMarket) does not accept time sensitive, action-oriented messages or transaction orders, including orders to purchase or sell securities, via e-mail. SecondMarket does not produce in-house research, make recommendations to purchase or sell specific securities, provide investment advisory services, or conduct a general retail business.
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