                             T.C. Memo. 2017-211



                        UNITED STATES TAX COURT



        NEIL FEINBERG AND ANDREA E. FEINBERG, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent

                  KELLIE MCDONALD, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 10083-13, 10084-13.             Filed October 23, 2017.



      James D. Thorburn and Richard A. Walker, for petitioners.

      Luke D. Ortner, Matthew A. Houtsma, and Michael W. Lloyd, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      KERRIGAN, Judge: Petitioners in these consolidated cases are Neil

Feinberg (N. Feinberg) and Andrea E. Feinberg (together, Feinbergs), and Kellie
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[*2] McDonald (K. McDonald). For K. McDonald respondent determined

deficiencies of $13,369, $63,641, and $12,262 for tax years 2009-11, respectively.

For the Feinbergs respondent determined deficiencies of $47,203 and $35,809 for

2010 and 2011, respectively. Most of the deficiencies are attributable to income

adjustments for Total Health Concepts, LLC (THC).

      After concessions the issues for consideration are whether petitioners have

substantiated that they should be allowed costs of goods sold (COGS) greater than

those allowed in respondent’s examination report for THC and whether respondent

properly disallowed business expense deductions pursuant to section 280E.

Unless otherwise indicated, all section references are to the Internal Revenue Code

in effect for the tax years in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure.

                               FINDINGS OF FACT

      The stipulation of facts and the attached exhibits are incorporated herein by

this reference. Petitioners resided in Colorado when they timely filed their

petitions.

THC’s Business Activity

      THC was a limited liability company organized under the laws of the State

of Colorado. Articles of organization for THC were filed with the Colorado
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[*3] secretary of state on October 12, 2009. K. McDonald was a shareholder of

THC for tax years 2009-11. N. Feinberg was a shareholder for tax years 2010-11.

      The State of Colorado licensed THC to grow and sell medical marijuana,

and THC’s operating agreement stated that its purpose was to “promote the

cultivation and sale of medical marijuana products.” Its business operations began

in December 2009. During the tax years in issue it held licenses to operate at least

two medical marijuana dispensaries. THC leased a separate warehouse facility,

for which it held a license to operate a cultivation premises.

Tax Reporting

      For the tax years in issue THC 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. It reported ordinary business losses of $105,478, $295,321, and

$54,231 for tax years 2009-11, respectively. Each year THC calculated its total

income by subtracting COGS from gross receipts.

      THC claimed deductions from total income for ordinary and necessary

business expenses (below-the-line deductions). It claimed below-the-line

deductions for salaries and wages, repairs and maintenance, rents, depreciation,

advertising, and “other deductions”, which it detailed on attached statements. It
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[*4] claimed total below-the-line deductions for business expenses of $110,405,

$687,093, and $498,723 for the tax years in issue, respectively.

      Petitioners did not receive any compensation from THC. They reported

passthrough losses from THC on Schedules E, Part II, Income or Loss From

Partnerships and S Corporations, attached to their respective income tax returns.

The Feinbergs filed joint income tax returns for 2010-11.

Respondent’s Determination

      On December 6, 2012, respondent issued THC an examination report for its

tax returns for the tax years in issue. The examination report proposed

adjustments to taxable income based on respondent’s determination that section

280E applied to THC. The report also made adjustments to COGS.

      Respondent reclassified as COGS a number of THC’s expenses that were

claimed originally as below-the-line deductions. For both 2010 and 2011

respondent’s net adjustments allowed greater COGS than THC had actually

claimed on its original returns. However, respondent disallowed deductions for all

other business expenses not reclassified as COGS. The adjustments increased

THC’s taxable income for the tax years in issue by $104,051, $630,835, and

$375,442, respectively.
                                       -5-

[*5] On February 6, 2013, respondent issued K. McDonald and the Feinbergs

notices of deficiency that reflected the adjustments determined for THC. The

notices of deficiency reflected K. McDonald’s shares from THC as $52,025,

$157,708, and $93,861 for tax years 2009-11, respectively, and N. Feinberg’s

shares as $223,946 and $114,030 for 2010 and 2011, respectively.

                                    OPINION

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. At a

minimum petitioners must produce business records or other evidence

substantiating the amounts and the purpose of the deductions that they assert

respondent improperly disallowed. Higbee v. Commissioner, 116 T.C. 438, 440

(2001). Under section 7491(a) in certain circumstances the burden of proof may

shift from the taxpayer to the Commissioner. Petitioners have not claimed or
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[*6] 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.   Evidentiary Issues

      During the trial petitioners produced no contemporaneous records or any

other business records pertaining to THC’s operations. Instead they rely

exclusively on an expert report.

      In accordance with the Court’s standing pretrial order and Rule 143(g),

petitioners exchanged and submitted the expert report of Jim Marty, C.P.A., whom

they contend is an expert in cost accounting, with an emphasis in the marijuana

industry. In his report Marty opines on COGS for medical marijuana businesses in

Colorado during the tax years in issue. Petitioners contend that the report

establishes that the COGS respondent allowed THC for the tax years in issue were

incorrect.

      Before trial respondent filed a motion in limine, asserting that the Marty

report should be excluded on the following grounds:

      (1) Admitting the report is improper where petitioners have refused to
      comply with any discovery requests; (2) the report is an attempt to
      usurp the Court’s own role insofar as it attempts to substitute Mr.
      Marty’s legal conclusions and unsupported factual assertions for the
      Court’s role in applying the law to the facts of this case; and (3) the
      report’s factual conclusions are not reliable.
                                        -7-

[*7] At the trial the Court deferred ruling on respondent’s motion in limine

because of the substantial effect on the case of eliminating petitioners’ primary

evidence. The Marty report was marked, and the related testimony of petitioners’

expert was heard solely as an offer of proof. Whether the report and testimony

will be received in evidence and considered in determining THC’s COGS for tax

years 2009-11 depends on application of principles expressed in Daubert v.

Merrell Dow Pharms., Inc., 509 U.S. 579 (1993), and rule 702 of the Federal Rules

of Evidence.

      Respondent contends the Marty report reaches a number of speculative

conclusions regarding the amount of allowable COGS based wholly on his

“unscientific, unprincipled opinion”. Respondent further contends that there is no

analysis or reliable data for figures in the report. Petitioners contend that Daubert

does not apply to a bench trial.

      Rule 702 of the Federal Rules of Evidence provides:

      A witness who is qualified as an expert by knowledge, skill,
      experience, training, or education may testify in the form of an
      opinion or otherwise if:

            (a) the expert’s scientific, technical, or other specialized
      knowledge will help the trier of fact to understand the evidence or to
      determine a fact in issue;
                                         -8-

      [*8] (b) the testimony is based on sufficient facts or data;

           (c) the testimony is the product of reliable principles and
      methods; and

             (d) the expert has reliably applied the principles and methods to
      the facts of the case.

      In Daubert, 509 U.S. at 592, the Supreme Court stressed the trial court’s role

as a “gatekeeper” in excluding at the outset evidence that is unreliable or

irrelevant. The trial judge must make “a preliminary assessment of whether the

reasoning or methodology underlying the testimony is scientifically valid and of

whether that reasoning or methodology properly can be applied to the facts in

issue.” Id. at 592-593. The reliability and relevancy standards are embodied in

rule 702 of the Federal Rules of Evidence, and they apply equally to expert

testimony that is not “scientific”. Kumho Tire Co. v. Carmichael, 526 U.S. 137,

148 (1999). Although special considerations apply to jury trials, the Daubert

analysis applies to bench trials as well as jury trials. Boltar, L.L.C. v.

Commissioner, 136 T.C. 326, 334 (2011) (citing Att’y Gen. of Okla. v. Tyson

Foods, Inc., 565 F.3d 769, 779 (10th Cir. 2009)).

      The Marty report is brief and summary, and its content is unreliable.

Multiple statements in the report refer to no underlying source of information. For

other statements that do cite an underlying source, Marty has failed to include the
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[*9] information or data on which he relied. In many instances the report does not

reference or provide sufficient information or data for us to conclude that the

opinions expressed are based on anything other than his own conjecture.

      The report states that during the tax years in issue the average wholesale

purchase price for medical marijuana remained between $2,000 and $3,000 per

pound. The report later posits an average purchase price of $2,500 per pound and

reconstructs an income and expense schedule for THC “assuming” that COGS

equaled 55% of gross sales. The report does not explain how or on what basis

Marty determined these sales figures, and the exhibits do not include any sales

records or other documents that would support them. The report asserts that tax

returns Marty’s firm prepared show that “actual” COGS for medical marijuana

businesses during the tax years in issue was between 66% and 100% (or more) of

gross sales.

      The conclusions in the Marty report are an attempt to present reconstructed

income tax returns as evidence of petitioners’ correct tax liabilities. The report is

not based on personal knowledge of THC’s business. To determine the correct

COGS for THC, substantiation of THC’s expenses is necessary. A reconstructed

income tax return based on industry averages does not take the place of

substantiation and does not help determine a fact in issue.
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[*10] By relying on returns that Marty and his firm prepared for other businesses,

the Marty report provides the Court with legal conclusions as to which types of

expenses may be treated as COGS. Expert testimony about what the law is or that

directs the finder of fact on how to apply the law does not assist the trier of fact.

Stobie Creek Invs., LLC v. United States, 81 Fed. Cl. 358, 364 (2008). Expert

opinions on law are inadmissable. Fed. R. Evid. 702(a); see Hosp. Corp. of Am. v.

Commissioner, 109 T.C. 21, 59 (1997).

       For the reasons stated above, we conclude that the Marty report is not

admissible under rule 702 of the Federal Rules of Evidence because is it is not

helpful in understanding evidence or in determining a fact and it includes legal

conclusions.

       During the trial respondent offered Exhibits 32-R and 34-R through 39-R.

All were offered in relation to the Marty report, and the ruling on these exhibits

was reserved. These exhibits are not admitted because the Marty report was

excluded.

III.   Cost of Goods Sold

       A taxpayer engaged in manufacturing or merchandising can subtract

COGS from gross receipts to arrive at gross income. See secs. 1.61-3(a), 1.162-

1(a), Income Tax Regs.; see also Rodriguez v. Commissioner, T.C. Memo. 2009-
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[*11] 22, slip op. at 6. COGS is not a deduction but an offset to income for the

purpose of calculating gross income and is subtracted from gross income to arrive

at taxable income. See Kazhukauskas v. Commissioner, T.C. Memo. 2012-191,

slip op. at 24; Rodriguez v. Commissioner, slip op. at 6-7.

      Petitioners must show that they are entitled to COGS for THC above and

beyond those respondent allowed. See Kazhukauskas v. Commissioner, slip op. at

24. The substantiation rules require a taxpayer to maintain sufficient reliable

records to allow the Commissioner to verify the taxpayer’s income and

expenditures. See sec. 6001; sec. 1.6001-1(a), Income Tax Regs.; see also Olive

v. Commissioner, 139 T.C 19, 32 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015).

      COGS is determined under section 471 and the accompanying regulations.

See secs. 1.471-3(c), 1.471-11(c), Income Tax Regs. Petitioners contend we

should allow the COGS in THC’s income tax returns under the Cohan rule. See

Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). Petitioners further contend

that they should be able to subtract an amount for COGS based on industry

standards for the medical marijuana industry during the tax years in issue.

Respondent allowed COGS that were substantiated and also recharacterized

below-the-line expenses as COGS to the extent allowable under section 471.
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[*12] Petitioners produced no evidence to substantiate COGS higher than those

which respondent allowed.

      The Court may estimate the amount of a deductible expense if a taxpayer

establishes that an expense is deductible but is unable to substantiate the precise

amount. See Cohan v. Commissioner, 39 F.2d at 543-544; Vanicek v.

Commissioner, 85 T.C. 731, 742-743 (1985). This principle is often referred to as

the Cohan rule. See, e.g., Van Dusen v. Commissioner, 136 T.C. 515, 537 n.39

(2011). The Cohan rule also applies to COGS. See Goldsmith v. Commissioner,

31 T.C. 56, 62 (1958).

      In Cohan v. Commissioner, 39 F.2d at 544, the Court of Appeals for the

Second Circuit held that this Court should in some cases make “as close an

approximation as it can” with respect to a taxpayer’s deductible expenses,

“bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own

making.” The Court of Appeals for the Second Circuit stated that “to allow

nothing at all appears to us inconsistent with saying that something was spent.”

Id.

      During the tax years in issue THC held licenses for selling medical

marijuana in Colorado. We will proceed as if THC was in the business of selling
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[*13] medical marijuana. However, there is not enough evidence in the record to

make a finding of fact that THC sold medical marijuana.

      Respondent did allow for some COGS. Under the Cohan rule there must be

sufficient evidence in the record to provide a basis upon which an estimate can be

made. Vanicek v. Commissioner, 85 T.C. at 742-743. There is no evidence to

support higher COGS for THC. We sustain respondent’s allowances for COGS.

IV.   Business Expenses

      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. at

84; New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Section 162(a)

permits a taxpayer to deduct ordinary and necessary expenses incurred during the

taxable year in carrying on a trade or business. Section 261 provides that “no

deduction shall in any case be allowed in respect of items specified in this part.”

“[I]tems 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 Drugs”. See Californians Helping to Alleviate Med.

Problems, Inc. v. Commissioner, 128 T.C. 173, 180 (2007). Section 280E

provides:
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      [*14] 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 Substance Act)
      which is prohibited by Federal law or the law of any state in which
      such trade or business is conducted.

      We do not need to address whether section 280E applies because petitioners

have failed to substantiate any expenses for which respondent disallowed

deductions. Petitioners did not produce any business records or any other

supporting documents. They have not met their burden of proving respondent’s

determinations in the notices of deficiency are incorrect. Respondent’s

determinations will be sustained.

      To reflect the foregoing,


                                               Decisions will be entered

                                      for respondent.
