                               T.C. Memo. 2018-85



                        UNITED 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,
                                        -4-

[*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.
                                         -6-

[*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.
                                       - 12 -

[*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.
