                                           MARTIN OLIVE, PETITIONER v. COMMISSIONER                                OF INTERNAL
                                                          REVENUE, RESPONDENT
                                                     Docket No. 14406–08.                        Filed August 2, 2012.

                                                  P operates a sole proprietorship whose principal business is
                                                the retail sale of medical marijuana pursuant to California
                                                law. The business also provides minimal activities and serv-
                                                ices incident to the sales. P failed to maintain sufficient
                                                records to substantiate the business’ income or expenditures.
                                                Held: P underreported the business’ gross receipts in amounts
                                                R alleges in an amendment to answer. Held, further, P may
                                                deduct cost of goods sold for the business in amounts greater
                                                than those R allows. Held, further, I.R.C. sec. 280E precludes
                                                P from deducting any expense related to the business in that
                                                the business is a single business that consists of trafficking in
                                                a controlled substance. Californians Helping to Alleviate Med.
                                                Problems, Inc. v. Commissioner, 128 T.C. 173 (2007), distin-
                                                guished. Held, further, P is liable for accuracy-related pen-
                                                alties under I.R.C. sec. 6662(a) to the extent stated.

                                        Henry G. Wykowski and Chris Wood (student), for peti-
                                     tioner.
                                        Daniel J. Parent, for respondent.
                                        KROUPA, Judge: This case stems from the operation of peti-
                                     tioner’s sole proprietorship, the Vapor Room Herbal Center
                                     (Vapor Room). The Vapor Room’s principal business is the
                                     retail sale of marijuana (medical marijuana) pursuant to the
                                     California Compassionate Use Act of 1996 (CCUA), codified at
                                     Cal. Health & Safety Code sec. 11362.5 (West 2007). 1 The
                                     Vapor Room provides minimal activities and services as part
                                     of its principal business of selling medical marijuana.
                                        Respondent determined deficiencies of $367,531 and
                                     $1,146,633 in petitioner’s Federal income tax for 2004 and
                                     2005, respectively, after determining that petitioner failed to
                                     substantiate any costs of goods sold (COGS) or expenses
                                     reported for the Vapor Room. Respondent also determined for
                                       1 Unless otherwise indicated, section references are to the applicable versions of the Internal

                                     Revenue Code (Code), Rule references are to the Tax Court Rules of Practice and Procedure and
                                     dollar amounts are rounded to the nearest dollar.


                                                                                                                                    19




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                                     20                  139 UNITED STATES TAX COURT REPORTS                                       (19)


                                     the respective years that petitioner was liable for section
                                     6662(a) accuracy-related penalties of $73,506 and $229,327
                                     due to substantial understatements of income tax or, alter-
                                     natively, negligence or disregard of rules and regulations.
                                     Respondent, in an amendment to answer, increased the defi-
                                     ciencies to $692,501 for 2004 and $1,199,814 for 2005 to
                                     reflect unreported gross receipts that respondent discovered
                                     after he issued the deficiency notice. Respondent correspond-
                                     ingly increased the accuracy-related penalties to $138,500
                                     and $239,963.
                                       We decide as to the Vapor Room for 2004 and 2005:
                                       1. whether petitioner underreported gross receipts in
                                     amounts respondent alleges in an amendment to answer. We
                                     hold he did;
                                       2. whether petitioner may deduct COGS in amounts greater
                                     than those respondent allows. 2 We hold he may to the extent
                                     stated;
                                       3. whether petitioner may deduct his claimed expenses. We
                                     hold he may not; and
                                       4. whether petitioner is liable for the accuracy-related pen-
                                     alties. We hold he is to the extent stated.

                                                                         FINDINGS OF FACT

                                     I. Preliminaries
                                        The parties submitted stipulated facts and exhibits. We
                                     incorporate the stipulated facts and exhibits by this ref-
                                     erence. Petitioner is a high school graduate who resided in
                                     California when he filed the petition. He filed Federal income
                                     tax returns for 2004 and 2005 and included in each return
                                     a Schedule C, Profit or Loss From Business (Sole Proprietor-
                                     ship), reporting the Vapor Room’s gross receipts, COGS and
                                     expenses for the corresponding year. He reported that the
                                     Vapor Room’s ‘‘principal business’’ is ‘‘Retail Sales’’ and that
                                     its product is ‘‘Herbal.’’



                                       2 COGS is not a deduction within the meaning of sec. 162(a) but is subtracted from gross re-

                                     ceipts in determining a taxpayer’s gross income. See Max Sobel Wholesale Liquors v. Commis-
                                     sioner, 69 T.C. 477 (1977), aff ’d, 630 F.2d 670 (9th Cir. 1980); sec. 1.162–1(a), Income Tax Regs.
                                     We refer to COGS as a deduction for convenience.




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                                     (19)                              OLIVE v. COMMISSIONER                                         21


                                     II. CCUA
                                        The State of California’s voters approved the CCUA as a
                                     ballot initiative in 1996. The CCUA is intended to ensure that
                                     ‘‘seriously ill Californians’’ (recipients) can obtain and use
                                     marijuana if physicians recommend marijuana as beneficial
                                     to recipients’ health. Numerous medical marijuana
                                     dispensaries were formed in California to dispense medical
                                     marijuana to recipients. 3 Medical marijuana, however, is a
                                     controlled substance under Federal law.
                                     III. Petitioner Forms the Vapor Room
                                       Petitioner, while pursuing a college degree in arts and edu-
                                     cation, became involved in the medical marijuana industry
                                     by volunteering at a medical marijuana dispensary in San
                                     Francisco, California. The dispensary had a single business,
                                     the dispensing of medical marijuana. Petitioner learned that
                                     an approximately 1,250-square-foot room in his low-income
                                     neighborhood of San Francisco was available to rent at a
                                     minimal cost and he decided to abandon his college studies
                                     during his second year and establish a medical marijuana
                                     dispensary in the room. He sought the help of local friends
                                     and marijuana suppliers and, on January 25, 2004, began
                                     operating an unlicensed medical marijuana dispensary as a
                                     sole proprietorship. 4 He named his dispensary the Vapor
                                     Room. 5 He established the Vapor Room so that its patrons,
                                     almost all of whom were recipients (including some with ter-
                                     minal diseases such as cancer or HIV/AIDS) could socialize and
                                     purchase and consume medical marijuana there. 6
                                       Petitioner designed the Vapor Room with a comfortable
                                     lounge-like, community center atmosphere, placing couches,
                                     chairs and tables throughout the premises. He placed vapor-
                                     izers, games, books and art supplies on the premises for
                                     patrons to use at their desire. He set up a jewelry-store-like
                                           3 Approximately
                                                        50 medical marijuana dispensaries were located in California in 2004.
                                           4 Petitioner
                                                    was oblivious to the licensing requirement for his medical marijuana dispensary.
                                     He received the requisite license from San Francisco in or about July 2004.
                                       5 A vaporizer is an expensive apparatus that extracts from marijuana its principal active com-

                                     ponent and allows the user to inhale vapor rather than smoke. Petitioner chose the name of
                                     his business to publicize that the Vapor Room had the requisite equipment to allow patrons to
                                     vaporize marijuana there.
                                       6 We say ‘‘almost all’’ because patrons also included designated caregivers of the recipients,

                                     who were entitled to receive medical marijuana for recipients. We use the term ‘‘patrons’’ to in-
                                     clude only recipients.




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                                     22                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     glass counter with a cash register on top and jars of the
                                     Vapor Room’s medical marijuana inventory displayed under-
                                     neath and behind the counter.
                                     IV. Operation of the Vapor Room
                                        The Vapor Room was generally open for business (except
                                     on some holidays) on weekdays from 11 a.m. to 8:30 p.m.,
                                     and on weekends from noon to 8 p.m. The Vapor Room sold
                                     nothing but medical marijuana (in three different forms) and
                                     its patrons went to the Vapor Room primarily to consume
                                     marijuana, knowing that it was readily available there. 7
                                     Patrons also frequented the Vapor Room to socialize with
                                     each other incident to consuming marijuana. Petitioner
                                     required that each patron possess either a doctor’s rec-
                                     ommendation to use medical marijuana or a similar certifi-
                                     cate the San Francisco government issued. This documenta-
                                     tion contained the person’s picture and identification
                                     number, but not his or her name. Patrons came to know at
                                     least the first name of the other patrons who regularly fre-
                                     quented the Vapor Room.
                                        The Vapor Room’s staff members (collectively, staff mem-
                                     bers) were petitioner and a few other individuals (four
                                     working as employees and an undisclosed number working as
                                     volunteers) and all staff members qualified under the CCUA
                                     to receive and consume medical marijuana. Neither the staff
                                     members nor the other patrons paid petitioner a stated fee
                                     to frequent the Vapor Room. Nor did petitioner require that
                                     any patron purchase medical marijuana from him to frequent
                                     the Vapor Room or to take part in its activities or services.
                                     Patrons had access to all of the activities and services that
                                     the Vapor Room provided and marijuana was routinely
                                     passed throughout the room for consumption without cost to
                                     patrons who wanted to partake.
                                        The Vapor Room’s sole source of revenue was its sale of
                                     medical marijuana and patrons did not specifically pay for
                                     anything else connected with or offered by the Vapor Room.
                                     Petitioner purchased for cash (or sometimes received for free)
                                     the Vapor Room’s medical marijuana inventory from sup-
                                     pliers, each of whom was eligible under the CCUA to receive
                                       7 The medical marijuana in the Vapor Room’s inventory was in the following three forms: (1)

                                     dried marijuana, (2) food (e.g., bakery goods, butter and candy) laced with marijuana and (3)
                                     a concentrated version of the principal active component of marijuana.




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                                     (19)                            OLIVE v. COMMISSIONER                                         23


                                     and consume marijuana. Petitioner typically purchased high-
                                     quality marijuana to dispense to the patrons and he allowed
                                     them to consume the marijuana virtually anywhere on the
                                     premises. Petitioner sold to the patrons for cash 93.5% of the
                                     marijuana that he received and he gave the rest to patrons
                                     (including himself and the other staff members) for free. One
                                     to three staff members monitored the counter in the Vapor
                                     Room and they explained to patrons the attributes and
                                     effects of the different types of medical marijuana in the
                                     Vapor Room’s inventory. Petitioner set each patron’s cost for
                                     the medical marijuana according to the quantity desired, the
                                     quality of the marijuana and the amount petitioner decided
                                     the patron should pay. Petitioner sometimes gave patrons
                                     medical marijuana for free. Petitioner and the other staff
                                     members occasionally sampled the medical marijuana inven-
                                     tory for free and they would regularly ‘‘hang out’’ at the
                                     Vapor Room after business hours and consume marijuana.
                                     Staff members and other patrons sometimes consumed med-
                                     ical marijuana together. 8
                                        Petitioner provided regular activities at the Vapor Room,
                                     such as yoga classes, chess and other board games and
                                     movies (with complimentary popcorn and drinks). Patrons
                                     sometimes consumed medical marijuana while participating
                                     in these activities. The Vapor Room regularly offered chair
                                     massages with a therapist. Patrons sometimes consumed
                                     medical marijuana before or after a massage. Patrons, while
                                     at the Vapor Room, regularly drank complimentary tea or
                                     water and they occasionally ate complimentary snacks or
                                     light food such as pizza and sandwiches.
                                        Staff members explained to patrons the promoted benefits
                                     of vaporizing marijuana (as opposed to smoking it). The staff
                                     members also helped patrons understand how to operate a
                                     vaporizer and the staff members helped patrons operate
                                     a vaporizer upon request. Petitioner did not require that a
                                     patron buy medical marijuana from the Vapor Room as a
                                     condition of using one of the Vapor Room’s vaporizers and
                                     patrons sometimes consumed in a vaporizer (or elsewhere in
                                       8 Petitioner was not forthcoming with the specific prices at which he sold his marijuana or

                                     the specific amount of medical marijuana that was consumed for free. Nor does the record con-
                                     tain a formula for the price that petitioner charged a patron for medical marijuana or reveal
                                     whether any discount price had a set floor such as the Vapor Room’s cost. Petitioner, during
                                     2004, sold approximately 32% of the marijuana (inclusive of the portion he dispensed for free)
                                     for less than what would otherwise have been the sale price.




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                                     24                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     the room) marijuana they obtained elsewhere. Staff members
                                     sometimes delivered medical marijuana to terminally ill
                                     patrons at locations other than the Vapor Room and joined
                                     those patrons in consuming marijuana at those other loca-
                                     tions. The Vapor Room’s staff members lived near the Vapor
                                     Room.
                                        Patrons discussed with other patrons (sometimes one-on-
                                     one) their illnesses and their lives in general and they coun-
                                     seled one another on various personal, legal or political mat-
                                     ters related to medical marijuana. Staff members (or other
                                     persons the Vapor Room retained) educated patrons or mem-
                                     bers of the public on medical marijuana and about using
                                     medical marijuana responsibly. The Vapor Room had a pro-
                                     gram through which patrons wrote letters to individuals who
                                     were incarcerated for distributing medical marijuana.
                                     V. Vapor Room’s Gross Receipts, COGS and Reported Income
                                           A. Reported Income
                                       Petitioner’s tax returns for 2004 and 2005 reported that
                                     the Vapor Room’s net income was $64,670 and $33,778,
                                     respectively. 9 The net income was calculated as follows:

                                                                                                      2004              2005
                                           Gross receipts                                         $1,068,830          $3,131,605
                                           COGS                                                      993,377           2,812,478

                                           Gross income                                                 75,453           319,127
                                           Expenses:
                                             Advertising                                                 -0-                  660
                                             Bank fees                                                   -0-                  790
                                             Deductible meals and entertain-
                                               ment                                                      -0-                3,072
                                             Depreciation                                                -0-               11,506
                                             Internet services and fee                                   1,605              -0-
                                             Legal and professional services                             -0-               46,900
                                             Office                                                      -0-               13,337
                                             Payroll fees                                                -0-                1,353
                                             Postage and delivery                                        -0-                    13
                                             Printing and reproduction                                   -0-                1,952
                                             Rent                                                        4,000             14,300
                                             Repairs and maintenance                                       730              3,505
                                             Security services                                             750                412
                                             Supplies                                                    2,922              -0-
                                       9 Petitioner used the cash method to compute the Vapor Room’s net income. Respondent does

                                     not challenge petitioner’s use of that method. We discuss it no further.




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                                     (19)                            OLIVE v. COMMISSIONER                                          25


                                                                                                      2004              2005
                                             Taxes and licenses                                          -0-               8,750
                                             Telephone                                                   -0-                 965
                                             Travel                                                        776                10
                                             Utilities                                                   -0-               3,426
                                             Wages                                                       -0-             175,934

                                               Total                                                    10,783          1 285,349


                                               Net profit                                               64,670             33,778
                                              1 The expenses in this column actually total $286,885, or $1,536
                                           more than $285,349. Petitioner apparently reported the Vapor Room’s
                                           ‘‘Deductible meals and entertainment’’ at 100% of the reported cost
                                           and then reduced the $286,885 to $285,349 (without noting so) to take
                                           into account the 50% reduction of sec. 274(n).

                                           B. Gross Receipts
                                       Staff members noted the amount of the Vapor Room’s sales
                                     for each business day as shown on the cash register tape and
                                     counted the cash in the register. The total daily sales as
                                     ascertained by the cash register tape and by the daily count
                                     were recorded in a book (recording book).
                                       Petitioner’s Schedules C for 2004 and 2005 reported gross
                                     receipts of $1,068,830 and $3,131,605, respectively. The gross
                                     receipts reported on the Schedule C for 2004, however, did
                                     not include any gross receipts received before July 14, 2004.
                                           C. COGS
                                       Petitioner’s Schedules C for 2004 and 2005 reported that
                                     the Vapor Room’s COGS were $993,337 and $2,812,478,
                                     respectively. These amounts were calculated as follows:

                                                                                                      2004              2005

                                           Purchases less cost of items with-
                                             drawn for personal use                                      -0-          $2,796,724
                                           Cost of labor                                               $88,209             -0-
                                           Materials and supplies                                      905,168            15,754

                                             COGS                                                      993,377         2,812,478

                                     The labor amounts represent petitioner’s payments to mari-
                                     juana growers in return for marijuana that they grew.




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                                     26                   139 UNITED STATES TAX COURT REPORTS                                     (19)


                                           D. Expenses
                                       Petitioner paid the Vapor Room’s expenses by using cash
                                     from the cash register or by using a check or a debit card
                                     drawn on a bank account that petitioner opened as a sole
                                     proprietor ‘‘DBA Vapor Room.’’ Petitioner opened this account
                                     on July 6, 2004, and he regularly deposited funds into the
                                     account to cover the draws from the account.
                                       Petitioner paid the Vapor Room’s employees through a pay-
                                     roll service. Petitioner paid the employees (who were the
                                     same individuals in both 2004 and 2005) wages of $37,588
                                     and $96,965. Petitioner reported those wages to the Internal
                                     Revenue Service for Federal employment tax purposes. None
                                     of the employees had a specific job at the Vapor Room and
                                     each employee at one time or another performed all required
                                     jobs.
                                       Respondent concedes that petitioner paid the following
                                     ordinary and necessary business expenses during 2004 and
                                     2005:
                                                        Expense                                            2004            2005
                                           Advertising                                                     -0-             $650
                                           Bank and payroll (Paychex) fees                                 $557           1,271
                                           Bottled water                                                   -0-              473
                                           Employment taxes                                               3,002           7,609
                                           Garbage                                                         -0-              317
                                           Office expense and supplies                                    2,992          13,337
                                           Phone and Internet                                               681             784
                                           Postage                                                         -0-               13
                                           Rent                                                          12,000          12,300
                                           Repairs and maintenance                                         -0-            2,297
                                           Security alarm monitoring                                        361             413
                                           Security system/locksmith                                       -0-           11,506
                                           Utilities                                                        748           1,731
                                           Wages                                                         37,588          96,965

                                              Total                                                      57,929         149,666

                                     The items underlying the office expense and supplies for
                                     2004 include office supplies (e.g., labels), paper cups, a step
                                     ladder, a shredder, zip bags, glass canisters, a degreaser,
                                     marijuana rolling papers and lighters. The advertising
                                     expense for 2005 relates to advertisements aimed at medical
                                     marijuana audiences. The items underlying the office
                                     expense and supplies for 2005 include paper towels, mari-
                                     juana-related calendars, magazines and books, marijuana




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                                     (19)                            OLIVE v. COMMISSIONER                                         27


                                     rolling papers, zip bags, vaporizer bags, lighters, brown
                                     paper bags, containers and storage jars.
                                           E. Petitioner’s Withdrawals
                                       Petitioner regularly took cash from the cash register to use
                                     personally, including to pay for personal trips to New York,
                                     New York, to Barcelona, Spain, to Amsterdam, the Nether-
                                     lands, to Venice, Italy, to Cabo San Lucas, Mexico, and to the
                                     British Virgin Islands. He coded these withdrawals in the
                                     recording books so that the Vapor Room’s employees would
                                     not know the amount of money he was taking from the busi-
                                     ness.
                                     VI. Audit
                                        Respondent began auditing petitioner’s 2004 tax return in
                                     April 2006 and respondent’s revenue agent met with peti-
                                     tioner (accompanied by his independent accountant/tax pre-
                                     parer William Ehardt and an attorney) on July 6, 2006. 10
                                     The revenue agent requested the Vapor Room’s bank state-
                                     ments and substantiation for COGS and petitioner gave the
                                     revenue agent two documents Mr. Ehardt had prepared: a
                                     document entitled ‘‘Vapor Room Profit and Loss January
                                     through December 2004’’ (Ehardt P&L) and a document enti-
                                     tled ‘‘Vapor Room General Ledger As of December 2004’’
                                     (Ehardt GL). The Ehardt GL reports that the Vapor Room’s
                                     first sale occurred on July 14, 2004. The Ehardt P&L and the
                                     Ehardt GL each report that the Vapor Room’s total income
                                     for 2004 was $1,068,830, which corresponds to the amount of
                                     gross receipts reported on the Federal income tax return for
                                     2004. Many (but not all) of the expenditures shown on the
                                     Ehardt P&L and the Ehardt GL were reported on the return
                                     for 2004.
                                        The revenue agent next met with Mr. Ehardt in August
                                     2006 (the second and last meeting that the revenue agent
                                     had with petitioner or his representatives) and was informed
                                     that petitioner had ‘‘ledgers’’ showing cash received for sales
                                     and cash paid for purchases, but no further documents. Peti-
                                     tioner did not tender any ledgers at that time.
                                       10 Petitioner filed his Federal income tax return for 2005 during the last week of September

                                     2006. The audit was expanded at or about that time to include 2005.




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                                     28                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     VII. Deficiency Notice
                                        Respondent issued the deficiency notice to petitioner. The
                                     deficiency notice states that petitioner may not deduct any of
                                     the reported COGS on account of lack of substantiation. Peti-
                                     tioner, after the deficiency notice was issued, provided
                                     respondent’s counsel with $25,776 in receipts for COGS for
                                     2004 and $27,370 in receipts for COGS for 2005. Respondent
                                     concedes that petitioner may deduct those respective
                                     amounts as COGS for 2004 and 2005.
                                        The deficiency notice also states that petitioner may not
                                     deduct any of the reported expenses on account of lack of
                                     substantiation. Respondent later conceded that petitioner
                                     substantiated the $57,929 and $149,666 of expenses pre-
                                     viously mentioned but asserts that section 280E precludes
                                     any deduction of these expenses. Respondent’s revenue agent
                                     had relied upon sections 280E and 6001 during the audit to
                                     disallow all of the Vapor Room’s reported expenses, but the
                                     deficiency notice does not specifically say that. Respondent
                                     formalized the applicability of section 280E in a second
                                     amendment to answer.
                                     VIII. Ledgers
                                        Petitioner gave respondent five ledgers (collectively,
                                     ledgers) during this proceeding. The credible evidence in the
                                     record fails to establish when the ledgers were prepared. The
                                     ledgers, however, do not appear to be (and we do not find
                                     that they are) the same as the recording books.
                                        The ledgers purport to show the Vapor Room’s receipts and
                                     cash disbursements (not including payments through the
                                     Vapor Room’s bank account) for January 25 through March
                                     13, 2004; June 1 through October 30, 2004; November 1,
                                     2004, through April 25, 2005; April 26 through October 8,
                                     2005; and October 9, 2005, through February 18, 2006,
                                     respectively. Petitioner has never produced a ledger (or
                                     recording book) for the 79-day period from March 14 through
                                     May 31, 2004.
                                        The ledgers show categories of cash received and expendi-
                                     tures made during each business day in a total figure for
                                     each category and they list few (and in some cases no) spe-
                                     cifics on the components of the categories. The ledgers some-




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                                     (19)                            OLIVE v. COMMISSIONER                                         29


                                     times contain no identification for an expenditure. Petitioner
                                     cannot definitively identify some of the entries in the ledgers.
                                       The ledgers (as respondent adjusted for 2004 to reflect the
                                     missing 79-day period) report that the Vapor Room’s gross
                                     receipts for 2004 and 2005 were $1,967,956 and $3,301,898,
                                     respectively.

                                                                                  OPINION

                                     I. Overview
                                       California law allows petitioner to dispense medical mari-
                                     juana to the recipients through the Vapor Room. Federal law
                                     prohibits taxpayers, however, from deducting any expense of
                                     a trade or business that consists of the trafficking of a con-
                                     trolled substance such as marijuana. See sec. 280E. We are
                                     asked to decide whether the Vapor Room, a medical mari-
                                     juana dispensary permitted by California law, may deduct
                                     any of its expenses. We also are asked to decide whether
                                     petitioner underreported the Vapor Room’s gross receipts,
                                     whether petitioner overreported the Vapor Room’s COGS and
                                     whether petitioner is liable for an accuracy-related penalty.
                                       We first discuss the burden of proof and our perception of
                                     the witnesses. We then decide the referenced issues.
                                     II. Burden of Proof
                                       Petitioner bears the burden of proving that respondent’s
                                     determination of the deficiencies set forth in the deficiency
                                     notice is incorrect. See Rule 142(a)(1); Welch v. Helvering,
                                     290 U.S. 111, 115 (1933). Section 7491(a) sometimes shifts
                                     the burden of proof to the Commissioner, but that section
                                     does not apply where a taxpayer fails to satisfy the record-
                                     keeping and substantiation requirements. See sec.
                                     7491(a)(2)(A) and (B). Petitioner has failed to satisfy those
                                     requirements. Respondent bears the burden of proof only
                                     with respect to the increased deficiencies pleaded in the
                                     amendment to answer. 11 See Rule 142(a)(1).

                                       11 Petitioner does not argue that respondent bears the burden of proving the applicability of

                                     sec. 280E. We need not decide that issue because our resolution of that issue does not rest on
                                     which party bears the burden of proof. See Estate of Morgens v. Commissioner, 133 T.C. 402,
                                     409 (2009), aff ’d, 678 F.3d 769 (9th Cir. 2012); see also Knudsen v. Commissioner, 131 T.C. 185,
                                     186–189 (2008).




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                                     30                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     III. Witness Testimony
                                        We determine the credibility of each witness, weigh each
                                     piece of evidence, draw appropriate inferences and choose
                                     between conflicting inferences in finding the facts of a case.
                                     The mere fact that one party presents unopposed testimony
                                     on that party’s behalf does not necessarily mean that we will
                                     find the elicited testimony to be credible. We will not accept
                                     the testimony of witnesses at face value to the extent we per-
                                     ceive the testimony to be incredible or otherwise unreliable.
                                     See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43,
                                     84 (2000), aff ’d, 299 F.3d 221 (3d Cir. 2002); see also Ruark
                                     v. Commissioner, 449 F.2d 311, 312 (9th Cir. 1971), aff ’g per
                                     curiam T.C. Memo. 1969–48; Clark v. Commissioner, 266
                                     F.2d 698, 708–709 (9th Cir. 1959), aff ’g in part and
                                     remanding T.C. Memo. 1957–129.
                                        Petitioner’s testimony and the testimony of his other wit-
                                     nesses were rehearsed, insincere and unreliable. We do not
                                     rely on petitioner’s testimony to support his positions in this
                                     case, except to the extent his testimony is corroborated by
                                     reliable documentary evidence. We also do not rely on the
                                     uncorroborated testimony of petitioner’s other witnesses,
                                     three of whom are (or were) patrons of the Vapor Room and
                                     all of whom are closely and inextricably connected with the
                                     medical marijuana industry and with a desired furtherance
                                     of that movement.
                                     IV. Unreported Gross Receipts
                                        We start our analysis of the substantive issues by deter-
                                     mining the amount of the Vapor Room’s gross receipts. Peti-
                                     tioner reported that the Vapor Room’s gross receipts were
                                     $1,068,830 for 2004 and $3,131,605 for 2005. Respondent did
                                     not adjust those amounts in the deficiency notice. Petitioner
                                     later, however, gave respondent the ledgers that revealed
                                     that the Vapor Room’s gross receipts were greater than the
                                     reported amounts. Respondent then computed the Vapor
                                     Room’s gross receipts using the ledgers. Respondent first
                                     totaled the cash that petitioner recorded in the ledgers for
                                     each year as sales receipts ($1,513,370 and $3,301,898,
                                     respectively). Respondent then extrapolated from the ledgers’
                                     recording of the sales receipts for 2004 that the Vapor
                                     Room’s total sales during the missing 79-day period were




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                                     (19)                            OLIVE v. COMMISSIONER                                         31


                                     $454,586. Respondent concluded that the Vapor Room’s gross
                                     receipts for 2004 and 2005 were $1,967,956 ($1,513,370 +
                                     $454,586) and $3,301,898, respectively, and asks the Court to
                                     find the same.
                                        Petitioner does not dispute that he underreported the
                                     Vapor Room’s gross receipts for 2004 and 2005 (including
                                     that he failed to report any gross receipts received before
                                     July 14, 2004). He asks the Court, however, to find that the
                                     Vapor Room’s gross receipts for the respective years totaled
                                     $1,969,331 and $3,264,798 (i.e., $1,375 more and $37,100 less
                                     than the respective amounts respondent determined). He
                                     supports his proposed finding with citations to profit and loss
                                     statements that his current accountant, Marlee Taxy, C.P.A.,
                                     prepared for the respective years. One statement reports
                                     without further explanation that the Vapor Room’s ‘‘Sales (as
                                     per Ledger)’’ for 2004 were $1,948,882 (inclusive of a
                                     $450,904 adjustment to reflect the 79 missing days) and that
                                     its total income for 2004 also included a $20,448 upward
                                     adjustment for ‘‘Actual to agree with cash in Ledger’’
                                     ($1,948,882 + $20,448 = $1,969,331). The other statement
                                     reports without further explanation that the Vapor Room’s
                                     ‘‘Sales (as per Ledger)’’ for 2005 were $3,308,328 and that its
                                     total income for 2005 also included a $43,530 downward
                                     adjustment for ‘‘Actual to agree with cash in Ledger’’
                                     ($3,308,328 – $43,530 = $3,264,798). Neither petitioner nor
                                     any of his witnesses explained the calculation of the numbers
                                     in those statements.
                                        Petitioner’s reporting in the ledgers of the Vapor Room’s
                                     sales is reliable evidence of the amount of the Vapor Room’s
                                     gross receipts for 2004 and 2005. Respondent and Ms. Taxy
                                     calculated the Vapor Room’s gross receipts using those
                                     ledgers. They arrived at slightly different totals for each
                                     year. We place more weight on respondent’s calculations.
                                     They were accompanied by sufficient detail. We accept
                                     respondent’s computation as the more accurate calculation of
                                     the Vapor Room’s gross receipts for 2004 and 2005. We hold
                                     that the Vapor Room’s gross receipts for the respective years
                                     were $1,967,956 and $3,301,898. We note that petitioner in
                                     his answering brief sets forth no objection to respondent’s
                                     request in his opening brief that the Court find that the
                                     ledgers (as adjusted for the missing period) stated that the




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                                     32                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     Vapor Room’s sales during the respective years were in the
                                     amounts that respondent calculated.
                                     V. COGS
                                        We now turn to the parties’ dispute as to the Vapor Room’s
                                     COGS.   Petitioner argues that respondent arbitrarily deter-
                                     mined the Vapor Room’s COGS in the deficiency notice
                                     because the notice states that the Vapor Room’s COGS were
                                     zero for 2004 and 2005. Petitioner argues that the burden of
                                     proof is therefore upon respondent. See Helvering v. Taylor,
                                     293 U.S. 507, 515 (1935); Palmer v. United States, 116 F.3d
                                     1309, 1312 (9th Cir. 1997). We disagree that respondent’s
                                     determination of the Vapor Room’s COGS was arbitrary so as
                                     to shift the burden of proof on that issue to respondent.
                                        A cash method taxpayer like petitioner may generally
                                     deduct all ordinary and necessary expenses of the business
                                     upon payment of those expenses. See sec. 162(a). Deductions
                                     are strictly a matter of legislative grace, however, and peti-
                                     tioner must prove he is entitled to deduct the Vapor Room’s
                                     claimed amounts of COGS (as well as the Vapor Room’s
                                     claimed amounts of expenses). See Rule 142(a)(1); New Colo-
                                     nial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Goldsmith
                                     v. Commissioner, 31 T.C. 56, 62 (1958); Hahn v. Commis-
                                     sioner, 30 T.C. 195, 198 (1958), aff ’d, 271 F.2d 739 (5th Cir.
                                     1959); see also Briggs v. Commissioner, T.C. Memo. 2000–
                                     380; King v. Commissioner, T.C. Memo. 1994–318, aff ’d with-
                                     out published opinion, 69 F.3d 544 (9th Cir. 1995); Whatley
                                     v. Commissioner, T.C. Memo. 1992–567, aff ’d without pub-
                                     lished opinion, 21 F.3d 1119 (9th Cir. 1994). Petitioner is
                                     required to maintain sufficient permanent records to
                                     substantiate the Vapor Room’s deductions. See sec. 6001; see
                                     also Briggs v. Commissioner, T.C. Memo. 2000–380; sec.
                                     1.6001–1(a), (d), Income Tax Regs. Respondent’s determina-
                                     tion in the notice of deficiency of the Vapor Room’s COGS as
                                     zero reflects that petitioner failed to produce credible records
                                     supporting any greater deductions of COGS. Petitioner, in
                                     fact, concedes in his posttrial brief that he ‘‘freely admitted’’
                                     to the revenue agent that he had no receipts for COGS.
                                        Petitioner argues nonetheless that the ledgers alone are
                                     sufficient substantiation for taxpayers operating in the med-
                                     ical marijuana industry because, he states, that industry




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                                     (19)                            OLIVE v. COMMISSIONER                                         33


                                     ‘‘shun[s] formal ‘substantiation’ in the form of receipts.’’ We
                                     disagree with petitioner that the ledgers standing alone are
                                     sufficient substantiation. The ledgers did not specifically
                                     identify the marijuana vendors or reflect any marijuana that
                                     was received or given away. The ledgers neither were
                                     independently prepared nor bore sufficient indicia of reli-
                                     ability or trustworthiness. The substantiation rules require a
                                     taxpayer to maintain sufficient reliable records to allow the
                                     Commissioner to verify the taxpayer’s income and expendi-
                                     tures. See sec. 6001; sec. 1.6001–1(a), Income Tax Regs.; see
                                     also Obot v. Commissioner, T.C. Memo. 2005–195. Neither
                                     Congress nor the Commissioner has prescribed a rule stating
                                     that a medical marijuana dispensary may meet that substan-
                                     tiation requirement merely by maintaining a self-prepared
                                     ledger listing the amounts and general categories of its
                                     expenditures. It is not this Court’s role to prescribe the spe-
                                     cial substantiation rule that petitioner desires for medical
                                     marijuana dispensaries and we decline to do so.
                                        Petitioner seeks to strengthen the probative value of the
                                     ledgers through his and Ms. Taxy’s testimony. He testified
                                     that he contemporaneously recorded in the ledgers all of the
                                     Vapor Room’s purchases of marijuana and Ms. Taxy testified
                                     that she totaled the Vapor Room’s COGS for the respective
                                     years at $1,651,554 and $2,713,128. Respondent rebuts that
                                     petitioner has failed to substantiate that the amount of the
                                     Vapor Room’s COGS exceeded $25,776 for 2004 or $27,370 for
                                     2005. Respondent concludes that the Vapor Room’s COGS are
                                     limited to the amounts petitioner was able to substantiate to
                                     respondent’s satisfaction. We disagree with both parties.
                                        The Vapor Room’s sales for the respective years were
                                     $1,967,956 and $3,301,898. We consider it unreasonable to
                                     conclude that the Vapor Room’s COGS totaled the small
                                     amounts that respondent asks us to find. We also consider it
                                     unreasonable, however, to conclude that the Vapor Room’s
                                     COGS are those amounts set forth in the ledgers. We do not
                                     believe that the COGS entries set forth in the ledgers are
                                     entirely accurate and we decline to rely upon those entries
                                     in their entirety. Petitioner consciously chose to transact the
                                     Vapor Room’s business primarily in cash. He also chose not
                                     to keep supporting documentation for the Vapor Room’s




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                                     34                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     expenditures. He did so at his own peril. 12 The mere fact
                                     that we rely on the ledgers to determine the amounts of the
                                     Vapor Room’s gross receipts is not necessarily inconsistent
                                     with our refusing to rely upon the ledgers to determine the
                                     amount of the Vapor Room’s COGS (or expenses). Nor are the
                                     ledgers necessarily accurate as to COGS (and expenses)
                                     simply because petitioner recorded more sales receipts in the
                                     ledgers than he did in the Federal income tax returns he
                                     filed for the years at issue. We find the expenditure entries
                                     in the ledgers vague and incomplete in many instances.
                                     Moreover, we seriously doubt that they were recorded
                                     contemporaneously or accurately with the expenditures. 13
                                     We also doubt that petitioner made each recorded expendi-
                                     ture in the amount and for the purpose (if any) stated. 14
                                        We are left to ascertain the Vapor Room’s COGS on the
                                     basis of the record. The evidence is not satisfactory for this
                                     purpose. We nevertheless must do our best with the mate-
                                     rials at hand. ‘‘Absolute certainty in such matters is usually
                                     impossible and is not necessary; * * * [we] make as close an
                                     approximation as * * * [we] can, bearing heavily * * * upon
                                     the taxpayer whose inexactitude is of his own making.’’
                                     Cohan v. Commissioner, 39 F.2d 540, 543–544 (2d Cir. 1930);
                                     accord Edelson v. Commissioner, 829 F.2d 828, 831 (9th Cir.
                                     1987) (stating that ‘‘a court should allow the taxpayer some
                                     deductions [under the Cohan rule] if the taxpayer proves he
                                     [or she] is entitled to the deduction but cannot establish the
                                     full amount claimed’’), aff ’g T.C. Memo. 1986–223; see also
                                     Lollis v. Commissioner, 595 F.2d 1189, 1190 (9th Cir. 1979),
                                        12 Petitioner asserts that he minimized the Vapor Room’s use of checks because he did not

                                     want his bank to know that the Vapor Room was a medical marijuana dispensary. We find that
                                     assertion incredible, especially given that petitioner informed the bank that his business was
                                     named ‘‘Vapor Room.’’
                                        13 The ledgers apparently were not available at the start of this proceeding when petitioner

                                     admitted under Rule 90 that the Vapor Room started its business in July 2004. The ledgers
                                     show sales for the Vapor Room on most (if not all) of the days from January 25 through March
                                     13, 2004, and June 1 through October 30, 2004.
                                        14 Petitioner informs us that California did not allow medical marijuana dispensaries to earn

                                     a profit for the years at issue. The need to report no profit may improperly cause a dispensary
                                     to understate gross receipts or to overstate expenditures. We are especially wary here, where
                                     petitioner by his own admission understated his gross receipts and took steps to disguise his
                                     cash withdrawals from his business to conceal them from his employees. We also note that peti-
                                     tioner in his petition challenged only respondent’s disallowance of the COGS and expenses peti-
                                     tioner reported on the returns and stated in the petition that he had incurred the reported ex-
                                     penditures in the amounts stated (without mention of any greater or additional expense
                                     amounts).




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                                     (19)                            OLIVE v. COMMISSIONER                                         35


                                     aff ’g T.C. Memo. 1976–15; Goldsmith v. Commissioner, 31
                                     T.C. at 62.
                                        We are aided, in small part, by the testimony of Henry C.
                                     Levy, C.P.A. Petitioner called Mr. Levy as an expert on the
                                     medical marijuana industry and the Court recognized him as
                                     such. Having said that, we generally found Mr. Levy to be
                                     unreliable. He was unreliable in that he was not sufficiently
                                     independent of petitioner and his cause (e.g., Mr. Levy is
                                     petitioner’s current bookkeeper and accountant and has
                                     approximately 100 other medical marijuana dispensaries as
                                     clients). See Neonatology Assocs., P.A. v. Commissioner, 115
                                     T.C. at 86–87. In addition, his testimony improperly con-
                                     sisted mainly of legal opinions and conclusions. 15 See Gibson
                                     & Assocs., Inc. v. Commissioner, 136 T.C. 195, 229–230
                                     (2011); Alumax, Inc. v. Commissioner, 109 T.C. 133, 171
                                     (1997), aff ’d, 165 F.3d 822 (11th Cir. 1999); see also United
                                     States v. Scholl, 166 F.3d 964, 973 (9th Cir. 1999).
                                        We have broad discretion to evaluate the cogency of an
                                     expert’s analysis. We may adopt only those parts of an
                                     opinion we consider to be reliable. See Helvering v. Nat’l Gro-
                                     cery Co., 304 U.S. 282, 294–295 (1938); Neonatology Assocs.,
                                     P.A. v. Commissioner, 115 T.C. at 85–86; IT & S of Iowa, Inc.
                                     v. Commissioner, 97 T.C. 496, 508 (1991). Mr. Levy opined
                                     that the average COGS of three of his medical marijuana
                                     dispensary clients was 75.16% of their sales for 2005 and
                                     that part of his opinion comports with Dr. Gieringer’s opinion
                                     that the COGS of medical marijuana dispensaries ranged from
                                     70 to 85% of sales during the years at issue. We consider
                                     75.16% of sales to be a reasonable measure of the Vapor
                                     Room’s COGS. We therefore adopt that percentage of sales as
                                     a measure of the Vapor Room’s COGS for each year at issue.
                                        This does not mean, however, that the Vapor Room’s COGS
                                     equals 75.16% of its gross receipts. We are mindful that this
                                     is not the right percentage because petitioner gave some of
                                     the Vapor Room’s inventory to patrons for free and the par-
                                     ties dispute whether the Vapor Room’s cost of that portion of
                                     the medical marijuana is includable in the Vapor Room’s
                                       15 Petitioner also called Dale Gieringer, Ph.D., and Ms. Taxy to testify as experts on the med-

                                     ical marijuana industry and the Court recognized them as such. We similarly consider their tes-
                                     timony to be unreliable for similar reasons. We adopt their opinions only to the limited extent
                                     stated.




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                                     36                  139 UNITED STATES TAX COURT REPORTS                                      (19)


                                     COGS.   Petitioner argues that these costs are so includable.
                                     We disagree.
                                        Petitioner did not sell the marijuana underlying these
                                     costs and he did not hold all the marijuana out for sale.
                                     These costs, therefore, hardly reflect the cost of the goods
                                     that petitioner sold. See Fuller v. Commissioner, 20 T.C. 308,
                                     316 (1953), aff ’d, 213 F.2d 102 (10th Cir. 1954). Petitioner
                                     acknowledges that inventory withdrawn for personal use is
                                     not included in a COGS calculation and petitioner withdrew
                                     the referenced medical marijuana from the Vapor Room’s
                                     inventory of marijuana for sale. He personally consumed
                                     some of it and gave the rest to his selected patrons for free.
                                     Petitioner’s claim that he gave the marijuana to needy
                                     patrons out of compassion, even if true (which we need not
                                     decide), does not dictate a different result. 16 Inventory that
                                     is given to a qualified charitable organization may receive
                                     special treatment. The recipients of petitioner’s gratuities,
                                     however, were not qualified charitable organizations. Nor
                                     does the record or caselaw support petitioner’s characteriza-
                                     tion of the free medical marijuana distributions as rebates to
                                     customers. We conclude that the Vapor Room’s COGS for each
                                     year at issue equals 75.16% of the Vapor Room’s gross
                                     receipts for the year, as further adjusted to take into account
                                     our finding that petitioner gave away 6.5% of the Vapor
                                     Room’s purchases. 17 We therefore hold that the Vapor
                                     Room’s COGS for 2004 and 2005 are $1,382,973 ($1,967,956 ×
                                     75.16% × 93.5%) and $2,320,396 ($3,301,898 × 75.16% ×
                                     93.5%), respectively.
                                     VI. Expenses
                                           A. Overview
                                       We turn now to decide the parties’ dispute on the deduct-
                                     ibility of the Vapor Room’s expenses. Respondent argues that
                                     petitioner failed to substantiate expenses in amounts greater
                                     than $57,929 for 2004 and $149,666 for 2005. Respondent
                                     also argues that section 280E precludes petitioner from
                                       16 Both staff members (including petitioner) and other patrons received medical marijuana for

                                     free. The record does not disclose how much of the free marijuana actually went to ‘‘needy’’ indi-
                                     viduals.
                                       17 The medical marijuana petitioner gave away might arguably still qualify as an ordinary and

                                     necessary business expense under sec. 162(a). We need not decide that issue, however, because
                                     we hold later that sec. 280E precludes any such deduction.




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                                     (19)                            OLIVE v. COMMISSIONER                                          37


                                     deducting any of those amounts notwithstanding that the
                                     amounts were substantiated. Petitioner argues that he is
                                     entitled to deduct the Vapor Room’s expenses in full. Peti-
                                     tioner asserts that the Vapor Room’s expenses are as fol-
                                     lows: 18
                                                           Expense                                        2004             2005
                                           Advertising                                                   $1,466          $5,902
                                           Bank fees                                                        724           1,271
                                           Charity                                                        -0-             7,810
                                           Donations                                                        683           3,330
                                           Internet services and fee                                      2,219             784
                                           Legal and professional services                                  390          36,670
                                           Other                                                         12,787          24,596
                                           Payroll taxes                                                  2,876           7,418
                                           Rent                                                          14,369          12,300
                                           Repairs and maintenance                                        1,328          11,486
                                           Security services                                                827           5,988
                                           State                                                          -0-             1,547
                                           Supplies                                                      26,649          31,401
                                           Taxes and licenses                                               195           2,500
                                           Travel and meals and entertainment                             2,549           3,602
                                           Utilities                                                        973           2,248
                                           Wages:
                                             Paid in cash                                               133,071         161,751
                                             Paid through Paychex                                        37,588          96,965

                                                 Total                                                 1 236,502        417,569
                                             1 This column totals $238,694. Petitioner does not explain how his
                                           total differs.

                                     Petitioner asserts that section 280E, if applicable, which he
                                     argues it is not, precludes deductions for the years at issue
                                     of only $12,636 and $20,748 of expenses. He calculates those
                                     amounts on the basis of his reading of our Opinion in
                                     Californians Helping to Alleviate Med. Problems, Inc. v.
                                     Commissioner (CHAMP), 128 T.C. 173 (2007). We disagree
                                     with petitioner’s reading of our Opinion in CHAMP and fur-
                                     ther find that the factual settings of CHAMP and this case
                                     are distinguishable.
                                           B. Substantiation
                                       Petitioner has failed to maintain required permanent
                                     records. He also has failed to substantiate the Vapor Room’s
                                        18 The largest claimed expense is wages paid in cash. Petitioner opted not to specifically iden-

                                     tify the purported recipients of these ‘‘wages.’’ We are troubled with petitioner’s claimed cash
                                     transactions and doubt that any of the claimed cash wages were ever reported as income.




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                                     38                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     expenses with the exception of those expenses respondent
                                     concedes. We decline to attempt to estimate any of his
                                     expenses pursuant to Cohan v. Commissioner, 39 F.2d 540,
                                     because, as discussed below, we hold that section 280E pre-
                                     cludes any deduction of the Vapor Room’s expenses. See also
                                     Lewis v. Commissioner, 560 F.2d 973, 977 (9th Cir. 1977)
                                     (stating that the Cohan rule may not be applied to certain
                                     expenses), rev’g on other grounds T.C. Memo. 1974–59; San-
                                     ford v. Commissioner, 50 T.C. 823, 827–828 (1968) (same),
                                     aff ’d, 412 F.2d 201 (2d Cir. 1969). We hold that petitioner
                                     may not deduct any expense other than the expenses that
                                     respondent concedes. Those conceded expenses, however,
                                     must still fall outside section 280E to be deductible.
                                           C. Section 280E
                                        We now turn to section 280E. A taxpayer may not deduct
                                     any amount for a trade or business where the ‘‘trade or busi-
                                     ness (or the activities which comprise such trade or business)
                                     consists of trafficking in controlled substances * * * which is
                                     prohibited by Federal law.’’ 19 Sec. 280E. We have previously
                                     held, and the parties agree, that medical marijuana is a con-
                                     trolled substance under section 280E. See CHAMP, 128 T.C.
                                     at 181; see also Gonzalez v. Raich, 545 U.S. 1 (2005); United
                                     States v. Oakland Cannabis Buyers’ Coop., 532 U.S. 483
                                     (2001).
                                        Petitioner argues that he may deduct the Vapor Room’s
                                     expenses notwithstanding section 280E because, he claims,
                                     the Vapor Room’s business did not consist of the illegal traf-
                                     ficking in a controlled substance. He argues that the illegal
                                     trafficking in controlled substances is the only activity cov-
                                     ered by section 280E. We disagree that section 280E is that
                                     narrow and does not apply here. We therefore reject peti-
                                     tioner’s contention that section 280E does not apply because
                                     the Vapor Room was a legitimate operation under California
                                     law. We have previously held that a California medical mari-
                                     juana dispensary’s dispensing of medical marijuana pursuant
                                     to the CCUA was ‘‘trafficking’’ within the meaning of section
                                     280E. See CHAMP, 128 T.C. at 182–183. That holding
                                     applies here with full force.
                                       19 The parties agree that sec. 280E disallows deductions only for the expenses of a business

                                     and not for its COGS. See also Californians Helping to Alleviate Med. Problems, Inc. v. Commis-
                                     sioner, 128 T.C. 173, 178 n.4 (2007).




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                                     (19)                            OLIVE v. COMMISSIONER                                         39


                                        Petitioner asserts that the Vapor Room provided caregiving
                                     services in addition to dispensing medical marijuana. He
                                     invites the Court to reinterpret section 280E more narrowly
                                     than we did in CHAMP to reach only those illegal under-
                                     ground businesses that have a single business of drug traf-
                                     ficking. We decline to do so. The taxpayer in CHAMP was a
                                     legitimate (under State law) operation that had a second
                                     business (providing caregiving services) and we applied sec-
                                     tion 280E there. The dispensing of medical marijuana, while
                                     legal in California (among other States), 20 is illegal under
                                     Federal law. 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 dispen-
                                     sary business. This is true even if the business is legal under
                                     State law.
                                        Petitioner argues alternatively that he may deduct all of
                                     the Vapor Room’s expenses attributable to the Vapor Room’s
                                     caregiving business. He asserts that he trafficked marijuana
                                     only during the short time it took for the staff members to
                                     pass the medical marijuana to the patrons in exchange for
                                     payment and that the rest of the Vapor Room’s business was
                                     providing caregiving services. He compares his business to
                                     the medical marijuana dispensary in CHAMP. We found
                                     there that the taxpayer had two businesses (one the dis-
                                     pensing of medical marijuana and the other the providing of
                                     caregiving services). Petitioner asserts that the Vapor Room’s
                                     overwhelming purpose was to provide caregiving services,
                                     that the Vapor Room’s expenses are almost entirely related
                                     to the caregiving business and that the Vapor Room would
                                     continue to operate even if petitioner did not sell medical
                                     marijuana. We disagree. The record does not establish these
                                     assertions. Moreover, as previously stated, all of the testi-
                                     mony from petitioner and from his other witnesses was
                                     rehearsed, not impartial and not credible. We find instead
                                     that petitioner had a single business, the dispensing of med-
                                     ical marijuana, and that he provided all of the Vapor Room’s
                                     services and activities as part of that business.
                                       20 Our research reveals for information purposes that 17 States and the District of Columbia

                                     have legalized medical marijuana as of July 19, 2012. See http://medicalmarijuana.procon.org/
                                     view.resource.php?resourceID=000881 (last visited July 19, 2012). Those States are Alaska, Ari-
                                     zona, California, Colorado, Connecticut, Delaware, Hawaii, Maine, Michigan, Montana, Nevada,
                                     New Jersey, New Mexico, Oregon, Rhode Island, Vermont and Washington. Id.




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                                     40                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                        The record establishes that the Vapor Room is not the
                                     same type of operation as the medical marijuana dispensary
                                     in CHAMP that we found to have two businesses. The dif-
                                     ferences between the operations are almost too numerous to
                                     list. The dispensary there was operated exclusively for chari-
                                     table, educational and scientific purposes and its income was
                                     slightly less than its expenses. See CHAMP, 128 T.C. at 174,
                                     176–177. The director there was well experienced in health
                                     services and he operated the dispensary with caregiving as
                                     the primary feature and the dispensing of medical marijuana
                                     (with instructions on how to best consume it) as a secondary
                                     feature. See id. at 174–175. Seventy-two percent of the
                                     CHAMP dispensary’s employees (18 out of 25) worked exclu-
                                     sively in its caregiving business and the dispensary provided
                                     its caregiving services regularly, extensively and substan-
                                     tially independent of its providing medical marijuana. See id.
                                     at 175–176, 178, 183, 185. It rented space at a church for
                                     peer group meetings and yoga classes and the church did not
                                     allow marijuana on the church’s premises. See id. at 176. It
                                     provided its low-income members with hygiene supplies and
                                     with daily lunches consisting of salads, fruit, water, soda and
                                     hot food. See id. at 175. Its members, approximately 47% of
                                     whom suffered from AIDS, paid a single membership fee for
                                     the right to receive caregiving services and medical mari-
                                     juana from the taxpayer. See id. at 174–175. The names of
                                     the dispensaries are even diametrically different. The name
                                     of the dispensary there, ‘‘Californians Helping To Alleviate
                                     Medical Problems,’’ stresses the dispensary’s caregiving mis-
                                     sion. The name of the dispensary here, ‘‘The Vapor Room
                                     Herbal Center,’’ stresses the sale and consumption (through
                                     vaporization) of marijuana.
                                        Petitioner essentially reads our Opinion in CHAMP to hold
                                     that a medical marijuana dispensary that allows its cus-
                                     tomers to consume medical marijuana on its premises with
                                     similarly situated individuals is a caregiver if the dispensary
                                     also provides the customers with incidental activities, con-
                                     sultation or advice. Such a reading is wrong. A business that
                                     dispenses marijuana does not necessarily consist simply of
                                     the act of dispensing marijuana, just as a business that sells
                                     other goods does not necessarily consist simply of the passing
                                     of those goods.




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                                     (19)                            OLIVE v. COMMISSIONER                                         41


                                        All facts and circumstances must be taken into account to
                                     ascertain the parameters of a business. Two activities can be
                                     separated or aggregated for tax purposes depending on the
                                     ‘‘degree of organizational and economic interrelationship
                                     * * *, the business purpose which is (or might be) served by
                                     carrying on the various undertakings separately or together
                                     in a trade or business * * *, and the similarity of * * * [the]
                                     undertakings.’’ Sec. 1.183–1(d)(1), Income Tax Regs.; see also
                                     Tobin v. Commissioner, T.C. Memo. 1999–328 (listing certain
                                     factors to consider in deciding whether a taxpayer’s
                                     characterization of two or more undertakings as a single
                                     activity for purposes of section 183 is unreasonable). The
                                     Commissioner usually will accept a taxpayer’s characteriza-
                                     tion of several undertakings either as a single activity or as
                                     separate activities. See sec. 1.183–1(d)(1), Income Tax Regs.
                                     The Commissioner will reject the characterization, however,
                                     if it is artificial and cannot be reasonably supported under
                                     the facts and circumstances of the case. See id. A taxpayer,
                                     to be engaged in a trade or business for purposes of section
                                     162, must be involved in the activity with continuity and
                                     regularity and the taxpayer’s primary purpose for engaging
                                     in the activity must be for income or profit. See Commis-
                                     sioner v. Groetzinger, 480 U.S. 23, 35 (1987).
                                        The facts here persuade us that the Vapor Room’s dis-
                                     pensing of medical marijuana and its providing of services
                                     and activities share a close and inseparable organizational
                                     and economic relationship. They are one and the same busi-
                                     ness. Petitioner formed and operated the Vapor Room to sell
                                     medical marijuana to the patrons and to advise them on
                                     what he considered to be the best marijuana to consume and
                                     the best way to consume it. Petitioner provided the addi-
                                     tional services and activities incident to, and as part of, the
                                     Vapor Room’s dispensing of medical marijuana. Petitioner
                                     and the Vapor Room’s employees were already in the room
                                     helping the patrons receive and consume medical marijuana
                                     and the entire site of the Vapor Room was used for that pur-
                                     pose. The record does not establish that the Vapor Room paid
                                     any additional wages or rent to provide the incidental serv-
                                     ices and activities. Nor does the record establish that the
                                     Vapor Room made any other significant payment to provide
                                     the incidental activities or services. Petitioner also oversaw
                                     all aspects of the Vapor Room’s operation and the Vapor




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                                     42                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     Room had a single bookkeeper and a single independent
                                     accountant for its business. These facts further support our
                                     conclusion that the Vapor Room had only one trade or busi-
                                     ness. See Tobin v. Commissioner, T.C. Memo. 1999–328.
                                        That petitioner may have sometimes overcharged patrons
                                     for marijuana to subsidize the cost of the Vapor Room’s lim-
                                     ited services or activities does not change our view. Peti-
                                     tioner’s payment of the Vapor Room’s expenses to dispense
                                     medical marijuana allowed the Vapor Room to fulfill its busi-
                                     ness purpose of selling medical marijuana that in turn
                                     allowed the Vapor Room to offer its incidental services and
                                     activities in support of that purpose. Moreover, the Vapor
                                     Room’s only revenue was from patrons’ purchase of mari-
                                     juana. The Vapor Room would not have had any revenues at
                                     all (and could not have operated) if none of the patrons had
                                     purchased marijuana from petitioner. The Vapor Room did
                                     not spawn a second business simply by occasionally providing
                                     the patrons with snacks, a massage, or a movie, or allowing
                                     the patrons to play games in the room and to talk there to
                                     each other.
                                        Petitioner also has not established that the Vapor Room’s
                                     activities or services independent of the dispensing of med-
                                     ical marijuana were extensive. He tried to establish that they
                                     were but failed. His counsel, at trial, repeatedly asked peti-
                                     tioner’s patrons/witnesses to describe ‘‘caregiving’’ services
                                     that petitioner provided at the Vapor Room. The witnesses
                                     strained to come up with any such service, other than
                                     through their rehearsed statements that fell short of estab-
                                     lishing caregiving services of the type and extent described
                                     in CHAMP, 128 T.C. at 175–176. Petitioner’s actions spoke
                                     loudly when he filed the tax returns for 2004 and 2005,
                                     reporting that the Vapor Room’s principal business was the
                                     retail sale of ‘‘herbal’’ (which we understand to be mari-
                                     juana). We perceive his claim now that the Vapor Room actu-
                                     ally consists of two businesses as simply an after-the-fact
                                     attempt to artificially equate the Vapor Room with the med-
                                     ical marijuana dispensary in CHAMP so as to avoid the dis-
                                     allowance of all of the Vapor Room’s expenses under section
                                     280E. We conclude that section 280E applies to preclude
                                     petitioner from deducting any of the Vapor Room’s claimed
                                     expenses.




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                                     (19)                            OLIVE v. COMMISSIONER                                         43


                                     VII. Accuracy-Related Penalty
                                        We now turn to decide whether petitioner is liable for an
                                     accuracy-related penalty under section 6662(a). A taxpayer
                                     may be liable for a 20% penalty on any underpayment of tax
                                     attributable to negligence or disregard of rules or regulations
                                     or any substantial understatement of income tax. See sec.
                                     6662(a) and (b)(1) and (2). ‘‘Negligence’’ includes any failure
                                     to make a reasonable attempt to comply with the provisions
                                     of the Code and includes ‘‘any failure by the taxpayer to keep
                                     adequate books and records or to substantiate items prop-
                                     erly.’’ Sec. 6662(c); sec. 1.6662–3(b)(1), Income Tax Regs.
                                     Negligence has also been defined as a lack of due care or
                                     failure to do what a reasonable person would do under the
                                     circumstances. See Allen v. Commissioner, 925 F.2d 348, 353
                                     (9th Cir. 1991), aff ’g 92 T.C. 1 (1989). ‘‘Disregard’’ includes
                                     any careless, reckless or intentional disregard of rules or
                                     regulations. See sec. 6662(c); sec. 1.6662–3(b)(2), Income Tax
                                     Regs. An individual’s understatement of income tax is
                                     substantial if the understatement exceeds the greater of 10%
                                     of the tax required to be shown on the return or $5,000. See
                                     sec. 6662(d)(1)(A). An accuracy-related penalty does not
                                     apply, however, to any portion of an underpayment for which
                                     there was reasonable cause and where the taxpayer acted in
                                     good faith. See sec. 6664(c)(1).
                                        Respondent bears the burden of production to establish
                                     that it is appropriate to impose the accuracy-related penalty.
                                     See sec. 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446
                                     (2001). The burden of proof is then upon petitioner (except
                                     for the increased portions of the accuracy-related penalty
                                     raised in the amendment to answer) if and once respondent
                                     meets his burden of production. See Higbee v. Commissioner,
                                     116 T.C. at 447, 449. Respondent bears the burden of proof
                                     as to the increased portions of the accuracy-related penalty
                                     raised in the amendment to answer. See Rule 142(a)(1).
                                        Respondent argues that petitioner is liable for the
                                     accuracy-related penalty to the extent he has understated
                                     the Vapor Room’s gross receipts and failed to substantiate
                                     the Vapor Room’s COGS and expenses. Petitioner’s sole argu-
                                     ment in brief is that the penalty does not apply because, he
                                     states, any inaccuracy underlying an understatement was
                                     ‘‘accidental, not substantial, and/or not negligent on the part




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                                     44                  139 UNITED STATES TAX COURT REPORTS                                     (19)


                                     of the taxpayer.’’ Petitioner asserts that the Vapor Room was
                                     his first business and that he was not instructed on the
                                     proper way to keep the books and records of a business.
                                        We agree with respondent that the accuracy-related pen-
                                     alty applies in this case but disagree that it applies to the
                                     full amounts of the underpayments. Respondent concedes
                                     that petitioner substantiated $57,929 and $149,666 of the
                                     Vapor Room’s reported expenses for 2004 and 2005, respec-
                                     tively. We nonetheless disallowed the deduction of those
                                     expenses under section 280E. The application of section 280E
                                     to the expenses of a medical marijuana dispensary had not
                                     yet been decided when petitioner filed his Federal income tax
                                     returns for 2004 and 2005. The accuracy-related penalty does
                                     not apply, therefore, to the portion of each underpayment
                                     that would not have resulted had petitioner been allowed to
                                     deduct his substantiated expenses. Cf. Van Camp & Bennion
                                     v. United States, 251 F.3d 862, 868 (9th Cir. 2001) (‘‘Where
                                     a case is one ‘of first impression with no clear authority to
                                     guide the decision makers as to the major and complex
                                     issues,’ a negligence penalty is inappropriate[.]’’ (quoting
                                     Foster v. Commissioner, 756 F.2d 1430, 1439 (9th Cir. 1985),
                                     aff ’g in part and vacating as to an addition to tax for neg-
                                     ligence 80 T.C. 34 (1983))).
                                        The accuracy-related penalty does apply, however, to the
                                     remainder of each underpayment because those portions of
                                     the underpayments are attributable to negligence. 21 Peti-
                                     tioner consciously opted not to keep adequate books and
                                     records and that action was in reckless or conscious dis-
                                     regard of rules or regulations. See Higbee v. Commissioner,
                                     116 T.C. at 449. He also did not record or report any of the
                                     Vapor Room’s gross receipts for approximately the first six
                                     months of its business. He also initially gave respondent’s
                                     revenue agent one set of documents (the Ehardt GL and the
                                     Ehardt P&L) that does not correspond with the ledgers he
                                     now relies upon. Our decision to find petitioner liable does
                                     not change even though the Vapor Room may have been peti-
                                     tioner’s first business or he was not ‘‘instructed’’ on the
                                     proper way to keep books. The Code requires that taxpayers
                                     who decide to go into business for themselves maintain suffi-
                                      21 The underpayments also appear to be ‘‘substantial’’ within the statutory definition of that

                                     word. The accuracy-related penalty will also apply to the referenced portions of the underpay-
                                     ments if that definition is met.




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                                     (19)                            OLIVE v. COMMISSIONER                                         45


                                     cient records to substantiate their income and expenditures.
                                     A reasonable person would have sought to comply with this
                                     requirement. We sustain respondent’s determination (as
                                     supplemented through the amendment to answer but as we
                                     modify) that petitioner is liable for the penalty for each year.
                                     VIII. Epilogue
                                       We have considered all arguments that the parties made
                                     and have rejected those arguments not discussed here as
                                     without merit.
                                       To reflect the foregoing,
                                                                         Decision will be entered under Rule 155.

                                                                               f




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