Californians Helping to Alleviate Medical Problems Inc. v. Commissioner; 128 T.C. No. 14 (2007)- A victory for statutory construction and a little common sense

In Californians Helping to Alleviate Medical Problems Inc., the Court analyzed the language and the legislative history of § 280E and held, in good part, for the taxpayer. The Court’s opinion is a framework for statutory analysis and, just as important from a tax litigation perspective, a lesson on how the Court views testimony when it is corroborated by the objective facts.

The facts in Californians are rather straightforward. The taxpayer provided counseling and other caregiving services (collectively, caregiving services) to its members, who were individuals with debilitating diseases such as AIDS, cancer. Taxpayer's caregiving services were extensive:

  • Taxpayer's staff held various weekly or biweekly support group sessions that could be attended only by taxpayer's members. Taxpayer discussed healing techniques and occasionally hosted a guest speaker; the HIV/AIDS group addressed issues of practical and emotional support to individuals suffering form AIDS/HIV; focused on women-specific issues in medical struggles; helped elderly patients with lifelong addiction problems; and focused on spiritual and emotional development. 
  • Taxpayer provided its low-income members with daily lunches consisting of salads, fruit, water, soda, and hot food; made available to its members hygiene supplies such as toothbrushes, toothpaste, feminine hygiene products, combs, and bottles of bleach. 
  • Taxpayer provided its members to consult one-on-one with a counselor about benefits, health, housing, safety, and legal issues. 
  • Taxpayer coordinated for its members weekend social events including a Friday night movie or guest speaker and a Saturday night social with live music and a hot meal. 
  • Taxpayer encouraged its members to participate in political activities.

Taxpayer also provided its members with medical marijuana pursuant to the California Compassionate Use Act of 1996, codified at Cal. Health & Safety Code sec. 11362.5 (West Supp. 2007). Taxpayer charged its members a membership fee that generally reimbursed taxpayer for its costs of the caregiving services and its costs of the medical marijuana.

Because taxpayer provided medical marijuana, the IRS disallowed all of petitioner's deductions, determining that those items were "Expenditures in Connection with the Illegal Sale of Drugs" within the meaning of section 280E. Section 280E provides:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

In the context of § 280E, marijuana is a schedule I controlled substance, even when the marijuana is medical marijuana recommended by a physician as appropriate to benefit the health of the user. See United States v. Oakland Cannabis Buyers' Coop., 532 U.S. 483 (2001).

According to the IRS, the taxpayer had a single trade or business of trafficking in medical marijuana. Thus, argued the IRS, the taxpayer, because it trafficked in a controlled substance, was not permitted by section 280E to deduct any of its expenses. In contrast, taxpayer argued that it engaged in two trades or businesses. Taxpayer asserted that its primary trade or business was the provision of caregiving services. Taxpayer asserted that its secondary trade or business was the supplying of medical marijuana to its members. As to its trades or businesses, the deductions for those trades or businesses were not precluded by section 280E in that the trades or businesses did not involve "trafficking" in a controlled substance.

Addressing the latter argument, the Court looked at the statute and applied the plain meaning of the words found in the statute – "trafficking" by reference to the verb "traffic", which as relevant herein denotes "to engage in commercial activity: buy and sell regularly". Webster's Third New International Dictionary 2423 (2002). Taxpayer's supplying of medical marijuana to its members was within that definition in that taxpayer regularly bought and sold the marijuana, such sales occurring when petitioner distributed the medical marijuana to its members in exchange for part of their membership fees.

The Court addressed taxpayer’s argument as two separate businesses. The Court focused on the statute and the legislative history behind § 280E. The Court found that:

Section 280E and its legislative history express a congressional intent to disallow deductions attributable to a trade or business of trafficking in controlled substances. They do not express an intent to deny the deduction of all of a taxpayer's business expenses simply because the taxpayer was involved in trafficking in a controlled substance. We hold that section 280E does not preclude petitioner from deducting expenses attributable to a trade or business other than that of illegal trafficking in controlled substances simply because petitioner also is involved in the trafficking in a controlled substance.

The Court hen focused on the evidence. The IRS relied on the assertion, i.e. the IRS did not introduce any evidence or failed to persuade the Court with the evidence it did introduce, that taxpayer's “only income was from marijuana-related matters, except for a couple of small donations". In rebutting the IRS’s assertion, the Court focused on the on the testimony of taxpayer's executive director, whom the Court had an opportunity to hear and view at trial. [Contrast this statement with the opinion in Estate of Kanter v. Commissioner, T.C. Memo. 2007-21]. The Court found the director’s testimony to be coherent and credible, as well as supported by the record.

The Court in dicta stated:

He testified that petitioner's members paid their membership fees as consideration for both caregiving services and medical marijuana, and respondent opted not to challenge the substance of that testimony. While a member may have acquired, in return for his or her payment of a membership fee, access to all of petitioner's goods and services without further charge and without explicit differentiation as to the portion of the fee that was paid for goods versus services, we do not believe that such a fact establishes that petitioner's operations were simply one trade or business. As the record reveals, and as we find as a fact, petitioner's management set the total amount of the membership fees as the amount that management consciously and reasonably judged equaled petitioner's costs of the caregiving services and the costs of the medical marijuana.

Observation: In today’s world of tax shelters, credibility of witnesses can still be established and it exists through objective facts - the million dollar question. As to what constitutes objective facts, I humbly submit it is established by documents that reflect real world economics. That is why not all LILO’s are bad or Family Limited Partnerships should be viewed in a negative light. If the decisions made by the investors/creditors are based on true economic business decisions, i.e. not solely after-tax rate of returns, then these structures should withstand an assault from the IRS.

End result - this was a victory for common sense and more important statutory construction, which in today’s world is becoming a lost art. Simply stated, the opinion demonstrates why the Honorable Judge Laro is held in high regard by those who have been privileged to present their case before him. If the rumors are true that the Honorable Judge Laro is retiring from the Court, then we have lost an analytical mind on the bench that we will all miss.

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