THE CHAMP TAX COURT CASE: A STUDY IN IMPACT LITIGATION

I. INTRODUCTION
Many medical cannabis operations throughout the country are now facing federal tax court audits. This is no surprise. The federal government has a vast array of tools and resources to fight its war on drugs and the fact that the IRS is now ascendant as a key weapon was inevitable. The same approach was used to ultimately take Al Capone out of circulation. The IRS continues to bring civil audits and criminal charges relating to tax evasion by US attorneys are also on the rise along with other money-related crimes, e.g. laundering.

When I began practicing medical cannabis law in 1996 thanks largely to Tony Serra and his office, the idea was to trend the law and the courts’ approach to the issue. Based on that evaluation, our goal was, and is, to advise clients who decided to take the risks inherent in these commercial activities that while they had certain limited rights, there was also the potential for criminal prosecution. Ultimately, we sought to advise clients how to ensure that if they were prosecuted, they could assert important evidence in support of their criminal defense.

Unfortunately, between 1996, when the CUA was enacted until January 1, 2004, case law on the issue was relatively limited. Moreover, the statute itself did not authorize any commercial activity at all, except (as it turned out later in People v. Mentch (2008) 45 C.4th 274, 85 C.R.3d 480, 195 P.3d 1061), in a limited way by allowing real caregivers to be compensated. I counseled on other concepts like zoning, taxation, employment law, to name just a few areas of law that are part and parcel of operating a cannabis operation, based on a more general sense of where I thought the law was heading.

I jumped into that type of counseling, namely, trying to trend the direction of the law and the approach of the governmental authorities. The problem was, there was no law to use as the basis for the counseling and if there’s one thing lawyers don’t like, it’s counseling in the dark. Still, clients were clamoring for advice and I was not going to let them act without some advice and counsel.

I started my analysis with this fundamental prediction: that while law enforcement was always going to try to go in the “front door”, at least some of the time, (meaning there would always be criminal prosecutions of medical cannabis operations), it was also clearly predictable that the government, and particularly its civil arm, would also use a host of other means to harass and shut down this emerging industry. My counseling strategy grew out of this fundamental prediction and it boiled down to this: everyone involved in operating a medical cannabis business (as the California Attorney General declaims in his Guidelines issued in August, 2008) must follow, as much as possible, every single law on the books. To do less than that opened up the possibility of attack on less serious issues than a criminal prosecution. Nevertheless, the civil issues could take an operation down.

II. OPPORTUNITIES TO CREATE NEW LAW
Attorneys who read this will understand the concept of “impact litigation.” The idea is to find a nearly perfect case or set one up from its inception, to create new, favorable laws.

How the CHAMP case arose and how I set it up goes back to the period between 1996 and 2003 when there was almost nothing in reported case law on how medical cannabis would be treated in the civil arena, and particularly tax treatment. The only reported cases focused on criminal law issues and there were only a handful of them.

During that period, some clients who were thinking long term asked about taxes – state and federal income taxes and state sales taxes. My first response was this: it is unlawful not to pay taxes, even if the income upon which the tax is based is an illegal activity. It wasn’t much, particularly since we were facing a draconian statute in the federal tax code that made it unlawful to deduct any expenses that were related to “drug trafficking.” Hungry for a better answer, I started to look for a good impact case to bring before the US Tax Court.

The opportunity came with CHAMP. CHAMP had been established in the late 1990’s as a support center for patients. 47% of the members had AIDS or cancer and CHAMP specialized in providing them with support groups, free hot lunches and a host of other services. Everyone who worked there was paid at the very low end of the salary scale and there was enormous care and attention paid, not only to the members, but to the idea of operating ethically and properly within the neighborhood and the surrounding community.

In 2002, the Executive Director (ED) of CHAMP, Michael Aldrich, Ph.D., contacted me about closing down. At that time, federal and state criminal law enforcement were on a major campaign to try to stamp out this burgeoning industry. Concern about staff safety ultimately led the board to vote to shut it down. Michael and I discussed various issues about the dissolution of the corporation (a California non-profit entity) including the filing of the final tax returns. Knowing that CHAMP was one of the ”poster children” of the movement and that any judge reviewing its operations would surely lean toward helping it, I supported Michael’s decision to close and file the final tax return . If the IRS took the audit, I felt confident we could win the court battle and create a precedent that could be used to guide other medical cannabis operations. If we lost, since the entity was closing down and had no assets anyway, I saw no downside or risk. In short, it was a perfect impact case. Michael agreed to the strategy and had the accountant prepare and file the return. I knew that if there was an audit, I would fight it all the way, regardless of the costs or time and effort.

III. THE IRS DECIDES TO AUDIT
In 2005, Michael called and informed me that the IRS had sent a notice of audit. While he had some personal concerns about his being personally liable for the federal income taxes that might be assessed after the audit, those concerns were allayed by Henry Wykowski, a federal tax attorney who Michael had hired around this issue.

Taking on the IRS in a test case was going to be time-consuming but since this was the test case that could make or break the industry, I agreed, going back to the 2002 set up, to take the case pro bono and realized that, without a tax background, I’d have to put a team together without any money! The corporation was broke (the lack of risk was part and parcel of the original plan) so I’d have to get volunteers. I called Bill Panzer, a noted criminal law expert in California who I knew from my work in the field and asked if he would be part of the team. He agreed. I also got Henry Wykowski to consult with the team. Bill agreed to the request to work without pay. Henry eventually went on the pleadings in the case as did Bill. Additionally, I met a former clerk of the US Tax Court at a friend’s party and he agreed to provide us with additional free consultation about tax court procedures.

IV. THE CASE PROCEEDS
The IRS began the audit in 2005 and it took some time before they reached their determination and it was a doozy. CHAMP’s return for 2002 showed no income, that is, its revenue and expenses were approximately equal. By the time the IRS was through with the audit, it had disallowed ALL the expenses and sought $425,000 in taxes, interest and penalties based on the gross revenues!
An over-eager IRS wanted to make a point. In their view, under Internal Revenue Code section 280E, “drug traffickers” (which was how they classified CHAMP) could not take any deductions for expenses related to their drug-trafficking business. When the IRS issued their final determination letter and deficiency notice, they relied exclusively on that section of the Code to deny the expenses that CHAMP had claimed on its tax return.

That however, was one of the biggest mistakes they made.
Once the IRS took the bait by taking the audit and issuing the deficiency notice, we were ready. We filed the petition in the Tax Court and the litigation began. The case, entitled, Californians Helping Alleviate Medical Problems, Inc. v. Commissioner of Internal Revenue, Docket No. 20795-05, eventually led to the landmark decision published in the Tax Court Decisions, 128 Tax Court No. 14.
As the case progressed, the IRS wanted to discuss settlement. Their initial position was to reduce the liability from $425,000 to $62,000 based on their reading of the “fine print” in the law, namely, they agreed that CHAMP could deduct the cost of the purchases of medical cannabis! For CHAMP, that came out to 80% of the total expenses.

Of course, we rejected that offer since we had no money, we wanted to get a clear ruling from the court to use for advising other clients and there was no downside to litigating. Again, since this was a corporation with a corporate tax return, no individuals would be on the hook for any tax assessed.

With a few months before trial, the IRS quickly became aggressive and changed their position. They claimed that the deductions for the cost of the purchased cannabis could be deductible but only if CHAMP could show receipts or other evidence that it was paid for. In the IRS’s parlance, this is called “substantiation.” They went to the judge, David Laro, and asked if they could amend their original answer to our petition to include that new ground, to wit, that CHAMP had not substantiated the Cost of Goods Sold expense. Luckily for us, Judge Laro, who was probably one of the most intellectual and objectives judges I have encountered, pointed out to the IRS that they had never raised that issue in the initial audit and had not raised it until just before trial. Believing CHAMP would be prejudiced by such a late-added new theory, Judge Laro denied the IRS’s request to amend their answer. Thus, the IRS was stuck with litigating whether the other, non-Cost of Goods Sold expenses, were related to drug-trafficking.
As the hearing approached, we took steps to get our case ready. We measured the CHAMP space (even though CHAMP was closed, another medical cannabis operation had taken the space over and we were able to get in and take the measurements). It turned out that only 10% of the floor space was dedicated to cannabis transactions. We used that number generally to show that only that percentage of the expenses was devoted to illegal “drug trafficking” sales, and thus, were non-deductible while the remaining expenses, related to patient care, intake, administration etc. were deductible.

Leading up to the hearing, I was involved in another trial that lasted 2 months and asked Bill Panzer to prepare and conduct the direct examination of Michael Aldrich at the hearing, which he readily agreed to handle.
On the day of the hearing, the courtroom was relatively un-crowded (a few CHAMP members came down to the Federal Building to show their support). We got a date to come back later in the week and as that day arrived, we were ready.
Michael testified for about an hour and a half about the services CHAMP provided and how the expenses were allocated. The IRS had not done their homework and was not able to introduce any conflicting facts. Judge Laro noted, as Michael walked off that stand and was done testifying, that in his 14 years as a tax court judge, he had never heard such clear and articulated (read: honest) testimony. We knew then that we were on good footing with Laro.

By the time Judge Laro issued his decision in May, 2007, it was a near complete victory. With the IRS having conceded the 80% Costs of Goods Sold (COGS) expense leading up the hearing, the only thing left for Judge Laro to determine was how much of the other expenses – the lease, payroll, utilities etc. – were deductible. He ended up using our 10% number as a rule of thumb – that is, the judge allowed CHAMP to take 90% of the remaining expenses as a deduction and disallowed 10% which constituted illegal drug-trafficking expenses. The final tax bill to CHAMP: $4,905, down from the initially assessed $425,000.

V. Lessons
The IRS didn’t expect this result and didn’t plan for an impact case. In that sense, my strategy worked. We got an exceptionally well-written decision that gives medical cannabis operations a way out from under the draconian 280E rule. So long as patient-member services are provided, those expenses can be deducted. Also, by reducing the amount of expenses directly related to transactions in medical cannabis, for example, by reducing the floor space used to conduct the transactions, an operator can deduct many of the expenses of the business.
The IRS is smarter now and has learned to bring both as 280E challenge as well as substantiation challenge. Medical cannabis operations not only have to ensure they are serving patients with more than just cannabis – they need to provide other services – but they have to substantiate all of their expenses, and particularly their purchases of medical cannabis. This is not easy as most cultivators don’t provide receipts and demand cash up front (or use a consignment system).

Clearly, the IRS has now gotten very involved in auditing medical cannabis operations. Any operators who want to avoid the worst federal tax problems must integrate a patient-centered services operation into the business, whether it’s in California, Colorado, Arizona, or in any other state that allows for medical cannabis use, cultivation and possession. And, they have to account for all their expenses.