T.C. Memo. 2017-238



                        UNITED STATES TAX COURT



    EDWARD ARASH JABARI AND CONSTANCE COLWELL JABARI,
                        Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 11331-14.                        Filed November 28, 2017.



      Edward Arash Jabari and Constance Colwell Jabari, pro sese.

      Melinda K. Fisher, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      THORNTON, Judge: Respondent determined deficiencies in petitioners’

2010 and 2011 Federal income tax of $5,270 and $7,978, respectively.

Respondent further determined additions to tax pursuant to section 6651(a)(1) for
                                          -2-

[*2] failure to timely file returns for 2010 and 2011 of $1,789 and $1,436,

respectively, and an accuracy-related penalty under section 6662(a) of $510 for

2011.1

         After the parties’ concessions, the issues remaining for decision are:

(1) whether petitioners had smaller amounts of flowthrough income from

Colorado Kind Care, LLC (CKC), than they reported on the basis of respondent’s

audit determinations with respect to CKC; (2) whether petitioners are liable for the

additions to tax for failure to timely file under section 6651(a)(1); and (3) whether

petitioners are liable for the accuracy-related penalty under section 6662(a) for

2011.2




         1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Monetary amounts are rounded to the
nearest dollar.
         2
        In a stipulation of settled issues, petitioners conceded that they had
unreported taxable interest of $90 and $47 for 2010 and 2011, respectively.
Petitioners also conceded that they had unreported taxable qualified dividends of
$58 and unreported long-term capital gains of $35,083 for 2011. On brief
respondent has conceded that petitioners are not liable for self-employment tax of
$6,170 and $5,936 for 2010 and 2011, respectively. Respondent’s concession
results in computational adjustments to, among other things, the determined
additions to tax and penalty; we expect the Rule 155 computations will so reflect.
                                         -3-

[*3]                            FINDINGS OF FACT

       The parties have stipulated some facts, which we incorporate by this

reference.

CKC’s Business Activity

       CKC was established in 2009 and was licensed by the State of Colorado to

grow and sell medical marijuana. During the tax years in issue CKC maintained

two separate locations, one for cultivation and the other for retail sales.

       In July 2010 Mrs. Jabari purchased a 53% interest in CKC, and as of

December 31, 2011, she owned a 59.6% interest. Although Mrs. Jabari was the

majority owner of CKC, she did not participate in the management and day-to-day

activities of the business. Instead, because CKC was required to have two people

on the premises at all times, Mrs. Jabari worked as needed when an employee

failed to show up. During the years in issue Mr. Jabari worked full time for CKC

as the general manager.

       In 2010 and 2011 Mrs. Jabari received wages from CKC of $209 and

$1,332, respectively. In 2010 and 2011 Mr. Jabari received wages from CKC of

$6,923 and $14,231, respectively.
                                       -4-

[*4] Tax Reporting

      For the tax years in issue CKC was a partnership not subject to the unified

audit and litigation procedures found at sections 6221 through 6233, commonly

known as TEFRA.3 It filed Forms 1065, U.S. Return of Partnership Income,

which were prepared by Jim Marty, a certified public accountant (C.P.A. Marty).

The 2010 Form 1065 reported cost of goods sold of $340,610 and an ordinary

business loss of $51,051.

      In July 2012 CKC’s 2010 Form 1065 was selected for audit. C.P.A. Marty

acted as CKC’s representative during the audit and worked with respondent’s

examiner in reviewing CKC’s books and records. In a Form 4605-A, Examination

Changes - Partnerships, Fiduciaries, S Corporations, and Interest Charge Domestic

International Sales Corporations (Unagreed and Excepted Agreed), dated October

16, 2012, the Internal Revenue Service (IRS) examiner determined cost of goods

sold of $70,458 and ordinary business income of $82,397 for 2010. CKC’s 2011

Form 1065, dated March 15, 2013, was prepared in accordance with the

examiner’s adjustments for 2010 and reported cost of goods sold of $439,320 and

ordinary business income of $81,097.


      3
       TEFRA is the acronym for the Tax Equity and Fiscal Responsibility Act of
1982, Pub. L. No. 97-248, sec. 402(a), 96 Stat. at 648.
                                         -5-

[*5] Petitioners requested and received extensions of time to file their 2010 and

2011 returns. The extended deadline for their 2010 return was October 17, 2011;

the extended deadline for their 2011 return was October 15, 2012. Petitioners

failed to meet these deadlines. In May 2012 the IRS issued a Notice CP59

informing petitioners that they had failed to file a tax return for 2010, and on

November 19, 2012, the IRS prepared a substitute for return under section

6020(b). On December 24, 2012, not having received petitioners’ 2011 return, the

IRS prepared a substitute for return under section 6020(b).

      Petitioners belatedly filed their 2010 and 2011 Forms 1040, U.S. Individual

Income Tax Return, on March 19, 2013. The returns, prepared by C.P.A. Marty,

reported CKC passthrough income on Schedules E, Supplemental Income and

Loss, of $43,670 and $48,334 for 2010 and 2011, respectively. The Schedule E

income from CKC as reported on petitioners’ returns reflects Mrs. Jabari’s

distributional share of the ordinary income as reported on the Form 4605-A for

2010 and on CKC’s Form 1065 for 2011.

Respondent’s Determination

      In the notice of deficiency respondent proposed no adjustments to

petitioners’ reported flowthrough income from CKC. Instead, respondent

determined that petitioners had failed to report taxable interest income and self-
                                         -6-

[*6] employment tax owed for both 2010 and 2011. Respondent also determined

that petitioners had failed to report qualified dividends and capital gains for 2011.

Respondent determined that petitioners were liable for additions to tax for failure

to timely file a tax return under section 6651(a)(1) for 2010 and 2011, and further

determined that petitioners were liable for an accuracy-related penalty under

section 6662(a) for 2011.

Petition and Amendment to Petition

      While residing in Colorado, petitioners timely petitioned this Court,

disputing only the additions to tax, penalty, and interest. In their pretrial

memorandum and in a motion for summary judgment, which we denied,

petitioners first raised issues about the application of section 280E to CKC’s tax

reporting. After a trial in Denver, Colorado, petitioners filed an amendment to

petition broadly challenging the CKC examination results and arguing, among

other things, that section 280E (1) is unconstitutional in that it forces individuals

to relinquish their Fifth Amendment rights, (2) creates fictitious income, and (3)

requires a presumption that CKC trafficked in illegal drugs, without due process.

                                      OPINION

      Although respondent has not proposed any adjustments to petitioners’

reported flowthrough income from CKC, petitioners challenge respondent’s
                                         -7-

[*7] determinations with respect to the CKC audit. Because CKC was a non-

TEFRA partnership for the years at issue, we have jurisdiction to consider these

challenges. See Wadsworth v. Commissioner, T.C. Memo. 2007-46, 93 T.C.M.

(CCH) 940, 943 (2007). As discussed below, however, petitioners have not

established that respondent erred in his determinations with respect to the CKC

audit.

I.       Burden of Proof

         The Commissioner’s determinations as set forth in a notice of deficiency are

generally presumed correct, and the taxpayer bears the burden of proving those

determinations wrong. Rule 142(a)(1); Welch v. Helvering, 

, 115

(1933). Petitioners bear the burden of proof on new issues raised in their petition

and amendment to petition, including the issues with regard to CKC’s costs of

goods sold and the application of section 280E. See Rule 142(a); see also Haigh

v. Commissioner, T.C. Memo. 2009-140, 

, 1799 (2009).

II.      CKC Flowthrough Income

         Petitioners contend that their reported CKC flowthrough income was

overstated because CKC had greater costs of goods sold and business expenses

than were determined, after applying section 280E, in respondent’s audit of CKC.
                                         -8-

[*8] Section 280E disallows any deduction or credit for any amount paid or

incurred for a trade or business where the “trade or business (or the activities

which comprise such trade or business) consists of trafficking in controlled

substances * * * which is prohibited by Federal law”.4 Medical marijuana is a

controlled substance within the meaning of section 280E. See Californians

Helping to Alleviate Med. Problems, Inc. v. Commissioner, 

, 181

(2007); see also Gonzales v. Raich, 

(2005); United States v. Oakland

Cannabis Buyers’ Coop., 

(2001).

      We need not and do not address petitioners’ challenges to the application of

section 280E because they have failed to establish that CKC’s business expenses

or costs of goods sold were greater than the amounts respondent determined for

2010 and that CKC reported for 2011.




      4
        Although sec. 280E disallows deductions for the expenses of a business, it
does not disallow cost of goods sold. See Californians Helping to Alleviate Med.
Problems, Inc. v. Commissioner, 

, 178 n.4 (2007). Cost of goods
sold is not a deduction within the meaning of sec. 162(a) but instead is subtracted
from gross receipts in determining a taxpayer’s gross income. See Beatty v.
Commissioner, 

, 273 (1996); Max Sobel Wholesale Liquors v.
Commissioner, 

(1977), aff’d, 

(9th Cir. 1980); sec.
1.162-1(a), Income Tax Regs. Sec. 1.61-3(a), Income Tax Regs., provides that in
a manufacturing, merchandising, or mining business, “gross income” means total
sales, less the total cost of goods sold.
                                       -9-

[*9] Taxpayers must show their entitlement to amounts claimed as business

expenses or cost of goods sold, see Rule 142(a), and must keep sufficient records

to substantiate such items, see sec. 6001; Newman v. Commissioner, T.C. Memo.

2000-345, 

, 663 (2000). Petitioners did not produce any

business records or any other supporting documents to substantiate CKC’s

business expenses or costs of goods sold. 5

      Under Cohan v. Commissioner, 

, 543-544 (2d Cir. 1930), if a

taxpayer establishes that a deductible expense has been paid but is unable to

substantiate the precise amount, we generally may estimate the amount of the

deductible expense, bearing heavily against the taxpayer responsible for the

inexactitude. The principle of Cohan, which governs a taxpayer’s entitlement to

deductions, also applies to cost of goods sold. See Goldsmith v. Commissioner,

, 62 (1958) (applying principle of Cohan to cost of goods sold). We

cannot estimate deductible expenses or cost of goods sold, however, unless the

taxpayer presents evidence providing a sufficient basis for making an estimate.

Vanicek v. Commissioner, 

, 742-743 (1985). Without such a basis,

      5
       The only evidence petitioners have offered in this regard is draft proposed
amended tax returns for themselves and CKC, which Mr. Jabari said reflect “how
we would have filed our returns had * * * [sec. 280E] not been applied”. As the
Court explained at trial, these draft returns do not constitute evidence as to the
correctness of the information contained therein.
                                        - 10 -

[*10] any allowance would amount to unguided largesse. Williams v. United

States, 

, 560 (5th Cir. 1957).

       Petitioners have failed to document CKC’s gross sales or to substantiate any

expenses or costs relating to any gross sales. Because there exists no reasonable

basis for applying the Cohan rule, it is inappropriate to approximate the amounts

of business expenses or costs of goods sold. Cohan v. 

. Accordingly, regardless of the applicability of section 280E petitioners

have failed to establish that CKC’s business expenses or costs of goods sold are

greater than respondent allowed in the Form 4605-A for 2010 and that CKC

reported on Form 1065 for 2011. Consequently, petitioners have failed to show

that their flowthrough income from CKC was less than they reported on their 2010

and 2011 returns.

III.   Addition to Tax for Failure To Timely File

       Respondent determined that petitioners are liable for additions to tax under

section 6651(a)(1) for failure to timely file their 2010 and 2011 Federal income

tax returns. Section 6651(a)(1) provides for an addition to tax for failure to file a

return by the date prescribed unless that failure is due to reasonable cause and not

willful neglect. The Commissioner bears the burden of production with respect to

whether it is appropriate to impose the section 6651(a)(1) addition to tax, see sec.
                                         - 11 -

[*11] 7491(c), and the burden of proof is on the taxpayer to establish reasonable

cause, United States v. Boyle, 

(1985).

      Petitioners’ 2010 Federal income tax return was due October 17, 2011, and

their 2011 Federal income tax return was due October 15, 2012. Petitioners filed

both returns on March 19, 2013.6 In addition, respondent entered into evidence

certified transcripts of account showing that petitioners’ returns were filed on

March 19, 2013. Respondent has met his burden of production.

      Petitioners contend that they had reasonable cause for filing their 2010 and

2011 returns late because, they say, they were advised that they should not file

those returns until respondent’s examination of CKC’s 2010 return was complete.

We are not convinced. In the first instance, petitioners’ 2010 personal income tax

return was already about 9 months late when respondent commenced his

examination of CKC’s returns. Consequently, we do not see how the late filing of

petitioners’ 2010 return can be blamed on the CKC examination.

      Moreover, the testimony of C.P.A. Marty convinces us that petitioners were

advised of the requirement for timely filing their returns but chose to file late, after

      6
       Petitioners contend that their 2010 and 2011 Forms 1040, as well as CKC’s
returns, were submitted under duress. The record does not support this allegation;
it shows that all of the returns were prepared with the assistance of C.P.A. Marty,
in consultation with petitioners and taking into account the input from
respondent’s examiner.
                                        - 12 -

[*12] the CKC examination was concluded, hoping that they could thereby avoid

filing amended returns and that any late-filing additions to tax would eventually be

waived. Petitioners have not adequately explained, however, why they waited

over five months after receiving the CKC examination results to file their already-

late returns.7 Moreover, setting aside any issues dealing with CKC, petitioners

had wage and investment income to report on their 2010 and 2011 returns.

Petitioners were required to timely file their returns using the best information

available and to file amended returns thereafter if necessary. See Estate of

Vriniotis v. Commissioner, 

, 311 (1982). Petitioners have failed to

show reasonable cause for filing their 2010 and 2011 returns late.

      Accordingly, we sustain respondent’s determination to impose the section

6651(a)(1) additions to tax.

IV.   Accuracy-Related Penalty

      Respondent determined that petitioners are liable for a 20% accuracy-

related penalty pursuant to section 6662(a) and (b)(1) and (2) for an underpayment

attributable to negligence or a substantial understatement of income tax for 2011.

      7
        Respondent’s examination changes with respect to CKC’s 2010 return were
set forth in a Form 4605-A dated October 16, 2012. Those examination changes
were the basis for the CKC flowthrough amounts petitioners eventually reported
on their 2010 and 2011 returns. Those returns were not filed, however, until
March 19, 2013.
                                       - 13 -

[*13] Respondent bears the burden of production with respect to this penalty. See

sec. 7491(c). To meet this burden, respondent must produce evidence establishing

that it is appropriate to impose this penalty. Once respondent has met his burden

of production, the burden of proof is upon petitioners to show that they are not

liable for the penalty. See Higbee v. Commissioner, 

, 449 (2001).

      Negligence includes any failure to make a reasonable attempt to comply

with the provisions of the internal revenue laws and is the failure to exercise due

care or the failure to do what a reasonable and prudent person would do under the

circumstances. Sec. 6662(c); Neely v. Commissioner, 

, 947 (1985);

sec. 1.6662-3(b)(1), Income Tax Regs. Failure to include income is evidence of

negligence. Gomar v. Commissioner, T.C. Memo. 2013-95, at *5; see sec. 1.6662-

3(b)(1)(i), Income Tax Regs. Petitioners conceded that they failed to report

taxable interest, qualified dividends, and capital gains for 2011. Respondent has

carried his burden of production with respect to the section 6662(a) penalty for

negligence.

      Section 6662(a) and (b)(2) imposes the accuracy-related penalty on any

portion of a tax underpayment that is attributable to any substantial understatement

of income tax, defined in section 6662(d)(1)(A) as an understatement that exceeds

the greater of 10% of the tax required to be shown on the return or $5,000. The
                                       - 14 -

[*14] exact amount of petitioners’ underpayment will depend upon the Rule 155

computations, in accordance with our findings and the parties’ concessions. To

the extent those computations establish that petitioners have a substantial

understatement of income tax for 2011, respondent has also met his burden of

production in this regard. See Prince v. Commissioner, T.C. Memo. 2003-247, 

, 288 (2003).

      The accuracy-related penalty does not apply with respect to any portion of

an underpayment if the taxpayer acted with reasonable cause and in good faith

with regard to that portion. Sec. 6664(c)(1). Petitioners have made no attempt to

establish reasonable cause and good faith. In fact, with regard to the largest item

of omitted income, the capital gain, Mr. Jabari stated: “We believe it was our

fault, an unintended omission.”

      Accordingly, we sustain respondent’s determination that petitioners are

liable for the section 6662(a) penalty for 2011 for an underpayment due to

negligence and, alternatively, to a substantial understatement of income tax insofar

as the Rule 155 computations show a substantial understatement.

      The Court has considered all of petitioners’ arguments, contentions, and

statements. To the extent not discussed herein, the Court concludes that they are

moot, meritless, or irrelevant.
                                  - 15 -

[*15] To reflect the foregoing,


                                                Decision will be entered

                                           under Rule 155.