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Feinberg v. Commissioner of Internal Revenue

United States Court of Appeals, Tenth Circuit

February 26, 2019

NEIL FEINBERG; ANDREA E. FEINBERG; KELLIE McDONALD, Petitioners - Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent - Appellee.

          Appeal from the United States Tax Court (Tax Court Nos. 10083-13 and 10084-13)

          James D. Thorburn (Richard Walker with him on the briefs), Thorburn Walker LLC, Greenwood Village, Colorado, for Petitioners-Appellants.

          Francesca Ugolini, Tax Division Attorney (Richard E. Zuckerman, Principal Deputy Assistant Attorney General, Gilbert S. Rothenberg, Tax Division Attorney, and Nathaniel S. Pollock, Tax Division Attorney, with her on the briefs), Department of Justice, Washington, D.C., for Respondent-Appellee.

          Before LUCERO, McHUGH, and MORITZ, Circuit Judges.

          McHUGH, Circuit Judge.

         Neil Feinberg, Andrea Feinberg, and Kellie McDonald (collectively, the Taxpayers) were shareholders in Total Health Concepts, LLC (THC), a Colorado company allegedly engaged in selling medical marijuana. After the Taxpayers claimed THC's income and losses on their tax returns, the IRS conducted an audit and disallowed certain deductions under 26 U.S.C. § 280E, which prohibits deductions for businesses engaged in unlawful trafficking of controlled substances. The IRS then recalculated the Taxpayers' tax liability and issued a notice of deficiency for the unpaid balance. The Taxpayers challenged that determination in the tax court, which affirmed on the basis that the Taxpayers had failed to substantiate the business expenses.

         Both parties agree the tax court erred by injecting a substantiation issue into this case not raised in the notice of deficiency, and then placing the burden for refuting that claim on the Taxpayers. But the Commissioner argues we should affirm on the alternative ground that the Taxpayers did not meet their burden of proving the IRS's determination that THC was unlawfully trafficking in a controlled substance was erroneous. The Taxpayers disagree and contend placing the burden on them would violate their Fifth Amendment privilege. Because we conclude allocation of the burden of proof does not constitute "compulsion" under the Fifth Amendment, and because the Taxpayers have made no attempt to meet their evidentiary burden, we affirm the tax court on the alternative ground that § 280E prohibited the deductions.

         I. BACKGROUND

         THC was a Colorado limited liability company organized to "promote the cultivation and sale of medical marijuana products" and was licensed by Colorado to operate two medical marijuana dispensaries. App. at 3586-87. Ms. McDonald was a shareholder for tax years 2009-2011, and Mr. Feinberg, who filed joint tax returns with Ms. Feinberg, was a shareholder for tax years 2010-2011. Because THC elected to be treated as an S corporation for tax purposes, its income and losses were reported on the Taxpayers' individual income tax returns.

         The deficiencies identified by the IRS were in the years in which the Taxpayers reported THC's income and losses on their individual returns. These deficiencies were mostly attributable to income adjustments the IRS made after determining THC was ineligible for deductions pursuant to § 280E because THC "operates medical marijuana dispensaries and marijuana growing facilities," App. at 41, and was therefore engaged in a trade or business that "consists of trafficking in controlled substances." As a result, the IRS disallowed deductions for business expenses otherwise permitted by the Tax Code. See 26 U.S.C. § 162(a). During its audit, the IRS also reclassified many of THC's claimed business expenses as Costs of Goods Sold (COGS), resulting in their exclusion from gross income. But because the net upward adjustments to COGS did not exceed the disallowed deductions for business expenses, THC's overall taxable income for the audited years increased.

         The Taxpayers filed a petition with the United States Tax Court seeking redetermination of the deficiencies. As part of the proceedings, the Taxpayers filed a motion in limine seeking a ruling that the Commissioner bore the burden of proving § 280E applied. Concluding the Taxpayers had the burden of proving § 280E did not apply, the tax court denied the motion.

         During discovery, the IRS issued a request for information about the nature of THC's business. Feinberg v. Comm'r, 808 F.3d 813, 814 (10th Cir. 2015) [hereinafter Feinberg I]. The Taxpayers resisted the request and asserted their Fifth Amendment privilege against self-incrimination. Id. at 814-15. The IRS responded by filing a motion to compel production, which the tax court granted. Id. at 815.

         The Taxpayers next sought to enforce their Fifth Amendment privilege through a writ of mandamus filed in this court. Id. We noted the tax court proceedings "took an especially curious turn" when the Commissioner sought to compel discovery because "[i]n tax court, after all, it's the petitioners who carry the burden of showing the IRS erred in denying their deductions-and by invoking the privilege and refusing to produce materials that might support their deductions the petitioners no doubt made their task just that much harder." Id. We then denied the writ, concluding the Taxpayers' Fifth Amendment privilege could be protected by an appeal in the normal course. Id. at 816.

         After the ruling in Feinberg I, the Commissioner abandoned the discovery request and instead filed a motion for summary judgment. The tax court denied the motion because "there [were] material issues of fact in dispute." App. at 2227. The parties stipulated that the two issues for trial were (1) whether the Taxpayers have "substantiated that they should be allowed [COGS] greater than those allowed" by the IRS's examination report and (2) whether the IRS "properly disallowed business expense deductions pursuant to section 280E." Id. at 3586.

         After trial, the tax court concluded the Taxpayers had failed to substantiate higher COGS. But the tax court refused to consider whether § 280E applied to the business expenses, concluding instead that the Taxpayers failed to substantiate any of the business expenses for which the deductions were disallowed. The Taxpayers filed a motion for reconsideration, arguing the tax court should not have relied on the Taxpayers' failure to substantiate their expenses because substantiation was not a basis for the IRS disallowing the deduction. The Commissioner agreed and urged the tax court to consider the § 280E arguments. The tax court denied the motion for reconsideration, and the Taxpayers appealed. Exercising jurisdiction pursuant to 26 U.S.C. § 7482(a)(1), we affirm, but on different grounds than those relied on by the tax court.

         II. DISCUSSION

         We begin our analysis of the issues on appeal with a discussion of the applicable standard of review. We then pause to provide legal context for our review. Turning next to the ground on which the tax court relied, we consider whether judgment against the Taxpayers was warranted by their failure to substantiate their business expenses. Concluding that it was not, we address the Commissioner's argument that judgment in its favor can be affirmed on the alternative ground that the Taxpayers failed to disprove the applicability of § 280E. In doing so, we reject the Taxpayers' argument that placing the burden of proof on them to disprove their business is engaged in the trafficking of a controlled substance violates their Fifth Amendment ...


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