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YOUR TAX RETURN ON DRUGS

April 25, 2006

You were caught importing hundreds of pounds of pot. You've been in jail since 1989. You've forfeited over a million dollars. Can things get any worse?

Hello, IRS!

The Tax Court yesterday held Charles McHan liable for taxes and penalties of more than $500,000 for failing to report the income from his mid-1980s "import" business.

Aside from the sad human interest angle, I find the case mostly interesting for the matter-of-fact reconstruction of the taxpayer's marijuana income. Not surprisingly, the income wasn't properly reported on the taxpayer's original return:

Petitioners did not provide any books and records or otherwise disclose to their tax return preparer any information relating to petitioner’s drug transactions, and petitioners failed to provide to their tax return preparer and to respondent any books and records with respect to the illegal drug transactions in which petitioner participated.

Imagine the look on the preparer's face if the taxpayer had included that information along with his W-2s and 1099s.

The IRS analysed the profitability of the drug smuggling business:

For example, respondent’s agent determined that petitioner paid on average $275 per pound for the marijuana purchased from the Texas source. Also, to take into account amounts paid by petitioner to the Colonel on the purchase of marijuana from Texas source, respondent’s agent added $20 per pound, allowing petitioner a total cost of goods sold in the amount of $295 pound.

The IRS seems to have made no Section 263A inventory capitalization computation for the taxpayers. Does this mean he qualified for the "small reseller" exemption, as he wasn't a manufacturer?

Actually, the tax law has a special rule that disallows all expenses other than costs of sales (what you paid for your "inventory") in computing taxable income from illegal activities. As a result there are no otherwise deductible expenses to capitalize into inventory. So while dealing drugs is dangerous and foolish, at least you don't have to mess with Section 263A.

The taxpayer argued that they didn't really make any money from the business, and that he was just accomodating his buddies. The court didn't buy that:

There is nothing in the record which would indicate that petitioner sold marijuana for philanthropic reasons, expecting no profit for his efforts. Common sense would dictate the conclusion that anyone who is in an illegal and dangerous business such as the dealing of drugs would demand a very large profit for his enormous risks.

The moral? If you're going to smuggle illegal drugs, the Tax Court expects you to make sure it pays well.

Link: McHan, T.C. Memo 2006-84

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