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Marijuana Audit Challenge Includes Claimed Hidden Criminal Case by Nathan J. Richman

Tax Analysts, 2017

A Colorado marijuana business is alleging that an IRS’s civil tax audit is actually a ruse to gather information for a Justice Department criminal drug prosecution.

The three petitioners in Rifle Remedies v. United States, No. 1:17-mc-00062-RM (D. Colo.), are seeking to quash a third-party summons issued in an IRS audit to the Colorado Department of Revenue’s Marijuana Enforcement Division for state data on Rifle Remedies LLC’s sales, transfers, harvests, and plant reports. The summons also sought information on the marijuana licenses held by the petitioners, which are the limited liability company and its owners.

Among their assertions, the petitioners allege that the IRS audit is part of a coordinated effort with the DOJ “to investigate the criminal culpability of those they believe are unlawfully trafficking in controlled substances.” The allegation is based on the fact that the agencies held a weeklong joint training session involving section 280E auditors. The individual petitioners have stated their intent to invoke the Fifth Amendment in response to IRS questions about purported violations of federal drug laws. The petition requests that the court either quash the summons outright or hold an evidentiary hearing to determine if the IRS has a legitimate purpose for issuing it.

The petitioners assert that the IRS cannot satisfy all four factors from United States v. Powell, 379 U.S. 48 (1964), to justify enforcing the summons. While they make arguments under three of the four factors, the argument that the IRS is conducting a drug crime investigation on behalf of the DOJ falls under the proper purpose prong.

The government responded by moving to dismiss the petition to quash. It points out that income from illegal activities has long been considered taxable income and thus a proper subject of investigation. Further, the allegations of collusion to use a civil audit for a criminal investigation are mere speculation, according to the government. The current audit is not an investigation into “any drug-related criminal liability” but merely an investigation into petitioners’ correct tax liability, it said.

The government’s motion to dismiss appears fully briefed and awaits the district court’s ruling.

The audit at issue concerns the application of section 280E to the petitioners’ state-legal marijuana business. Section 280E denies a taxpayer any deductions other than costs of goods sold for any trade or business that “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.”

Stalking Horse

If the civil tax audit is a front for an eventual criminal drug case, the later charges could run face-first into legal doctrines specifically meant to prevent that sort of duplicity. In United States v. Tweel, 550 F.2d 297 (5th Cir. 1977), the appellate court found bad faith when a criminal investigation was conducted under the guise of a civil audit. The Fifth Circuit reversed the defendant’s conviction and held that evidence the defendant gave during a civil audit should have been suppressed because an IRS revenue agent used a “sneaky” but literally true statement to conceal a criminal investigatory purpose of the audit.

The tax resource manual in the U.S. Attorney’s Manual contains a section devoted to the interaction between civil and criminal proceedings. It contains references to cases similar to Tweel in which using civil proceedings to support criminal investigations led to sanctions such as suppression of evidence or dismissal of indictments.

Sanford J. Boxerman of Capes, Sokol, Goodman & Sarachan PC said that petitioners’ allegations would not exactly fit Tweel because the summons is directed to a third party, rather than to petitioners. Also, a court would most likely rather deal with allegations of improper criminal purpose hiding in an avowedly civil audit if and when there is a criminal case rather than at the summons enforcement stage, he said.

While the remedies at the criminal stage — starting at suppression of evidence — are potent relief for an aggrieved party, it would be even better to prevent the criminal charges from being brought and thereby avoid the expense and stress of even a successful defense, Boxerman said. There is no real downside to presenting the arguments under Powell at the summons enforcement stage, he added. “If they move to quash the summons and they lose, then they are no worse off than if they had not done anything. So why not take a run at it?”

The most important aspect of any Tweel allegation in marijuana audits will be the timing of when an auditor decides or learns that a criminal investigation is warranted, Kevin F. Sweeney of Chamberlain, Hrdlicka, White, Williams & Aughtry said. If a drug investigation later emerges, using information developed at the audit stage, the critical questions would be at what point was the criminal investigation initiated and whether the auditor tricked the taxpayer into providing evidence for that investigation, particularly in light of the IRS’s current position that the Rifle Remedies audit is purely civil, he said.

Sweeney said that it is unusual to raise the issue of an allegedly hidden criminal investigation during summons enforcement proceedings. This type of issue is typically raised in the context of a criminal prosecution, he said, adding that if the case ever progresses to a criminal prosecution, this litigation could complicate potential Tweel motions by making it harder for the petitioners to argue surprise.

It is much different for a taxpayer to have potential culpability than it is for the taxpayer to be the target or subject of a criminal investigation in the context of bad faith arguments presented in either summons enforcement or criminal proceedings, Sweeney said. A section 280E audit, which depends on conduct that might be chargeable criminally, is not a grand jury investigation, he said.

Sweeney said that it is more complicated for an IRS civil auditor to make a referral to a non-IRS investigative agency or a U.S. attorney’s office for possible drug charges than to the IRS Criminal Investigation division for potential tax charges. The court may be less concerned by the petitioners’ bad faith arguments because of the reduced federal enforcement against marijuana businesses authorized by state law, he said.

Steven Toscher of Hochman, Salkin, Rettig, Toscher & Perez PC said that the petitioners’ allegations, particularly the joint training between the IRS and DOJ, may be enough to justify an evidentiary hearing on a potential improperly criminal-minded civil tax examination. “I think there is an underlying Tweel issue” not directly addressed in the briefing, he said, adding that the issue should be a concern given the dichotomy between state and federal marijuana laws.

“If there is some skullduggery going on or the civil people are acting as a stalking horse, then it is incumbent upon the district court to find out,” Toscher said. If the evidence supports Tweel stalking horse allegations, the investigation should be cut off at the civil examination stage, he said. It is particularly important to address the issue of potential institutional bad faith now because Nevada and California lawyers will be facing it within a couple of years, he said.

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