Tips to avoid an audit, save money and protect yourself and your business at tax time
It’s the time of year when the birds begin to return, trees start to bud, flowers push fresh, green shoots through the thawing ground and the minds of Americans begin to turn to … taxes.
Yes, tax season is upon us once again and while April 15 may be the filing deadline for personal income taxes, and not necessarily business taxes, the two returns are not mutually exclusive and the goal is the same either way: to only pay what you have to and to not get audited.
But unlike the taxes for most other categories of business, the cannabis industry is one of the most complicated and one of the most scrutinized by the government. It’s important to make sure all of your I’s are dotted and T’s crossed when it comes time to file.
“Statistically, the odds of getting audited are greater for cannabis businesses,” says Sandy Suchoff of The Canna CPAs, a firm that specializes in accounting for the cannabis industry.
“You’re not going to avoid an audit; you sell weed,” says James Hunt of Guske and Company, Inc. “Prepare for it.”
From negotiating IRC 280E to protecting your personal assets from an unexpected tax bill, it’s important to make sure to have a competent, professional accountant who understands both the Internal Revenue Code and the cannabis industry in order to protect yourself and your business from the additional cost and scrutiny of an audit.
“Unless you’re really knowledgeable of the tax code, of case law, of precedent set in the audit arena, I would have a knowledgeable professional help,” Suchoff says.
But even with professional assistance, there are a few things cannabis business owners can do to prepare and protect themselves.
GET YOUR HOUSE IN ORDER
For any business, but especially those in a federally illegal field, the first thing an owner can do to help ease their way through tax season is to make sure all financial reports, documents and books are clean, up-to-date and reconciled.
“We tell people the first thing you need to do is get your house in order,” says Dani Espinda, a CPA and principal at ACT Resources, PLLC. “If you are not prepared, your tax preparation is more expensive and your tax bill with the IRS will be larger.”
Espinda says she tells her clients to make sure they have their books, financial statements and disclosure up-to-date and ready to go, as well as to reconcile any accounts with both the bank and with the company’s bookkeeping system. She also says in a business like cannabis, which doesn’t have the banking services of other industries and is therefore cash-heavy, maintaining an up-to-date cash log is extremely important.
“I still have people who call me that don’t,” Espinda says with a sigh. “If you’re going to come in for tax preparation, it’s super important your books and financials be ready to go.”
“They should be very meticulous in their documentation, not only evidenced by receipts, but by having work papers to corroborate that these deductions are consistent with the applicable tax laws and the Internal Revenue Code,” echoes Suchoff.
“The most important thing you ought to do is look at your books, your Quickbooks and your bookkeeping and don’t just pay attention to your P&L — your income portion of your financials — but also look at your balance sheet,” Hunt says.
Espinda also says business owners should go through their documents with a fine-tooth comb, because the IRS certainly will, and to always keep any and all business receipts and documentation for up to seven years.
HOW YOU FILE
One of the first tips each tax expert offers is to be careful about how exactly a business is classified properly on tax returns and what that can mean for the business and the owners.
For example, filing as a C corporation, as opposed to an S corporation or an LLC, can help protect an owner from taking a personal hit if money is due.
“If you are an S corporation you should consider whether or not you should revoke that or not and whether that works for you,” Hunt says. “C corporations protect the owners from legal liability and S corporations do not. If you have a 280E adjustment and you’re an S corp, the liability flows up to the owners.”
“And you can never discharge that debt in a federal bankruptcy court,” adds Suchoff.
She also says companies that are registered as an LLC should consider electing to be treated as a C corporation for tax purposes, which will not at all affect the business’s incorporation status with the state.
“If they are an LLC, they can elect to be treated as a C corp. It doesn’t change the fact that they are an LLC at the Secretary of State level,” says Suchoff. “A C corporation gets taxed at the entity level, so they’re not personally liable for the income or the taxes.”
Also, for growers, according to Suchoff, it’s important to note that for federal tax purposes, cannabis cultivation operations do not have an agricultural designation, which can come with “a lot of credits and tax advantages.”
“Instead, for tax purposes at the federal level, a grow is deemed to be a miscellaneous manufacturing business. So on their tax returns they have to code it accordingly,” she says. “The tax returns should also include a disclosure statement prepared by a knowledgeable tax preparer.”
The biggest concern to any plant-touching cannabis business, especially retailers, is IRC Section 280E, which prevents any business that traffics in a federally controlled substance from taking standard business deductions beyond cost of goods sold (COGS).
“The only real deduction they have is the cost of the product itself,” Espinda says. “You cannot deduct your ordinary and necessary business expense. That is a big deal.”
“I see a lot of people putting in cost of goods sold. If it does not relate to inventory, then it’s not deductible. Just by putting it in there doesn’t mean you’re going to get it. And at a dispensary, a very large cost of goods sold may be a flag,” Suchoff says. “For a dispensary, for instance, you have to be very meticulous with how you are allocating things between cannabis and non-cannabis goods sold in your store. If you are going to have any general and administrative expenses deducted related to your non-cannabis goods, they have to be meticulously documented, substantiated and cross-referenced in your disclosure statement.”
The expenses that cannabis businesses are precluded from deducting due to 280E, however, are effectively treated as income on the tax return, despite the fact that it really isn’t income but disallowed expenses. Suchoff refers to it as “phantom income.” But even that phantom income must be accounted for and taxes must be paid on it.
Espinda says it is a little less treacherous on the cultivation and processing side where many activities, like rent, might be deductible because they actually do apply to the cost of goods, but growers should still have a professional look over their tax forms.
Generally, tax preparation experts advise erring on the conservative side to prevent creating a red flag for IRS auditors.
NOT JUST 280E
While 280E may be the section of the code most relevant to cannabis businesses — and the one they are most focused on — Hunt reminds business owners not to slack on ensuring that all other taxes are paid, including those at the state and municipal level, such as Oregon’s corporate activity tax or city business taxes in California and elsewhere, that often apply to any economic activity, whether the filer has a storefront or not.
“The entire tax code applies to you, not just 280E,” he says, adding that all cannabis businesses must also pay payroll taxes and are responsible for excise and sales tax payments as well. “Pay your taxes. Bake that into your business model.”
It’s also important to make sure to file on time, or to file for an extension within the allotted time frame.
Finally, and maybe most importantly: be honest.
While it may seem smart to try to avoid scrutiny by not straight-out telling the IRS that you work in cannabis, all of the experts say trying to hide the fact was even worse.
“Under product or service, I do put cannabis. You’re going to have 280E adjustments on this tax return. They’re going to know you’re in cannabis,” says Suchoff. “I never want the appearance that I’m deceiving because that would adversely affect my credibility if am in an IRS tax audit.”
“We absolutely disclose what’s on those returns,” Espinda says. “I am not a fan of hiding anything.”
Espinda points out that there is no NAICS code for cannabis retailer or marijuana grower, but she says to use the closest code as possible, but include that it’s a cannabis business on the return in the business purpose.
“This is a legal business in the state,” she says. “But even if it wasn’t legal in the state, you are still required to report your income, legal or illegal.”
At the base level, the business owner is responsible for understanding their filing obligations and making sure things are filed on time. The IRS makes available to business owners calendars with important dates that can be imported.
“Don’t wait until the last day to file,” Espinda says.