It’s hard enough running a cannabis business on a day-to-day basis.
There’s employee relations and inventory management, software and systems, competitors, product selection and processing, the immeasurable laws to stay in compliance with and, last but not least, the city and state reaching into your pockets on a monthly basis.
It’s a full-on war for cannabis business owners just fighting the daily fight to stay alive and be successful in this industry.
But lurking in the back of everyone’s mind — especially the minds of the devoted cannabis accountants, attorneys and tax professionals who look out for you — are the Internal Revenue Service, 280E and 471(c).
In our experience, IRS and other audits tend to begin with an initial year’s examination and may extend back three years if the audit results give the examining agent a reason to go back further. In California, recreational cannabis was legalized by Proposition 64 as of January 1, 2018, and several other states went legal the same year. This means that we are nearing the usual statute of limitations open for audit with the IRS for this specific industry by the end of 2021.
As we near that milestone, we feel it’s important to prepare our cannabis industry clients and other professionals in the industry for this process, to dispel fear and explain what the audit, appeals, resolution and tax court processes consists of.
A report published in March 2020 by the U.S. Treasury Inspector General for Tax Administration examined California, Oregon and Washington for the 2016 tax year and found 59% of marijuana companies had likely underpaid the IRS under 280E, estimating $48.5 million dollars were owed. And this was only for 2016 and only for those three states. Calculated out, this suggests that hundreds of millions of dollars are owed by businesses in states where some form of cannabis is legal.
The report confirms the IRS is preparing to increase marijuana industry audits nationwide. And it corroborates what cannabis industry tax and legal experts have warned about for years — that the IRS is closely watching the marijuana industry and intends to target companies that have failed to pay their full federal tax obligations. In other words, the agency plans to collect those taxes.
The IRS Audit Process
So what can a cannabis business owner expect in the coming months? Typically, the IRS begins by designing a proprietary algorithm to analyze all cannabis returns, producing a DIF Score (Discriminate Inventory Function) for each tax return — the higher the score, the higher the probability of errors on the tax return. Try as we might, we cannabis CPAs have been unable to find out information about the algorithm. We’re as much in the dark as you are.
Once a business is chosen for examination, it will be scheduled for a correspondence audit (snail-mail), an office audit (in which the taxpayer will come to the closest IRS office) or a field audit (in which the auditor will visit the taxpayer). Usually, the field audits are the most comprehensive, since records of the cannabis business may now be available for review.
What Will the IRS Be Focusing On?
A standard business audit tends to revolve around the areas most prone to misstatement by taxpayers: travel and entertainment expenses, purchases of assets, loan payments, receipts of borrowed funds and balances of cash on hand. With cannabis taxpayers, common misstatements are the business representation of gross profit (gross revenue minus cost of goods sold) and the flow of cash within the business. The IRS auditor will follow the trail of money in and out of a cannabis business very closely, ensuring all the sales are represented in the financial statements and on the tax return. They’ll be looking closely at inventory purchases to see if they suggest that additional, unrecorded sales might have taken place. They will also look at the tax positions taken on the tax returns with regards to 280E and 471(c), accountant disclosures and forms 3115 for a change of accounting method.
Burden of Proof
Unlike a criminal trial, in which a defendant is innocent until proven guilty, the IRS has historically placed the burden of proof on the taxpayer. However, the current code says as long as a client has reasonable records that bear out the numbers in their tax return, and if they’ve complied with IRS requests for documents, meetings, etc., then it is up to the IRS to disprove the taxpayer’s numbers. The burden of proof is stricter if an audit is contested in U.S. Tax Court.
Impact of COVID-19 on Audits
Everything we’ve stated above coincides with how the IRS has normally conducted audits of business taxpayers in the past. However, that was before the a pandemic ravaged the nation. COVID-19 has upended many businesses and organizations, including the IRS.
It is unclear exactly what impact the pandemic will have on IRS audits, other than the obvious, which is to make it quite likely that any audits will take place over Zoom during the near future.
To give you an idea of what is happening internally at the IRS, during a recent conversation with an IRS official, we learned from the agent that their whole building had been emptied when the pandemic began in March 2020, and they’d only returned to their offices in August. The last to return were the mail handlers. The agent’s office typically receives 80,000 pieces of mail a day, and the mail had remained unopened for five months. That equated to 12 million pieces of unopened correspondence. Needless to say, the IRS is struggling during this time as well as the rest of us, and this will probably end up slowing down the audit process significantly.
Whether COVID-19 delays the rollout of cannabis business audits altogether, and how the pandemic will affect these audits, remains to be seen. In terms of the pandemic, we are all in uncharted waters.
Simon Menkes, Rachel Wright and Abraham Finberg are certified public accountants at AB FinWright LLP (www.abfinwright.com) and 420CPA (www.420cpa.com). They serve clients throughout California and in all legalized cannabis states in the U.S. They can be reached at 310-237-3070.
This article is the first of a two-part series on federal tax procedures for businesses in the cannabis industry. Part II will be published in the June issue of Marijuana Venture and will discuss resolution efforts.