In January 2015, the IRS issued a memo to provide guidance to its agents on conducting audits of cannabis businesses addressing whether an IRS agent can require a taxpayer trafficking in a Schedule 1 controlled substance to change its tax accounting to conform to IRC section 280E. Not surprisingly that the IRS ruled that IRS agents have the authority to change a cannabis business’ method of accounting so that pursuant to IRC section 280E costs which should not be included in inventory are not included in Costs Of Goods Sold (“COGS”) and remain non-deductible for income tax purposes.
IRS Training Materials For Audits Of Cannabis Businesses
Recently, attorney Rachel K. Gillette released certain documents received from the IRS as a result of a Freedom Of Information Act (FOIA) Request she filed. Those documents include training materials for IRS revenue and field agents on how to conduct audits of cannabis related businesses, including any documents related to how to apply IRC section 280E. While the materials were produced in 2015 and therefore predate significant Tax Court rulings like the Harborside case and the Tax Cuts And Jobs Act of 2017 (TCJA) and the enactment of IRC section 471(c), the materials provide useful insight as to how the IRS is conducting these audits.
The main points from the IRS documents are summarized as follows:
Audit Techniques for Testing Gross Receipts
While the sale of cannabis is legal in California as well as in a growing number of states, cannabis remains a Schedule 1 narcotic under Federal law, the Controlled Substances Act (“CSA”) 21 U.S.C. § 812. As such businesses in the cannabis industry are not treated like ordinary businesses. Despite state laws allowing cannabis, it remains illegal on a federal level but cannabis businesses are obligated to pay federal income tax on income because IRC section 61(a) does not differentiate between income derived from legal sources and income derived from illegal sources.
Cannabis businesses are generally cash intensive businesses. Customers may pay in cash to protect their identity. In several states, banks have made it difficult to open accounts for known cannabis businesses. Accordingly, cannabis businesses claim that it is necessary that they deal in cash.
The main concern about cash intensive business is funds are often used to make purchases and are not accounted for by being deposited into bank accounts. Unlike checks and credit card receipts, cash does not get recorded before the funds are used. Cash funds are easily withdrawn from the safe by the taxpayer, business partner, or shareholder for personal use. Most medicinal centers deposit enough funds into bank accounts to pay rental and other expenses. If funds are used to pay business expenses, these transactions will be easier to identify than the funds used for personal expenditures. The use of an indirect method by the agent to determine income may be necessary if it appears that a taxpayer failed to report all cash sales.
Audit Techniques for Testing Expenses
Generally, businesses can deduct ordinary and necessary business expenses under IRC section 162. This includes wages, rent, supplies, etc. However, in 1982 Congress added IRC section 280E. Under IRC section 280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. Cannabis, including medical cannabis, is a controlled substance. What this means is that dispensaries and other businesses trafficking in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.
The agent should inquire as to the allocation and categories of COGS reported on each return. More and more taxpayers are combining their disallowed business expenses and wages with the reported COGS.
COGS for a retailer includes only inventoriable costs capitalized under §1.471-3(b) as it existed before the enactment of IRC section 263A: The purchase price of the cannabis (net of any trade discounts), and the transportation or other necessary charges incurred in acquiring possession of the cannabis.
COGS for a grower includes inventoriable costs capitalized under §1.471-3(c) and §1.471-11 as they existed before the enactment of IRC section 263A: Direct material costs; Direct labor costs; Category 1 indirect costs (§1.471-11(c)(2)(i)), such as repairs, maintenance, rent; and possibly, Category 3 indirect costs (§1.471-11(c)(2)(iii)), such as taxes, depreciation, officers’ salaries attributable to services incident to and necessary for production operations. COGS for a grower DOES NOT include Category 2 indirect costs (§1.471-1(c)(2)(ii), such as marketing expenses, advertising expenses, selling expenses, and general and administrative expenses incident to and necessary for the taxpayer’s activities taken as a whole.
A taxpayer who is facing increased taxes from an audit should be subject to an accuracy-related penalty under section IRC section 6662(a). A taxpayer may be liable for a 20% penalty on any underpayment of tax attributable to negligence or disregard of rules of regulations or any substantial understatement of income tax. See IRC section 6662(a) and (b)(1) and (2). “Negligence” includes any failure to make a reasonable attempt to comply with the provisions of the Code and includes “any failure by the taxpayer to keep adequate books and records or to substantiate items properly.” IRC section 6662(c). Negligence has also been defined as a lack of due care or failure to do what a reasonable person would do under the circumstances. An accuracy-related penalty does not apply, however, to any portion of an underpayment for which there was reasonable cause and where the taxpayer acted in good faith. See IRC section 6664(c)(1).
On March 30, 2020, the Treasury Inspector General For Tax Administration (TIGTA) released a report to the IRS pointing them toward targeting the state-licensed cannabis industry for lost tax revenue. The IRS has said it will implement certain recommendations in this report, specifically:
- Develop a comprehensive compliance approach for the cannabis industry, including a method to identify businesses in this industry and track examination results;
- Leverage publically available information at the State level and expand the use of existing Fed/State agreements to identify nonfilers and unreported income in the cannabis industry; and
- Increase educational outreach towards unbanked taxpayers making cash deposits regarding the unbanked relief policies available.
Cannabis Tax Audits & Litigation.
It is no surprise that cannabis businesses are proliferating as more States legalize cannabis and make available licenses to grow, manufacture, distribute and sell cannabis. The IRS recognizes this and it is making these cannabis businesses face Federal income tax audits. IRC section 280E is at the forefront of all IRS cannabis tax audits and enforcement of section 280E could result in unbearable tax liabilities.
Proving deductions to the IRS is a two-step process:
- First, you must substantiate that you actually paid the expense you are claiming.
- Second, you must prove that an expense is actually tax deductible.
Step One: Incurred And Paid The Expense.
For example, if you claim a $5,000 purchase expense from a cannabis distributor, offering a copy of a bill or an invoice from the distributor (if one is even provided) is not enough. It only proves that you owe the money, not that you actually made good on paying the bill. The IRS accepts canceled checks, bank statements and credit card statements as proof of payment. But when such bills are paid in cash as it typical in a cannabis business, you would not have any of these supporting documents but the IRS may accept the equivalent in electronic form.
Step Two: Deductibility Of The Expense.
Next you must prove that an expense is actually tax deductible. For cannabis businesses this is challenging because of the IRC section 280E limitation. Recall that under IRC section 280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. What this means is that dispensaries and other businesses trafficking in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.
A cannabis business can still deduct its Cost Of Goods Sold (“COGS”). Cost of goods sold are the direct costs attributable to the production of goods. For a cannabis reseller this includes the cost of cannabis itself and transportation used in acquiring cannabis. To the extent greater costs of doing business can be legitimately included in COGS that will that result in lower taxable income. You can be sure the IRS agents in audits will be looking closely at what is included in COGS. Working with a cannabis tax attorney can ensure that you receive the proper treatment of COGS versus ordinary and necessary expenses resulting in the lowest possible income tax liability.
In addition to IRS audits, state cannabis audits are also complex and thorough and generally include all taxes specific and nonspecific to the cannabis business. Potentially at risk is the cannabis license that enables the business to operate. State audits will focus on records regarding sales and use tax, excise taxes, and seed-to-sale tracking records.
Now if your cannabis IRS tax audit is not resolved, the results may be challenged and litigated in the U.S. Tax Court or Federal District Court. The U.S. Tax Court has jurisdiction to hear disputes over federal income taxes before final assessment and collections while the Federal District Court generally requires taxpayers to first pay the liability then seek repayment through a refund request.
Tips For Cannabis Tax Return Preparation.
Here are some tips for cannabis businesses to follow in the preparation of their 2020 tax returns.
- Reconcile Your Books Before Closing Your Books. Incomplete books can cause delays and add unnecessary complexities.
- Utilize A Cannabis Tax Professional. Engage a tax professional who has experience in the cannabis industry. Such a professional would be familiar with the intricacies of IRC Sec. 280E and relevant cases to make the proper presentation on the tax return in a manner that would support the smaller tax liability possible.
- Justify Your Numbers As If An IRS Audit Is A Certainty. Don’t wait to receive a notice from IRS that the tax return is selected for examination. That can be one or two years away. Instead make it a point to put together the backup to you numbers now while everything is fresh.
What Should You Do?
Ultimately it is the tax risk with IRS that could put any cannabis business “out of business” so you need to protect yourself and your investment. Level the playing field and gain the upper hand by engaging the cannabis tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), Los Angeles and other California locations. We can come up with tax solutions and strategies and protect you and your business and to maximize your net profits. Also, if you are involved in crypto-currency, check out what a Bitcoin tax attorney can do for you.