You should know that when the IRS wants to talk about a particular business sector that it is usually a sign that such business sector is identified as having a high potential for non-compliance and thus more tax revenues.
On September 27, 2021, De Lon Harris, the Commissioner of the IRS Small Business/Self Employed (SB/SE) Examination Division, published a blog on the IRS website discussing how his division is focusing on is the tax implications for the rapidly growing cannabis/marijuana industry. Even though at last count, 36 states plus the District of Columbia have legalized marijuana for recreational or medicinal use, or both, it’s still considered a Schedule 1 controlled substance under federal law. That means a cannabis/marijuana business has additional considerations under the law, creating unique challenges for members of the industry. Specifically, these businesses are often cash intensive since many can’t use traditional banks to deposit their earnings. It also creates unique challenges for the IRS on how to support these new business owners and still promote tax compliance.
Commissioner Harris’ states that while IRS Code Section 280E is clear that all the deductions and credits aren’t allowed for an illegal business, there’s a caveat: Marijuana business owners can deduct their cost of goods sold, which is basically the cost of their inventory. What isn’t deductible are the normal overhead expenses, such as advertising expenses, wages and salaries, and travel expenses, to name a few.
Change In The IRS’ Perception Of Cannabis
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 Cost Of Goods Sold (“COGS”) and remain non-deductible for income tax purposes.
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.
In a hearing before the House Appropriations Financial Services and General Government Subcommittee on February 23, 2021, IRS Commissioner Charles Rettig told Congress that the federal agency would “prefer” for state-legal marijuana businesses to be able to pay taxes electronically, as the current largely cash-based system under federal cannabis prohibition is onerous and presents risks to workers.
IRS Published Guidance For Cannabis Businesses
The IRS has created a page on its website IRS.gov/marijuana, which includes links to information on:
- IRC Section 280E
- Income reporting
- Cash payment options
- Reporting large cash receipts
- Estimated payments
- Keeping good records
The IRS also posted frequently asked questions on IRS.gov to answer questions commonly asked by those in the cannabis/marijuana industry.
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.