Two California-based cannabis companies had their petition thrown out of appeals court after it was delivered to court a day late by an unapproved delivery service. Organic Cannabis Foundation and Northern California Small Business Assistants (“NCSB”) were challenging a nearly $2 million combined tax bill at the U.S. 9th Circuit Court of Appeals based in San Francisco.
Appealing I.R.C. §280E Audits
Both Organic Cannabis Foundation and NCSB had been audited by the IRS. The IRS stated that these businesses are subject to Section 280E which doesn’t allow tax deductions related to cannabis because it is still federally prohibited. According to appellate-court documents, Organic Cannabis Foundation owed $1.1 million in taxes and $225,855 in penalties and NCSB owed $531,707 in taxes and $106,341 in penalties.
When the IRS reaches a final decision in an examination, it will issue a Notice Of Deficiency which starts a 90-day period to file a petition with the U.S. Tax Court to appeal such a decision. For Organic Cannabis Foundation and NCSB, their petition to the Notice Of Deficiency was due to the U.S. Tax Court in Washington DC on April 22, 2015. According to court records, the petition was delivered via FedEx “First Overnight” at 7:35am April 23, 2015. Having received the petition one day late, the U.S. Tax Court ruled that the petition for a review of the IRS decision lacked jurisdiction because it came after the petition filing deadline. The taxpayers appealed this verdict to the U.S. 9th Circuit Court of Appeals; however, the Appeals court upheld the Tax Court’s initial verdict.
The “IRS mailbox rule” states that: “If any return, claim, statement, or other document required to be filed…on or before a prescribed date under authority of any provision of the internal revenue laws is, after…such date, delivered by United States mail to the agency, officer, or office with which such return, claim, statement, or other document is required to be filed,…the date of the United States postmark stamped on the cover in which such return, claim, statement, or other document…is mailed shall be deemed to be the date of delivery…” I.R.C. §7502.
In other words, this IRS mailbox rule confirms that a tax document is timely filed with the IRS even though it is not physically delivered to the IRS in time, as long as it is delivered by an approved delivery service. Using the U.S. Postal Service at the time was an approved service (and still is). Although FedEx Priority Overnight and FedEx Standard Overnight were approved by the IRS at that time, court documents state that it wouldn’t be until May 5, 2015, two weeks after the late delivery, that FedEx First Overnight was designated as an approved service.
Since a timely postmark is crucial, filing a petition in the U.S. Tax Court by certified or registered mail with the U.S. Postal Service can provide taxpayers with assurance of a timely filing regardless of when the petition is received by the U.S. Tax Court in Washington DC.
Yes – Cannabis Businesses Have to Report Income To IRS And Pay Taxes!
We previously reported in our blog that the Trump Administration organized a committee of federal agencies from across the government to combat public support for marijuana and cast state legalization measures in a negative light while attempting to portray the drug as a national threat. The IRS appears to be following the agenda of the Trump Administration when it comes to Cannabis and has formed special audit groups that are tasked with conducting cannabis tax audits on medical and recreational cannabis businesses.
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 I.R.C. §61(a) does not differentiate between income derived from legal sources and income derived from illegal sources.
Generally, businesses can deduct ordinary and necessary business expenses under I.R.C. §162. This includes wages, rent, supplies, etc. However, in 1982 Congress added I.R.C. §280E. Under I.R.C. §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 marijuana, 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.
IRS Guidance On Cannabis.
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 I.R.C. §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 I.R.C. §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.
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 §280E is at the forefront of all IRS cannabis tax audits and enforcement of §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 I.R.C. §280E limitation. Recall that under I.R.C. §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 2019 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), Northern California (Sacramento and San Francisco) 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.