Chapter 4

California Audit Issues for Cannabis Businesses

Although most cannabis business tax audits will be conducted by the IRS, it is important to remember that the State of California has its own revenue department – the California Department of Tax and Fee Administration (CDTFA). This department is capable of auditing and assessing files on businesses in the cannabis industry.

The State of California may have a more heightened interest than the IRS in conducting cannabis business audits.

In Q2 of 2021 alone, CDTFA reports indicate that cannabis businesses paid over $333 million in taxes to the State of California.

The cannabis industry is the fourth-highest earning industry in California and has only begun to tap into its potential. See California Department of Tax and Fee Administration, Summary of Revenue.

As it pertains to the cannabis industry, the biggest difference between the California tax code and the IRS is that the California code does not incorporate § 280 (E) (or a functional equivalent).

Rather, cannabis business owners are permitted to deduct their trade and business expenses just like their mainstream business counterparts.

Since California does not regulate cannabis business deductions, the California Department of Tax and Fee Administration (“CDTFA”) regularly audits cash-intensive businesses on suspicion of unpaid state sales and use taxes.

Another important difference is that in addition to paying sales tax, cannabis business owners must also pay a state excise tax and a state cultivation tax directly to the State of California. Note that this amount is independent of what is owed to the IRS.

The CDTFA may conduct an audit of either your sales tax, excise tax, cultivation tax, or a combination of any thereof.

An excise tax is a supplemental tax, typically imposed on manufactured goods. It exists to discourage consumption and use of a product.

Examples of goods subject to excise tax include fuel, alcohol, tobacco, and of course, cannabis. Excise tax is presently set at 15 percent of the average market value of cannabis at retail.

A cultivation tax is imposed upon cannabis cultivators for all harvested cannabis that enters the commercial market. It is calculated based on the weight and type of cannabis.

The three categories of cannabis (for purposes of calculating cultivation tax) are flower, fresh cannabis plant, and cannabis leaves.

In addition to federal taxes and state taxes, several cities and counties in California have passed local taxes intended to tax cannabis businesses. These are frequently overlooked, thus flagging otherwise legitimate businesses for audit.

Cannabis business owners must ensure that they are up to date on federal, state, county, and local tax directives.

Like dealing with the IRS, it is in the best interest of cannabis business owners to implement in-house compliance programs, as the financial implications can be very large.

Without receipts or clear and defined records of gross income, the CDTFA can simply assign an estimate of gross income and force the business to pay sales and use taxes based on such an estimate.

Failure to pay taxes can result in up to 45-day suspension and fine. See California Department of Cannabis Control Publication “Disciplinary Guidelines For All Distributor, Retailer, Microbusiness, Cannabis Event Organizer, Cannabis Event, And Testing Laboratory Commercial Cannabis Licenses” (September 2021).

It is imperative that cannabis business owners keep impeccable records of cash transactions.

Why is the CDTFA Auditing Me?

Generally, the auditor is looking to make three determinations about the cannabis business owner. Did they:

  1. pay the correct sales tax,
  2. cannabis excise tax, and
  3. cultivation tax.

In determining whether a business owner paid the proper sales tax, an auditor will most likely want to verify the following:

  • Did you properly claim deductions?
  • Did you report the cost of all business equipment and supplies that you purchased?
  • Did you report all gross receipts from sales of tangible personal property and taxable labor and services?
  • Did you properly apply tax to your sales and uses of tangible personal property?
  • Did you use the correct rate of tax when reporting sales in special tax districts?

In calculating whether a business owner paid the proper excise tax, an auditor will most likely want to verify the following:

  • Whether the business properly calculated the average market price of its products.
  • Whether the business reported an excess cannabis excise tax collected from a retailer.
  • If the business is a wholesaler, whether it returned any credits for excess cannabis excise tax back to the retailer.

In calculating whether a cannabis business paid the proper cultivation tax, an auditor may review the following:

  • Whether the business reported in ounces, as directed.
  • Whether all cannabis that entered the market was labeled in the correct category.
  • Whether all cannabis that entered the market during the tax period was properly reported.

The auditor’s goal is to answer these questions as accurately as possible in the least amount of time. See California Department of Tax and Fee Administration Publication, “Audits” (October 2020).

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What to Expect from a State Audit

The CDTFA will supply cannabis business owners with ample notice about an upcoming audit, as it rarely conducts an audit without prior notice.

The CDTFA may attempt to conduct a “surprise” audit if it believes that the business owner is actively trying to conceal or destroy evidence of tax liability.

Initial contact is usually by phone. Note that this differs from the IRS, which exclusively contacts taxpayers by mail.

During the initial phone call, the CDTFA auditor will inform the cannabis business owner about the audit period (usually three years) and will ask about business operations, including the type of records kept. The auditor will also instruct what business records should be ready for the audit and confirm a date and location for the audit.

Auditors are usually flexible about audit dates and locations, although most of them will be conducted at the business location. Taxpayers may request additional time to prepare for an audit, but the CDTFA may impose stipulations.

In general, the statute of limitations for auditing California income tax returns is three years. However, for those taxpayers who fail to file returns, the statute of limitations is eight years. It is imperative that you file your tax returns on an annual basis, prior to the filing deadline.

The audit usually starts with a preliminary examination of your records. This examination gives the auditor some ideas of what records are available and the procedures you use to record your transactions.

Auditors conduct examinations on two bases:

  1. an actual basis, where they are reviewing every transaction, or
  2. on a sample basis, where they review selected transactions.

For a sample basis audit, the auditor normally tries to use a statistical sample. Under this method, the auditor randomly selects enough transactions to enable him or her to draw a conclusion about all of the transactions under review. 

If your records are not suitable for a statistical sample, the auditor may use some other sampling method. In general, if an auditor is going to use a sampling method, he or she should discuss the sampling elements with you before finalizing the plan.

Sampling is normally used when an actual basis review would take too much time. In many cases, the auditor will use both methods on the same audit.


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