Chapter 6
How Long Will Cannabis Industry Obstacles Last?
Businesses operating in the cannabis industry know that § 280 (E) is perhaps the biggest obstacle to growth and prosperity.
Unfortunately, the IRS and US Tax Court are seeing eye-to-eye regarding the interpretation and implementation of § 280 (E) and COGS calculations when it comes to cannabis retailers and dispensaries. Richmond Patients Grp. v. Comm'r, T.C. Memo. 2020-52 (U.S.T.C. May. 4, 2020).
This means that both the IRS (the enforcer) and the Tax Court (a means of relief) are on the same page about imposing § 280 (E), further reducing options that cannabis business operators may have at their disposal.
These strict regulations eat into the profits of cannabis businesses. They also put them at a higher risk of getting audited, penalized, making both short and long-term growth difficult.
Instead of seeking guidance from the IRS, cannabis business owners have become conditioned to avoiding the IRS as much as possible, in many cases further perpetuating tax liability.
The IRS feeds off the uncertainty that cannabis business owners have of the applicability of § 280 (E), which in turn fuels their collection efforts.
Business owners in the cannabis industry will continue to be frequently audited. There is simply too much money to “tap into” for the IRS to cease its efforts anytime soon.
In fact, the IRS has made it apparent that it intends to increase the number of audits conducted on cannabis businesses.
At the point of writing this, it seems that the only way cannabis business owners will only see a reduction in the number of audits industry-wide will be when cannabis is re-classified as a Schedule II drug.
Reclassification of cannabis will also mean that the tax laws surrounding income derived from cannabis businesses will change – namely that § 280 (E) will no longer apply.
As a result, cannabis business owners will be able to claim most of the deductions and credits other business owners can, thereby drastically reducing their tax liability.
Audits may also decrease if cannabis is approved for medical use by the Drug Enforcement Agency (“DEA”).
When this happens, it will no longer be considered a controlled substance but one that is used for viable (and legal) medical purposes. However, the DEA has currently concluded that cannabis has no “accepted medical use” because:
- “the drug’s chemistry is not known and reproducible,
- there are no adequate safety studies,
- there are no adequate and well-controlled studies proving efficacy,
- the drug is not accepted by qualified experts, and
- scientific evidence is not widely available.”
Although the DEA noted that cannabis has a high potential for abuse, they concluded that there was little evidence to support the frequently cited concern that initiation of cannabis use leads to an abuse disorder with other illicit substances. See Denial of Petition to Initiate Proceedings to Reschedule Marijuana, 81 Fed. Reg. 156 (August 12, 2016).
The DEA’s stance on cannabis’s medicinal uses is highly controversial, as it has been noted for its ability to lessen tremors, reduce anxiety, stave off seizures, help glaucoma and relax otherwise tense muscles. See Harvard Health Blog on “Medical Marijuana” (April 10, 2020).
Although legislation is inching towards the federal legalization of cannabis it is highly unlikely that this will take place in the foreseeable future. Sisley vs. U.S. DEA, No. 20-71433 (August 31, 2021).
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So, the question remains: “Can I do anything to avoid an audit?” No. But there are things you can do to mitigate the damage that an audit can cause, including the following:
- Conduct periodic self-audits, even if the IRS hasn’t audited you. This allows a business owner to verify the accuracy and quality of their records. Think of it as doing inventory — for your books. If nothing else, you’ll get a sense of your financial situation. Self-audits allow business owners to pinpoint potential issues prior to the IRS finding them, thus staying ahead of the audit.
- Review your records and pinpoint questionable things. Does something seem off to you? Then it will probably seem off to the IRS.
- Reconsider the purpose of your expenditures. Are these expenses really “reasonable and necessary” to produce cannabis? If not, why attempt to claim them as a COGS? Is it worth the hassle and headache of an audit?
- Make minor changes to your business operations. Making some minor changes to your operations could significantly lower your risk of being selected for an audit. Since the IRS focuses on auditing cannabis businesses because they are cash-intensive, you can stop receiving cash payments to whatever extent possible.
Switching to electronic transactions allows the IRS to “follow the paper trail” and authenticate the money earned from your business, thus reducing the likelihood of any of your earnings being deemed unaccounted for.
- Implement a solid record-keeping system: The IRS feeds off businesses who have spotty records. It essentially provides an examiner with a gateway into the deficiencies in your business. The best solution to overcome this and increase the day-to-day functionality of your business is to implement a record-keeping system that you can rely on.
- Invest in your employees: As important as it is for the business owner to be on their “A” game, it’s just as important for the employees to be doing the same. They should be regularly assessed for deficiencies in record-keeping, as a business owner opens themselves up to liability when an employee’s efforts are sub-par.
- Outsource compliance: cannabis industry business owners can often get caught up in the ever-changing nature of cannabis laws. Some business owners simply don’t see the point in adhering to operational and tax regulations, as they do not know when their businesses may get shut down, or when cannabis regulation will change and put them out of business.
Since recreational cannabis is here to stay, it’s a best practice for cannabis business owners to make sure that their books are up to par.
It is also an excellent idea to know an attorney that specializes in cannabis regulation – or a cannabis compliance firm.
Although it may seem costly, the benefit they can provide to you will likely far outweigh the cost.
In today’s climate, it is unlikely that an audit can be avoided, but you can certainly steer clear of the kind of tax liabilities that can see a successful business venture go quite literally up in smoke.
