IRS Audit Issues for Cannabis Businesses
To enforce federal tax code compliance with IRC Section 280E, the IRS runs compliance initiative projects. This is probably in accordance to the noted “high likelihood that a good deal of cannabis dispensary owners were non-filers and not reporting their sales.”
IRS agents have admitted to using a specific ATG (audit technique guide). These guides are generally available to the public on the IRS website but the cannabis industry is mysteriously not listed or accessible.
As noted previously, the tax revenue gathered from the average hourly assessment rate during many cannabis company audits has been so fruitful that it is easy to understand why the IRS dedicates more resources to it than any other industry.
Clearly then, if you are a cannabis business owner, it’s best to accept that you will most likely be audited.
Keep in mind that auditors are independent third parties and can only give opinions on financials. If your books and records are well kept and can be supported with documentation and evidence to account for the activity of your company, you shouldn’t sweat the audit outcome.
The Three Possible Outcomes
- No change: the audit has substantiated all the items being reviewed and results in no changes. This generally means that the IRS will not demand.
- Agreed: an audit where the IRS proposed changes and you understand and agree with the changes.
- Disagreed: an audit where the IRS has proposed changes and you understand but disagree with the changes. Most cannabis business audits are closed as disagreed audits.
Penalties Not Withstanding
A cannabis business owner is subject to the same penalties and additions to tax as any other business. These include penalties for filing late returns, penalties for failure to make estimated tax payments if sufficient estimated tax payments are not made, accuracy-related penalties, and fraud-related penalties.
Although the IRS considers cannabis to be an illegal industry, there are no heightened punishments for cannabis business owners who get audited.
However, there may be penalties for compliance-related shortcomings. These are considered on a case-by-case basis.
For example, the Tax Court has previously upheld a negligence penalty where a cannabis industry business owner failed to keep adequate books and records. Olive v. Commissioner, 139 T.C. 19 (2012), 792 F.3d 1146 (9th Cir. 2015). Alternative Health Care Advocates v. Commissioner, 151 T.C. 225 (2018); Richmond Patients Group v. Commissioner, T.C. Memo. 2020-52.
Again, while these penalties exist, they are not harsher than those imposed on non-cannabis business owners.
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The Appeals Process
After an audit has been completed, the IRS will mail the business owner a detailed report, outlining the results. If a business owner is found to be liable for additional charges, the report will include a breakdown by interest, penalties, and taxes.
If you are deemed to be liable for taxes owed, it’s important to remember that you have options. In fact, some would argue that the audit itself is the most difficult part of the process.
Once an audit has been completed, you may choose to file an appeal with the IRS. See IRS Publication, “Considering an Appeal” (June 21, 2021).
The IRS advises taxpayers to appeal if they believe one of the following has occurred:
- The IRS made an incorrect decision based on a misinterpretation of the law.
- The IRS didn’t properly apply the law due to a misunderstanding of the facts.
- The IRS is taking inappropriate collection action against you or your offer in compromise was denied and you disagree with that decision.
- The facts used by the IRS to reach their conclusion are incorrect.
Business owners are requested to sign the report, thus acknowledging receipt of the IRS’ decision. Should you choose to appeal, you should not sign and return the report.
Not signing the report will result in a letter being mailed to the business owner, advising them of their rights. See IRS Publication, “Your Appeal Rights and How to Prepare a Protest if You Disagree” (April 2021).
To move forward with the appeals process, the business owner must file an official protest via mail with the IRS within 30 days of the letter being issued. See United States Government Accountability Office, Report to Congressional Committee on ‘Tax Administration: Opportunities Exist to Improve Monitoring and Transparency of Appeal Resolution Timeliness” (September 2018).
The IRS is then required to forward your file to the Office of Appeals. Before doing so, the IRS Examination or Collection office that made a tax assessment will consider your protest and attempt to resolve the disputed tax issues.
If that office can’t resolve these issues, they will forward your case to Appeals for consideration. This is an indication that once your case reaches the appeals phase, the IRS is committed to resolution and cooperation every step of the way, in order to avoid costly and lengthy litigation in tax court.
The IRS understands that many taxpayers won’t agree with the findings of its auditors. Therefore, it has created a separate branch of service called the Office of Appeals, which consists of approximately 2,000 employees located nationwide. See IRS Publication on “Appeals Process” (November 2, 2020).
There are several factors that must be weighed prior to the filing of an appeal. On the upside, an appeal costs nothing to file (unless you choose to hire a professional) and most cases result in a reduced tax liability.
Appealing an audit decision also delays your tax audit bill for several months, as you are not required to pay your outstanding taxes while the matter is pending. This gives a business owner time to discuss payment arrangements with the IRS.
Of course, there is always a chance that an appeals officer will raise an issue that the auditor missed, potentially increasing tax liability. Interest and penalties on the tax bill will continue to accrue during the appeals process, although this amount is typically considered to be a worthy trade-off, as the amount of interest owed is considerably less than the potential tax savings arising from an appeal. See IRS Publication, “Your Appeal Rights and How to Prepare a Protest if You Disagree” (April 2021).
Appeals officers have greater authority and flexibility in deciding cases than auditors. Their sole purpose is to reach a successful compromise with taxpayers and to avoid litigation. It is important to note however, that they are not encouraged to default to the examiner’s findings
Rather, the Office of Appeals has broad discretion to consider any arguments under the law in favor of the business owner, barring arguments made based on religious, moral, or political beliefs.
The Appeal’s mission is to resolve tax controversies without litigation. This is on a basis which is fair and impartial to both the government and the taxpayer, and in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the IRS.
This means that there is a good chance a taxpayer could walk out of an appeal owing considerably less than the amount calculated by the examiner. See Internal Revenue Manual §8631.
The appeals officer may not immediately decide. They may request that further documentation be provided. If this happens, don’t worry. Take diligent notes and promptly provide the appeals office with the paperwork they are requesting.
Taking the IRS to Tax Court
Much like meeting with the Office of Appeals, filing a petition with the Tax Court begins with receiving a notice of determination in the mail.
A business owner must complete a petition and submit it to the court with the appropriate filing fee. A trial date will be set, at which point you will be permitted to evidence and witness.
After the trial, the judge will review the merits of the case and issue a decision. Don’t be surprised if the judge’s decision echoes that of the IRS. Remember, the Tax Court and the IRS take the same stance on § 280 (E).
By and large, Tax Courts across the country have been ruling in favor of the IRS, leaving cannabis business owners with no means of recourse.
Knowing this before going to tax court – which is a very costly endeavor – should be carefully considered. In addition to time away from your business, you may also have to pay attorney’s fees, transportation costs, witness transportation and lodging costs, and potentially a tax liability. These factors should weigh into the decision of whether going to tax court is a worthy venture.