Chapter 2

What the IRS is Looking For in a Cannabis Tax Audit

IRS examiners are encouraged to bring up all issues related to gross sale receipts. They are told to develop all issues relating to the deduction of expenses while considering the disallowance of retail related expenses. See IRS “Marijuana Secrets: Participant Guide” (April 2015).

The purpose of this audit isn’t to help the business owner correct tax mistakes. Rather, the IRS examiner intends to find evidence of a “reasonable indication” that payment is owed. See IRS “Marijuana Secrets: Reference Guide.”

IRS examiners go into audits with the mindset that the business owner is hoarding their earnings – specifically cash. Where a standard, non-cannabis business audit revolves around the practices most prone to misstatement by business owners (travel and entertainment expenses, purchases of assets, and loan payments), with cannabis taxpayers, common misstatements are the business representation of gross profit and the flow of cash within the business.

The IRS examiner will follow the trail of money in and out of a cannabis business very closely, ensuring all the sales are represented in the financial statements and on the tax return. They will look closely at inventory purchases to see if they suggest additional, unrecorded sales might have taken place.

Cannabis businesses may sometimes operate as more than one business, especially as most retailers are required to produce a substantial proportion of the products they sell.

Some business owners will try to misappropriate costs, assigning expenditures from one business to another. This is only allowed if one business is completely separate from another.

In determining whether the two businesses are truly separate, the IRS examiner will look at a variety of factors including the goods being produced (if any), the purpose of the business, and the standard operating procedures (“SOPs”). In most cases, the IRS finds the businesses are not separate, and the business owner is held liable for the taxable income.

Unlike a criminal trial where the defendant is innocent until proven guilty, the IRS has historically placed the burden of proof on the cannabis business owner, even when it is not warranted.

However, this burden has recently shifted. If a business owner has reasonable records that substantiate the numbers in their tax return, and if they’ve complied with IRS requests for documents demands, then it is up to the IRS to disprove the taxpayer’s numbers. 

What Methods do IRS Agents Use to Conduct Audits?

The IRS uses two main methods to conduct audits. The first technique, simply known as the “direct method,” involves reviewing business-related documents and records, such as bank accounts, financial statements, and utility statements. Examiners may also interview the business owner and employees.

Examiners will also want an in-depth explanation of how cash transactions are handled on the premises. They will want to review ATM transaction history, count the amount of cash on hand, evaluate cash registers, and inspect records of cash deposits.

Perhaps most important, the examiners will want to review the business’ SOPs and will ask to tour the business to evaluate it from an income and transaction standpoint. Since the cannabis business is cash-intensive, questions such as the following are not uncommon:

  • What is the procedure for recording cash transactions?
  • How much cash is to be kept on the premises?
  • What happens when there is excess cash on the premises? How is it transferred from the premise?

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The second technique, also quite simply known as the “indirect method” is utilized when examiners suspect there is a strong possibility of underreporting but are otherwise unable to substantiate it with direct method inquiries.

The IRS expressly authorizes that if “the method of accounting used by the business owner does not clearly reflect income,” then indirect methods are acceptable and backed by legal precedents.

Indirect method inquiries include establishing a net worth for a business owner and calculating how much that changed based on various records, comparing records related to sources of income with expenditures, and in-person interviews with people not affiliated with the business itself.

In fact, the IRS believes “determining personal living expenses and the accumulation of cash is one of the most significant parts of the equation.”

How to Minimize Your Tax Liability

Unfortunately, most audits end with the business owner being held liable for unpaid taxes – especially for those operating within the cannabis industry. Knowing this, most savvy business owners have a singular goal in mind when going into an audit: minimizing the financial damage.

There isn’t much a business owner can do during an audit but as Ben Franklin famously quoted “Failing to prepare is preparing to fail.”. To help you, here is a list of things you can do to help the audit go smoothly:

  • Gather bank statements, and ledgers ahead of time. The IRS examiner will most definitely want documents that follow the “trail of money,” especially as cannabis is a cash-intensive business. Most states require that cannabis businesses keep impeccable financial and inventory records. Gathering documents for IRS review should not be a problem if your business has been complying with state-mandated practices.

  • Go over your tax returns. The examiner may want to question you about a particular entry or value. You should have a response prepared to these questions ahead of time.

  • Neatly organize all records. The IRS examiner is looking to see whether you have adequate record-keeping procedures. Messy records mean more digging. For the IRS more digging means more gold for them.

Conversely, auditors frequently reward good record keepers by giving these folks the benefit of the doubt if any problems arise.

Dedication to record-keeping and establishing accounting procedures indicates that a business owner is perhaps less likely to underreport or misreport income.

  • Meet with your bookkeeper. If someone else does your taxes, it’s a good idea to meet with them prior to the audit. Even though they have been delegated the financial responsibility, an IRS examiner will direct the majority of questions to the taxpayer (usually the licensee or business owner).
The business owner will appear to be knowledgeable and well-informed of business practices if they are able to answer at least some of the financial questions posed by the examiner.
  • Ask your tax attorney to be present during the audit. Attorneys are valuable assets during an audit, even though it may not seem like it. They can answer any legal or accounting questions on your behalf and may even intervene if they feel the tax examiner is being unfair or frivolous with their inquiry.

A tax attorney may also be able to go through a “mock audit” with you and hopefully be able to give you an idea of what to expect during the real thing.

Keep in mind that how you conduct yourself during the audit may be even more important than the list above.

  • Don’t be rude, unprofessional, or question the examiner’s judgment. Hostility will NOT do you any favors, especially if you are required to continue interacting with the examiner.
  • Don’t lie to the examiner. Although seemingly self-explanatory, it is crucial that you not lie during an audit. Providing no answer is better than providing a wrong answer. The examiner may perceive your attempts at deception as a sign of bad faith, further convincing them that you must be concealing income.
  • Don’t give away your original documents! This cannot be overstated enough, especially for those business owners who do not seek assistance or representation during the audit. Do not give the IRS your original documents.
If they ask for something, always make them a copy and keep the original with yourself. Should the IRS refer to a specific document in the findings, you will need to refer to it.
  • Don’t bring documents from years that are not being audited. While this principle isn’t exactly applicable in 2021 because the California cannabis industry is within the three year “audit window,” it will become applicable in the future.

Don’t offer the IRS more than they ask for, however. This opens the business owner up to further inquiry – and further liability.

Business owners in the cannabis industry have opted into selling a heavily-regulated product, but the growth potential is huge. In fact, recent statistics report the U.S. cannabis industry is worth $61 billion dollars and is projected to be worth $100 billion USD by 2030.

If you are in the industry or just contemplating it, keeping compliant is important. Scheduling regular internal audits with an audit checklist with guidelines for your state will also help you when the IRS comes knocking.

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