Chapter 1

Why is Tax Compliance so Challenging for Cannabis Businesses?

Washington, Oregon, and California were among the first states in the country to legalize cannabis for recreational use.

Through monitoring the audit trends and outcomes of these states, the IRS has concluded that this Western region is a “high-impact compliance area,” worthy of its undivided attention and planned audits.

On multiple occasions, the IRS has confirmed prioritizing extensive initiatives for auditing cannabis businesses since the recreational legalization of its use.

The IRS believes that it “risks diminished taxpayer compliance when cannabis businesses fail to report all income as required regardless of source,” and that cannabis business owners often “deduct expenses not allowed,” thus fueling its audit frenzy. 

After examining data from 2018 and 2019, the IRS concluded that roughly 48% of cannabis business owners had misreported § 280 (E) adjustments. The tax impact of these adjustments was $5,060,011 in California alone.

The IRS further discovered that the two primary compliance issues for cannabis returns were:

  1. Business expenses incorrectly deducted based on I.R.C. § 280E and,
  2. unreported income.

Once these issues were clearly understood, it became a more productive use of a revenue agent’s time and resources to audit cannabis businesses as compared to other mainstream industries. 

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The agency calculated that cannabis companies owed more in unpaid taxes than their federally legal counterparts. See Treasury Inspector General for Tax Administration Publication, “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.” (March 30, 2020).

In short, the IRS was able to collect anywhere from two to four times as much in unpaid taxes from cannabis business owners than they did from mainstream companies also identified as ripe targets for audits in a given fiscal year. Id.

By 2019, the average in unpaid taxes had leapt to $2,752 from cannabis industry audits in Colorado versus $1,065 an hour from mainstream businesses. See id.

The IRS continues to utilize a stringent approach to enforcing § 280 (E) because of the massive financial gains they’ve seen from auditing cannabis businesses.

It should also be noted that the IRS does not retain an interest in educating cannabis business operators.

However, the Treasury Inspector General recommended that the IRS implement a comprehensive compliance approach geared towards reducing the overall volume of audits.

Five Ideas as Means for Improvement

  1. Develop a method to identify businesses in the cannabis industry and track examination results.
  2. Develop and publicize guidance specific to the cannabis industry.
  3. Develop a comprehensive compliance approach for the cannabis industry.
  4. Leverage publicly available information at the state level and expand the use of existing federal and state agreements to identify non-filers and unreported income in the cannabis industry; and
  5. Increase educational outreach towards unbanked taxpayers making cash deposits regarding the unbanked relief policies available.

The IRS agreed with four of the five recommendations but did not feel the need to agree with the recommendation to develop and provide guidance, citing other priorities.

Another prominent concern is that cannabis is a cash-intensive business, meaning that transactions are frequently made in cash.

Customers may prefer cash transactions for a number of reasons including avoiding scrutiny from employers, peers, and society.

Limiting Banking Access

A huge tax-related concern about cash-intensive businesses is that cash transactions are more difficult to track and are therefore more likely to go unreported to the IRS.

Unlike checks and credit card receipts, cash transactions do not generally result in third-party information capable of being reported to the IRS.

Cannabis business owners have limited access to banking because cannabis is still classified as a Schedule I controlled substance.

Due to this fact, banks and credit unions who service cannabis business owners can potentially be charged with money laundering.

As a result, many financial institutions are not willing to risk potential civil or criminal liability. Those that do choose to service cannabis business owners often impose substantial fees.

Since both federal and state regulations discourage banking institutions from servicing cannabis-related business, they may be indirectly and unintentionally encouraging tax noncompliance.

Lack of access to banking services also creates a barrier to paying taxes. The IRS allows for cash payments at specific service centers, but they are limited by specific times and procedures.

Consequently, the IRS has classified the cannabis industry as a high-impact compliance area, which explains the frequent audits.

The IRS Audit Process

When it comes to cannabis-related businesses, the typical audit rules sometimes don’t apply.

Generally, the IRS can include returns filed within the last three years in an audit. In the event of a gross and substantial error, the IRS can include returns filed within the last six years.

Notwithstanding, such audits are extremely rare.

Cannabis was legalized in California on January 1, 2018, marked by the passing of Proposition 64. As the end of 2021 approaches, the first audit window for cannabis-related businesses nears.

The audit process begins with the filing of tax returns. Once the IRS receives your business’ tax return, it may either approve the return or request additional information, thus initiating the audit process.

There is no easy method to identify non-compliant cannabis business owners based on tax return filing information.

While there are some contributing factors (such as prior audits), most audits are simply performed at the IRS’ discretion. 

Should the IRS choose to audit a cannabis business, they will notify the business owner by mail at the business mailing address.

The IRS has the option to conduct the audit by mail, at their office (office audit) or in person (field audit).


Since the cannabis industry is a high-impact compliance area, it is highly likely that the IRS will want to conduct the audit in person, especially given the IRS’ interest in the cash portions of the business.

This will generally entail an IRS examiner (or team of examiners) appearing at the place of business.

Be warned that examiners are NOT required to obtain the business owner’s consent prior to entering and inspecting the premises.

Some may ask “Don’t I have the right to decide who gets to enter my property?” The short answer is no.

Since many cannabis businesses are operated by business entities, such an LLC, corporation, or sole proprietorship, they are not afforded the same protections from government intrusion that a typical business owner would be.

Examiners are authorized to inspect a place of business regardless of whether the business owner consents or not.

If the business owner refuses to allow them on the premises, the IRS can execute a “Writ of Entry,” which formalizes their ability to enter the business premises and impose a $500 fine for non-compliance.

You may wonder- how long can this process last? The duration of the audit varies from case to case, depending entirely on the complexity of the issues. Some of the typical issues include:

  • the availability of information and evidence requested,
  • the availability and attitudes of the parties,
  • whether or not they desire an efficient resolution, and
  • whether the taxpayer will choose to pursue further relief after the IRS renders a decision. 

From 1920 until 1933 our nation had an alcohol prohibition. The federal government eventually realized not only how unpopular the 18th Amendment was, but that legalizing alcohol would be an easy way to tax a very popular product.

Sure enough, once the 21st Amendment was ratified, and the 18th was repealed, tax money began to fill the federal coffers without having to send IRS revenue agents out to collect it.

Like the distilling and sale of alcohol, perhaps cannabis will be federally decriminalized soon. Until that day comes, it’s best to assume that the IRS will likely ramp up auditing business owners in the cannabis industry.

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