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?