Cannabis Tax Audit: Red Flags that Attract IRS Attention

Hendershot Cowart P.C.
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Cannabis-based business audits are lucrative for the Internal Revenue Service. IRS auditors are more likely to see returns from cannabis audits than from mainstream industries and therefore prioritizes the cannabis industry.

This means that the IRS is actively seeking out budtenders, dispensaries, and other cannabis-based business as audit targets.

When filing your tax return, make sure to report all your income, keep records of all expenditures, use exact values, and file on time. You should also be careful of your deductions.

Proper documentation can help you and your business avoid – and survive – a cannabis tax audit.

What Attracts IRS Attention to your Cannabis Business?

The IRS has several methods for selecting a tax return for audit. Businesses in the cannabis industry, should be especially aware of these methods:

  • The IRS uses vendor’s 1099 reports to cross-check income. If a vendor you work with reports income, and you did not file a return, your return could get flagged.
  • The IRS benchmarks typical deductions for businesses in your industry. If your return reports deductions in excess of the norm, the IRS will likely want to investigate.
  • The IRS will audit tax returns related to a return they are already auditing. That relationship may be via a transaction, investment, or partnership. If a business associate, vendor, or partner is undergoing an audit, your business may be next.
  • Many cannabis business owners operate more than one business. For example, you may have one business to grow your product and another to sell it. Beware of assigning expenditures from one business to another, as this could attract IRS attention and trigger an audit.

What Is the IRS Looking for in a Cannabis Tax Audit?

IRS auditors are looking for proof that you owe the IRS money. An IRS examiner generally enters a tax audit with the belief that you are mis- or underreporting your earnings.

Specifically, the IRS looks for these missteps when conducting a marijuana business audit:

  • Improper deductions
  • Misrepresentations of gross profit
  • Commingling personal and business funds; or using the funds from one company to pay for the expenses of another
  • Unrecorded sales
  • Financing and ownership arrangements that lead to inaccurate reporting
  • Unpaid employment taxes
  • Failure to file correct supporting documents
  • Late or unfiled tax returns – even if you have no income for the year, you should still file a return
  • Consecutive losses

During your audit, the IRS examiner will examine the way money flows in and out of your business. IRS auditors pay special attention to cash transactions. Be sure to fill out a Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business for each qualifying cash transaction by the 15th day after the date the cash was received (or the next business day if the 15th day falls on a weekend or federal holiday).

Maintaining well-organized records – including receipts, canceled checks, employee compensation records, and other financial and inventory records – is the only way to set the record straight. Generally, it is best to record transactions daily, and keep documents together in one place.

A Note About Deductions in the Marijuana Industry:

Because cannabis is still illegal at the federal level, you cannot claim deductions or credits for your marijuana business in your federal tax return. You may, however, reduce your tax liability by subtracting the cost of goods sold, or the cost of your inventory, from your income.

How do you calculate the cost of goods sold (COGS)? According to IRS Chief Counsel Advice 201504011, “a taxpayer derives COGS using the following formula: beginning inventories plus current-year production costs (in the case of a producer) or current-year purchases (in the case of a reseller) less ending inventories.”

Keep all receipts related to the cost of acquiring or producing the marijuana you sell. A tax professional can advise you on which expenses may or may not be an allocated as COGS.

What Are the Chances of a Cannabis Business Being Audited?

If you work in the cannabis industry, your odds of being audited are higher than other industries. Prepare your tax return with the assumption that it will be audited. This way, you will be ready for any questions the IRS asks.

One way to prepare for both a tax return and an audit is to organize all your financial documents, so you can quickly access the information you need whenever you need it.

What Should I Do if I Get an IRS Audit Letter?

If you get an IRS audit letter, don’t panic, and do not ignore it. Contact a tax professional who can represent your best interests, guide your interactions with the IRS, and help you assemble the exact documentation requested. Make sure all your correspondence is in writing, don’t offer more information than requested, and keep your original documents for reference.

Throughout the audit process, be mindful that your cooperation speaks volumes:

  • Do not withhold documentation
  • Do not mislead the examiner
  • Do not respond to the examiner’s requests or questions with hostility

Be polite and professional throughout your audit and go into every meeting prepared.

Your tax attorney can help answer questions you don’t know the answer to and even intervene if the auditor asks an unfair question.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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