Cannabis Tax Audit & Investigations

Defending a cannabis tax audit and investigations involves several strategic steps due to the unique legal and tax environment surrounding cannabis businesses, especially given the discrepancies between federal and state laws in the U.S. In California, cannabis tax audits usually revolve around licensing and proper reporting of sales taxes to the CDTFA whereas IRS focus on marijuana business tax investigations traditionally have scrutinized gross income verification and proper categorization of expenses. Here’s a comprehensive approach based on general tax audit defense strategies and insights relevant to the cannabis industry:

1. Preparation Before the Audit:

• Organize Financial Records: Ensure all financial transactions are well-documented. This includes receipts, invoices, bank statements, and any transaction that affects your business’s financials. Cannabis businesses often deal in cash, so meticulous record-keeping is crucial.
• Understand Section 280E: This IRS code section disallows deductions for businesses trafficking in substances illegal under federal law, which includes cannabis. However, you can still deduct the cost of goods sold (COGS). Understanding this distinction is key.
• Role of a Cannabis Tax Attorney: Due to potential legal jeopardy surrounding the cannabis business, the foremost concern in representing taxpayers in this industry is confidentiality. Often times, the business operators and investors in the cannabis operation are proxies of a third party investment firms or individuals who seek utmost privacy. If you are facing tax investigation or tax audit related to a cannabis business, it is prudent to engage with a tax lawyer who specialize in cannabis law. They can guide you through the nuances of tax compliance, tax audit in this industry.

2. During the Audit:

• Professionalism: Be professional and cooperative when dealing with the IRS, CDTFA or FTB during your tax audit. While you should defend your position, avoid confrontational behavior before you seek representation by a tax attorney.
• Know Your Business: Be prepared to share with your tax attorney your cannabis business operations, especially how you calculate COGS, as this is one of the few deductions allowed under Section 280E.
• Documentation: Accumulate all requested documentation so your tax attorney can provide internal audit of your tax case prior to meeting with the IRS, CDTFA or FTB. If you’re using software for tracking sales and inventory (like seed-to-sale tracking systems), ensure this data is accessible and verifiable.
• Separate Business and Personal Finances: Ensure there’s no commingling of funds. This clarity helps in proving business expenses related to COGS.

3. Common Tax Audit Focus Areas:

• Gross Profit and Cash Flow: IRS, CDTFA and FTB auditors often scrutinize how gross profit is reported and the flow of cash. Be ready to explain discrepancies or unusual patterns.
• Deductions: While most deductions are barred, understanding what can be deducted (like COGS) and proving these costs with documentation is crucial.
• Unrecorded Sales: Ensure all sales are recorded. Cannabis businesses are often cash-heavy, making unrecorded sales a red flag.