Cannabis Tax Audit by IRS & CDTFA Sales Tax Audit

Cannabis businesses operate in a unique legal and tax environment where state legality contrasts with federal illegality. This dichotomy, coupled with IRS Section 280E restrictions, creates a challenging tax landscape. Cannabis businesses must be vigilant in their tax practices, employing strategies like optimizing COGS deductions and maintaining impeccable financial records. Engaging experienced cannabis tax lawyers becomes essential for navigating this complex terrain, ensuring tax & regulatory compliance, and defending against potential income and sales tax audits or other legal challenges that may jeopardize the cannabis investors and operators alike.

Cannabis Tax Audit Issues

Registration and Permits: Cannabis retailers in California must register with the CDTFA for a seller’s permit and a cannabis retailer excise/sales tax permit. The registration process is streamlined online, where new businesses or existing ones can apply directly through the CDTFA’s website. This dual permit requirement ensures that retailers are legally recognized to sell cannabis and are prepared to comply with cannabis tax obligations.

Sales Tax: Starting from January 1, 2023, cannabis retailers are responsible for collecting a 15% cannabis excise tax on the gross receipts from retail sales of cannabis or cannabis products. This tax rate could potentially change after July 1, 2025. The tax applies to the total amount paid by the consumer, including any local cannabis business taxes, delivery fees, or packaging costs, but does not need to be stated separately on invoices since January 1, 2023. Retailers must also handle sales and use tax, which applies to all tangible personal property sold, including cannabis.

Tax Filing and Payment: Cannabis retailers are required to file cannabis retailer excise tax returns online, even if they have no taxable transactions to report. For significant tax liabilities, electronic funds transfer might be mandated for payments. The CDTFA provides various tax filing options via their online portal, including the ability to tax file returns, make sales tax payments, amend returns, or request penalty relief.

IRS vs CDTFA Sales Tax Audit Law: Although cannabis is legal in states like California, Colorado, and Washington, it remains illegal under federal law, which complicates tax matters significantly. Cannabis business owner’s tax return for the state and federal will look completely different.

Internal Revenue Code Section 280E: This section of federal tax law prohibits cannabis businesses from deducting most ordinary business expenses, leading to an unusually high effective tax rate. The law was a response to a case allowing deductions for expenses related to trafficking in illegal drugs, predating widespread cannabis legalization. This law is likely to change as cannabis will be reclassified from a Schedule I drug to Schedule III. This would put marijuana or cannabis in the same category as Tylenol and ketamine. It would classify it as a drug that has the potential for abuse but has medicinal benefits allowing a different treatment IRS tax treatment during upcoming tax audits. The new IRS tax rules should go into effect in 2025 if the reclassification is approved.

Criminal Tax Exposure of Cannabis Business:

Cash-Based Operations: Due to banking restrictions, cannabis businesses often operate in cash, which makes them targets for IRS scrutiny regarding under reported income. This can lead to substantial civil and criminal penalties.

Sales Tax Audits by CDTFA: Besides federal issues, state tax authorities like the California Department of Tax and Fee Administration (CDTFA) also audit cannabis businesses for sales tax compliance. Without proper records, businesses face the risk of the CDTFA estimating income based on minimal evidence, leading to potential personal liability for owners.

Expense Documentation: The cash nature of the business makes it hard to prove expenses, which is crucial for any deductions allowed under tax laws. Without documentation, IRS or CDTFA sales tax auditor may be triggered to make a criminal referral in these types of tax audit cases.

Employee Classification: Like any business, cannabis dispensaries must correctly classify workers as employees or independent contractors. Mis-classification can lead to significant payroll tax liabilities and penalties. In addition, workers with prior felony convictions cannot be involved in cannabis business which is often overlooked by the cannabis retailer.