IRS audits involving the Bank Secrecy Act (BSA) and the infamous tax code 280E are ramping up throughout the nation, and if operators aren’t properly prepared for this process, they’ll be vulnerable to fines, penalties, and other unsavory legal complications.
Whether you operate under a cannabis cultivation, dispensary, or extraction license, It’s critical to understand 280E and BSA audits, the tax implications of your company, the expertise you need to successfully get through an audit, and what to expect during the whole process.
The History of 280E and BSA Audits of Cannabis Companies
One of the most well-known legal cannabis audits is Champ v. Commissioner, the case of a San Francisco-based AIDS clinic that went under fire for selling medical cannabis to its patients. The court effectively decided to only apply 280E to the cannabis portion of the business and not to the AIDS clinic itself.
This case is referenced frequently because of what it gave the industry and its regulators: it was officially recognized that 280E could and would be applied to the cannabis industry, and in some instances with mixed businesses, 280E can be applied to a partial aspect of operations without speaking to the full picture.
Unfortunately, the industry ran into even bigger trouble with 280E in Colorado in 2014, when the IRS determined the state’s market was out of compliance. Widespread audits were soon opened, and many operators were randomly selected for financial examination.
In 2016, we began to see BSA audits move through cannabis in tandem with many of the 280E audits, making market success that much more arduous for many cultivators and retailers.
From an IRS standpoint, these audits were highly successful in generating up to three times the dollars per hour spent on non-cannabis companies. “IRS revenue agents noticed a pattern of non-compliance with Section 280E in the cannabis industry. One of them sought authorization to start a Compliance Initiative Project (CIP) that targeted Colorado MJ Companies. The CIP audits (according to TIGTA) were very successful and should be expanded to other states. We are now seeing the expansion,” said Nick Richards, partner and chair of the Los Angeles-based Cannabis Law Group.
Based on this understanding, the IRS decided to expand the program, increasing its revenue and success by digging deeper into cannabis businesses.
Lessons Learned from Recent Tax Litigation Against U.S. Cannabusinesses
These IRS audits have sent shockwaves through the industry, but experience often comes with new knowledge and the potential for a calculated response. That being said, there are a few points the industry has taken note of from recent tax litigation that can help inform how operators should prepare for a potential audit.
Your company’s formation will determine the tax implications
When a C corporation (or C-corp) earns income, they’re expected to pay a corporate tax rate on their income. However, in cases where an LLC or S corporation’s profits flow to the individual owners, they must report it as an owner’s tax return and pay individual tax rates.
“The difference is between owners having personal liability for 280E or not,” said Richards. “If they have personal liability (receive a k-1) then the owner is under a personal audit and is personally liable. Of course, liability also affects IRS collections.
As a basic example, if a dispensary purchases a pre-roll at wholesale for $2 and pays an employee $2 to sell it at retail for $5, the profit is $1 but the tax is $3. In the case of a flow-through company, the owner would get $1 and be responsible for $3 in tax. If their tax rate is more than 33 percent, they’ve lost money.
If you own a cannabis company, do thorough research on your tax implications, especially if you fall under individual tax rates. Those rates can follow you even if the business doesn’t, and not enough operators are aware of this hazard.
Proper cash reporting is vital for major business transactions
Form 8300 is a BSA form that is required to be filed whenever an operator receives more than $10,000 in cash or cash equivalent, and if it isn’t filed properly, you’ll come across some potentially punitive legal issues.
Make sure you have the proper on-hand expertise during an audit. In order to successfully pass an IRS audit, it’s vital for cannabis operators to get legal professionals including CPAs and/or attorneys involved to ensure everything goes smoothly. If you do find yourself in an audit, the first thing you should do is seek out an attorney with cannabis industry experience to speak to the auditors on your behalf.
Understand your auditor’s authority
It’s always a good idea to be wary of authority. Just because someone is in charge doesn’t mean they’re acting accordingly, and it’s important to have an in-depth knowledge of what your auditor can and cannot enact beforehand. According to Richards, you’ll want to offer “cooperation up to the extent of the IRS’s authority. Less is more.” In his professional opinion, it’s never a good idea to let the IRS speak with the taxpayer directly.
How to Reach a Favorable Audit Settlement
The most surprising thing you might find about IRS audits? You don’t have to win to succeed.
An audit ends with a proposal that takes you to the next step of litigation, depending on the results of your examination. The result at this stage will either be “agree or disagree.” “Most cannabis company audits end unagreed but are then resolved in later steps of the process [trial, appeal, collections],” Richards said. He noted that limiting your exposure at this moment is the key goal.
But how do you end up with a positive proposal and next step? Simply stated, you cooperate with the IRS as much as possible.
In cases where you’ve been served some but not of the information the IRS is seeking, it’s still possible to demonstrate expenses through other relevant means. If you’re missing vital information or documentation, “inform the IRS and look for other ways to establish the TPs position from other docs,” said Richards.
The cannabis industry remains one of the most difficult to navigate, and these added stressors around IRS audits definitely don’t help. However, as more operators are forced to undergo this process, the rest of us can listen and learn to better prepare for how we combat the industry’s most consistent aggressor: the federal government.