Mar 20, 2020

Why Is Taxation Related To Cannabis Businesses So Complicated?

Beware: 2020 Could Be A Banner Year For IRS Audits Of Cannabis Businesses

It has been reported that the White House organized a committee of federal agencies from across the government to combat public support for marijuana and cast state legalization measures in a negative light while attempting to portray the drug as a national threat. The IRS appears to be following the agenda of the Trump Administration when it comes to Cannabis and has formed special audit groups that are tasked with conducting cannabis tax audits on medical and recreational cannabis businesses.

Yes – Cannabis Businesses Have to Report Income To IRS And Pay Taxes!

While the sale of recreational cannabis is legal in eleven states and Washington, D.C., cannabis remains a Schedule 1 narcotic under Federal law, specifically under the Controlled Substances Act (CSA) 21 U.S.C. § 812. As such, businesses in the cannabis industry are not treated like ordinary businesses. Despite state laws allowing cannabis sale and consumption, it remains illegal on a federal level. Yet, cannabis businesses are obligated to pay federal income tax on income because I.R.C. §61(a) does not differentiate between income derived from legal sources and income derived from illegal sources.

I.R.C. § 280E

Generally, businesses can deduct ordinary and necessary business expenses under I.R.C. §162. This includes wages, rent, supplies, etc. However, in 1982, Congress added I.R.C. §280E. Under I.R.C. §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances, which are prohibited by Federal law. Cannabis, including medical marijuana, is a controlled substance. This means that dispensaries and other businesses “trafficking” in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.

IRS Guidance on Cannabis.

The IRS issued a memo to provide guidance to its agents on conducting audits of cannabis businesses addressing whether an IRS agent can require a taxpayer trafficking in a Schedule 1 controlled substance to change its tax accounting to conform to I.R.C. §280E.

Not surprisingly, the IRS ruled that IRS agents have the authority to change a cannabis business’ method of accounting so that costs pursuant to I.R.C. §280E which should not be included in inventory are not included in Costs Of Goods Sold (COGS) and remain non-deductible for income tax purposes.

Cannabis Tax Audits & Litigation.

It is no surprise that cannabis businesses are proliferating as more states legalize and make licenses available to grow, manufacture, distribute and sell cannabis. The IRS recognizes this and is making these cannabis businesses face Federal income tax audits. IRC §280E is at the forefront of all IRS cannabis tax audits and enforcement of §280E could result in unbearable tax liabilities.

Proving deductions to the IRS is a two-step process:

• First, you must substantiate that you actually paid the expense you are claiming.
• Second, you must prove that an expense is actually tax deductible.
  

Step One: Incurred And Paid The Expense.

For example, if you claim a $5,000 purchase expense from a cannabis distributor, offering a copy of a bill or an invoice from the distributor (if one is even provided) is not enough. It only proves that you owe the money, not that you actually made good on paying the bill. The IRS accepts canceled checks, bank statements and credit card statements as proof of payment. But when such bills are paid in cash as it typical in a cannabis business, you would not have any of these supporting documents but the IRS may accept the equivalent in electronic form.

Step Two: Is The Expense Deductible?

Next, you must prove that an expense is actually tax deductible. For cannabis businesses, this is challenging because of the I.R.C. §280E limitation. Recall that under I.R.C. §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances which are prohibited by Federal law. As previously mentioned, dispensaries and other businesses “trafficking” in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.

A cannabis business can still deduct its Cost of Goods Sold (COGS). Cost of goods sold are the direct costs attributable to the production of goods. For a cannabis dispensary, for instance, this includes the cost of cannabis itself and transportation used in its acquisition. To an extent, greater costs of doing business can be legitimately included in COGS that will result in lower taxable income. You can be sure the IRS agents performing audits will be looking closely at what is included in COGS. Working with a cannabis tax attorney can ensure that you receive the proper treatment of COGS versus ordinary and necessary expenses resulting in the lowest possible income tax liability.

In addition to IRS audits, state cannabis audits are also complex, thorough, and generally include all taxes specific and nonspecific to the cannabis industry. Potentially at risk is the cannabis license that enables the business to operate. State audits will focus on records regarding sales and use tax, excise taxes, and seed-to-sale tracking records.

If your cannabis IRS tax audit is not resolved, the results may be challenged and litigated in the U.S. Tax Court or Federal District Court. The U.S. Tax Court has jurisdiction to hear disputes over federal income taxes before final assessment and collections, while the Federal District Court generally requires taxpayers to first pay the liability before seeking repayment through a refund request.

Tips for Cannabis Tax Return Preparation

Here are some tips for cannabis businesses to follow in the preparation of their 2019 tax returns.

• Reconcile Your Books Before Closing Them - Incomplete books can cause delays and add unnecessary complexities.
• Utilize A Cannabis Tax Professional - Engage a tax professional who has experience in the cannabis industry. Such a professional would be familiar with the intricacies of I.R.C. §280E and relevant cases to make the proper presentation on the tax return in a manner that would support the smaller tax liability possible.
• Justify Your Numbers As If An IRS Audit Is A Certainty - Don’t wait to receive a notice from IRS that the tax return is selected for examination. That can be one or two years away. Instead, make it a point to put together the backup to your numbers while everything is fresh.

What Should You Do?

Ultimately, it is the tax risk with IRS that could put any cannabis business “out of business,” so you need to protect yourself and your investment. Level the playing field and gain the upper hand by discussing your unique situation with a cannabis-exclusive human resource management group, a cannabis tax attorney, etc. Enlisting the help of a fellow industry professional can help you prepare for any issues you may encounter, cannabis-specific or otherwise. Seasoned pros can provide tax solutions and strategies and protect you and your business while maximizing net profits.