As more states have legalized marijuana for medical or recreational use, the IRS has taken notice. Now the Small Business/Self-Employed Examination Unit announced several days ago a new enhanced enforcement action to increase voluntary compliance with the tax law for cannabis/marijuana businesses. The Unit oversees compliance of businesses with less than $10 million of assets. Since small businesses do not always have a lot of resources available to them, the IRS believes that by auditing them it will educate them as to their responsibilities. To make the “Cannabis/Marijuana Initiative” successful, the Service plans to put into effect the following strategic activities:
- Providing training and job aids to IRS examiners working cases
- Ensuring a coordinated and consistent approach to the industry as a whole
- Developing new ways to identify non-compliant taxpayers
- Collaborating with external stakeholders to increase an awareness of tax responsibilities to improve compliance
- Giving taxpayers access to clear information on how to properly comply with filing requirements
Basic federal tax principles that cannabis businesses need to know include:
- All income, even income from an illegal activity, is included in taxable income.
- Expenses from an illegal business are not deductible.
- However, even an illegal business can deduct cost of goods sold.
Even though states are legalizing marijuana and treating its sale as a legal business enterprise, it’s still considered a Schedule 1 controlled substance under federal law. That means a cannabis/marijuana business has additional tax considerations under the law. For example, IRS Code §280E is clear that while all deductions and credits aren’t allowed for an illegal business, there is an exception, i.e., marijuana business owners can deduct the cost of goods sold, which is basically the cost of their inventory.
Normal overhead expenses, such as advertising expenses, wages, and travel expenses, are not deductible. During an examination, Revenue Agents will seek to distill out and disallow all overhead expenses. They may also review compliance with employment taxes; the receipts of large amounts of cash prompting the filing of Form 8300 when the cash payment exceeds $10,000; the funding and use of digital cash; etc.
Moreover, the social stigma and federal designation as an illegal substance have led to unregistered and silent financing and ownership arrangements within the industry. These undisclosed beneficial owners enjoy the benefits of ownership, but the property’s title or activity is in another name. Revenue Agents will explore the potential for unravelling and reallocating income and gains from these arrangements during examination engagements.
Unfortunately, the cannabis/marijuana industry stigma is often accepted by the Revenue Agents who informally assert that the burden of proof during the examination is upon the taxpayers, while even in criminal prosecutions the burden remains with the government, not the defendant. Certain Agents can be unrelenting in their search for unreported cash, employing both direct audit methods (e.g., reviewing books and records) as well as indirect audit methods (e.g., investigating where a taxpayer’s increase in net worth came from). Revenue Agents may also attempt to interview business owners and employees (watch out for the trick questions!). In addition, where a retailer also has non-cannabis/marijuana businesses, overhead expenses may be (either intentionally or unintentionally) incorrectly allocated to the businesses not subject to Code §280E. Therefore, the examiners’ audit plan will also cover this area.
It is not a matter of whether the cannabis/marijuana business will be audited, but rather a matter of when it will be audited. Business owners in this industry can be proactive by retaining a tax attorney skilled in negotiating tax audits who is available to conduct a “pre-audit” to ensure the business is in full compliance and prepared for any subsequent merger, acquisition, or tax audit.
If you have any further questions regarding tax issues as they pertain to your cannabis/marijuana business, please contact Alvan L. Bobrow.
