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Why and How the IRS Audits Cannabis Businesses

Posted by Jack Wilson on Apr 30, 2021 1:11:24 PM

In comparison to mainstream industries, cannabis businesses have considerably greater odds of being audited by the IRS. Why the IRS prioritizes auditing the cannabis industry may come as no surprise to the majority of cannabis business owners across the US. However, we weren't aware of how the IRS audits cannabis businesses until just a few weeks ago.

The IRS recently, openly confirmed they have been prioritizing extensive initiatives for auditing cannabis businesses. 

In the last few weeks, the Internal Revenue Service has released more information, revealing why, how, and where they have been cracking down on the cannabis industry. This news should be a cautionary signal for cannabis business owners – particularly those that don’t have their taxes and finances in order. 

Continue reading to learn more… 

 

Why These IRS Reports are Critical for Cannabis Businesses

These recently released IRS documents reveal the detailed procedures on how tax agents are auditing cannabis businesses in the US. 

These files openly illustrate why the IRS has been planning and executing large-scale initiatives to audit and collect on cannabis businesses that are not following tax protocols (namely, deductions), that are unique to the cannabis industry. 

These official IRS documents are critical for cannabis business owners because they unveil the IRS’s standard operating procedures and techniques for how their tax agents conduct audits of cannabis businesses. They also cover why the Internal Revenue service has such a high level of interest in this industry. 

This information can help cannabis business owners prepare and protect themselves in the event of an audit. 

 

How Did These IRS Documents Get Released?

This April, the IRS released some 200 pages of internal documents that were obtained by the news outlet Marijuana Business Daily (MBD). This was the result of MBD filing a Freedom of Information Act Request with the IRS, which required the agency to release these documents for the sake of transparency and the benefit of cannabis business owners. 

*Note: If you are interested in reading the full report, you can access the documents on Marijuana Business Daily's website here. 

The U.S. Department of the Treasury also disclosed a 2020 report which included some of the IRS’s large-scale audits of cannabis businesses. 

The most recent documents were just released in the last few weeks and further expand on four out of five major tax compliance projects the IRS has had in progress, exclusive to the cannabis industry. 

Some information from these most recent reports was already made publicly available in previous years, however, this is the first time that information about all 5 IRS investigations has been revealed to the American public. 

 

How the IRS Audits Cannabis Businesses: Compliance Initiative Projects in the Cannabis Industry 

As far as we know, the IRS has always carefully examined cannabis industry tax returns. Over the years, they have cracked down on cannabis businesses, primarily for deductions they are making on their tax returns. 

So what are these Compliance Initiative Projects? 

Compliance Initiative Projects (or “CIPs”) were first implemented by the IRS in California and Colorado more than 10 years ago. They expanded into New Mexico and Arizona back in 2013. 

CIPs are the IRS’s hyper-involved approach for making sure cannabis businesses are compliant with section 280E of the tax code

Though the agency maintains that their CIPs are intended to: 

  • Educate and inform cannabis business owners on the importance of compliance. 
  • Increase taxpayer awareness of these regulations so they can stay in line with tax regulations in their industry.

We know that’s not the whole story. The IRS has taken a heavy-hand approach to enforcing 280E because of the massive financial gains they’ve seen from auditing cannabis businesses.

Stringent enforcement pressures cannabis owners, partners, investors, and shareholders to live in ongoing fear of the IRS, all while the tax code squeezes them to stay solvent on razor-thin margins. 

 

How the IRS Audits Cannabis Businesses: Section 280E

Essentially, section 280E of the IRS tax code prohibits cannabis businesses from making standard operating expenses that mainstream businesses are allowed to make. 

This was developed in the 1980s by the IRS to prevent ”drug dealers” from making deductions related to trafficking controlled substances. Despite operating legally at the state level, cannabis operators will have to navigate 280E until cannabis is descheduled at the federal level. 

These stringent regulations eat into the profits of cannabis businesses, put them at a higher risk of getting audited and penalized, and make short and long-term growth difficult, at best. 

To frame this a little better, section 280E typically results in state-legal cannabis businesses having to pay astronomical federal tax rates ––– as much as 80%-100% in many cases.

*See our resources below to learn more about 280E: 

 

How Lucrative are IRS CIPs and Cannabis Businesses Audits?

The Internal Revenue Service (IRS) has been hard at work scrutinizing the tax filings of cannabis businesses

Why have they spent so much of their time and resources auditing cannabis businesses and analyzing audit data from this industry? 

IRS audits of cannabis businesses generate 2-4 times higher hourly return when auditing cannabis businesses vs. audits of mainstream non-cannabis companies.

How the IRS audits cannabis businesses

Source: Marijuana Business Daily Research on the IRS

Cannabis businesses, on average in the US owe much more than your typical business ––– up to five times as much. In one series of industry audits in the state of California, it was reported that the IRS generated $2,788/hour in their cannabis industry audits vs. $682/hour for mainstream industries.

When cannabis companies have contested the results of audits in US Tax Court cases, the results have not been good. Here are a few examples in which cannabis companies were disallowed deductions and exclusions and assessed sizable back taxes and penalties: 

This industry has been so lucrative for them, that several of their tax agents made statements, on record, that they could foresee their department starting a national program that solely specializes in auditing cannabis businesses.

 

Is There a Foreseeable End to the IRS Auditing Cannabis Businesses?

Until cannabis is legalized at the federal level, this is unlikely. 

The U.S Department of Justice made it clear in a legal filing back in February that our current presidential administration will not slow down on enforcing 280E anytime soon.

At this point in time, the IRS has already been conducting CIPs in the cannabis industry for over a decade, and enforcing 280E is too lucrative of an opportunity for the agency to pass up.

 

What these IRS Documents mean for Cannabis Business Owners

To keep it brief: “be prepared.” 

The best defense you have against the IRS is to operate within the law and maintain compliance with the tax code. There’s no easier or better way to do this than to carefully file tax payments in collaboration with CPAs with deep, specific experience with the cannabis industry.

Our cannabis accountants at GreenGrowth CPAs have observed that cannabis businesses that: 

  • Insist on preparing their taxes themselves, without the aid of an accountant;
  • Or have their taxes prepared by a CPA that does NOT specialize in the cannabis industry. 

Are much more likely to get audited by the IRS

Additionally, the IRS has reported that a mere 3% of cannabis business returns that were filed with them had zero adjustments or errors.

In comparison, 21% of businesses in mainstream industries had zero errors. 

Don’t run the risk of having your taxes prepared incorrectly and facing an audit that could put you or your cannabis business on the line.

 

Contact our Cannabis CPAs Today

If you need guidance or assistance with tax planning, tax preparation, audit and assurance services, or accounting due diligence ––– don’t hesitate to get help before it’s too late. 

Contact our cannabis CPAs and financial advisors at GreenGrowthCPAs.com or call us today at 800-674-9050.

Topics: Compliance, Taxes

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