Cannabis Knowledge & Insights

How to Avoid an IRS Cannabis Tax Audit

The term audit makes cannabis business owners cringe, and a potential visit from the IRS causes panic among most of us. Tax issues can have harsh penalties and serious negative impacts on the financial health of your cannabis business. While some audit notices may not be too much cause for concern, it is crucial to take action immediately if your cannabis company faces a tax audit. And with the IRS making two to four times as much from cannabis audits, the chances your cannabis business will face an audit are increasing.

In the following we will discuss the different types of tax audits. In addition, we cover the steps to take to limit your chances of being audited. And lastly, we let you know what to do if you receive an audit notification from the IRS.

What is an IRS Audit, and How Will I Be Notified If My Cannabis Business is Audited?

The first rule of thumb to remember is that not all audits are the same. Here is a list of the three types of audits and what to expect.

Four Types of IRS Tax Audits:

1.    Correspondence Audit

This is the most typical kind of audit involving more than three-fourths of all IRS audits and is considered fairly routine. This type of audit is the simplest of the three. It starts with the IRS sending a letter in the mail requesting more information about a part of the tax return. This type of audit notification generally comes in a 566 letter. It is often in reference to specific deductions or information provided in tax returns that do not align with the IRS records.  Cannabis business owners can usually answer these types of questions quickly by keeping good records and working with a trusted tax accountant.

 2.    Office Audit

The second type of audit involves questions about your return that are too complex for a correspondence audit. These types of audits are more detailed than correspondence audits. One issue can sometimes trigger an audit, but the IRS investigation can quickly expand if the auditor has concerns in other business areas. Since the Covid-19 pandemic, many office audits are currently on suspension from in-person meetings and held virtually.

 3.    Field Audit

This type of audit requires a visit from an IRS representative to your place of business. A field audit is the most intense and intrusive audit. A typical audit for a cannabis business includes a full review of all financial records, interviews with employees, and often a facility tour.

 4.    Taxpayer Compliance Measurement Program (TCMP) Audit

The principal purpose of the third type of audit is to update IRS data collection. The IRS scores the data by analyzing a group of 50,000 randomly selected returns. These intensive audits are conducted every few years. They require every part of the tax return to be substantiated and proven by documentation.

In any instance, the IRS will contact you via standard USPS snail mail. The IRS will not email, text, or call you. It is crucial cannabis business owners remember this as many fraudsters attempt to steal confidential information and money from businesses by posing as IRS revenue agents. Be sure to validate the seal on the correspondence, the contact information of the IRS, etc. Before you send over any secure data, it is best to enlist the help of a trusted accounting professional. GreenGrowth CPAs has been through several audits with the IRS and know how to negotiate and talk with the IRS to ensure the best outcome for your cannabis business.

What To Do If You Receive Notice Your Cannabis Company Is Being Audited?

If your cannabis business receives an audit notification, don’t panic and don’t ignore it. Always cooperate with IRS agents. Operators can incur fines and criminal penalties for refusal to provide information to the IRS. We recommend enlisting the help of experts and working with a reputable firm to prepare for the audit. One of the many benefits of working with an experienced CPA firm is their knowledge in dealing with the IRS. Be sure to answer the notice on time and per the instructions given by the IRS in your correspondence. As long as your tax return was prepared correctly and you have a record of all source documentation (i.e., receipts, invoices, payments, etc.), your audit should run smoothly.

Red flags that can trigger an audit:

 Report all of your income

Failing to report received income is crucial to triggering an audit. The IRS requires companies to provide a 1099 report to vendors they pay. Then, the IRS uses this reporting to cross-check income. Even if you don’t receive 1099 reporting from a company you worked with, the IRS may still have a record of it. And therefore, you always want to report it and never try to hide it, no matter the amount. Since the cannabis industry is highly cash-intensive, it’s essential to keep good records. Also be sure to claim all income, and provide receipts for all sales.  

 File your returns on time each year and pay your taxes that are due

Even if you have a loss, it is vital to file your tax returns annually and report all of your income. Be sure to file your return before the cutoff and pay your taxes. If you cannot afford all taxes owed, the IRS will set up payment plans with cannabis business owners. It’s essential to set up payment plans to keep your accounts current. Everything is filed electronically now. Therefore, filing late or not filing at all are enormous red flags that can lead to an audit for cannabis companies.

 Keep all your records

Save all your receipts, invoices, past returns, tax correspondence, and all financial documentation for a minimum of seven years. In the event of an audit, you can easily prove expenditures and move on quickly with the IRS. The obligation to demonstrate proof of financial reporting falls on the cannabis business owner. If you don’t have significant documentation needed to prove the expense, it could be denied in a future audit. This comes with harsh penalties doubling or quadrupling the cost. We recommend having a solid team of financial experts to help with adequate record keeping. At GreenGrowth CPAs, our Outsourced CFO team can help business owners maintain excellent financial records. We can even help you prepare in the event of a future audit.

Report Income and Expenses Accurately

Do not round up or down when reporting income or expenses. Always use exact values, refer to receipts, invoices, etc., for accurate reporting numbers. Incomplete or inconsistent reporting is a huge red flag. It could give the IRS reason for concern of your business and accounting practices.

 Don’t take excessive deductions

Some business owners have widely abused certain deductions, including auto, dining, and travel expenses. There are tax deductions your cannabis business can take advantage of to reduce taxable profits. Although you’ll want to be sure you have clear-cut documentation to prove the deduction as a part of your business. Excessive or inconsistent deductions can often raise concerns and can cause an audit.

Are IRS Cannabis Audits Likely To Increase?

According to research, cannabis businesses have considerably higher odds of being audited by the IRS versus other mainstream industries. The IRS prioritizes auditing cannabis companies over other industries because cannabis business audits can double or quadruple the hourly return. Over the years, the IRS has primarily audited cannabis businesses over questions regarding taxable deductions on their returns. And lack of access to specialized business services has only increased inconsistency in reporting. Cannabis business owners who file their business and personal tax returns themselves or use a firm unfamiliar with the cannabis industry are much more likely to see issues with future audits down the road.

Filing your personal and business tax returns with a cannabis-specific firm ensures that both the individual and the company take the proper deductions and find the highest cost savings. And until federal legalization and more clear-cut regulations, we don’t see the cannabis audits slowing down. If the IRS is currently auditing your cannabis business, we can help. We have experience working through several audits and have the knowledge to resolve your audit.

Five Tips to Prepare for an Audit

1.    Organize all financial documentation and keep excellent records

The IRS representative assigned to your audit will ask for your business and financial documents. Good organization will help them complete your audit and answer IRS questions promptly.

2.    Work with cannabis-specific accounting and tax professionals

Working with experienced cannabis professional financial services can help your business with a looming audit. We have found examples where cannabis business owners have overpaid taxes as a result of incorrect audit calculations.

3.    Don’t lie or ignore notices from the IRS

Lying to the IRS is considered a federal offense, and what you say can and will be used against you. Therefore, it’s helpful to enlist the help of experienced professionals who can assist you with responding to IRS correspondence. Ignoring the issue won’t make it go away; the IRS will continue to follow up with you. In addition, they can impose harsh penalties for deliberately trying to avoid an IRS investigation.

4.    Ensure all correspondence with the IRS is in writing

The IRS will always communicate with you in writing. Be sure to save all correspondence and document all conversations.

5.    Prepare for interview questions and a tour of business operations

In the event of an extensive audit, be prepared to answer questions about your business operations and financials. Work with trusted professionals to ensure all your financial information is in order. One of the most significant benefits of working with an entrusted CPA firm is their ability to speak with the IRS and help answer questions on your behalf.

There are many reasons cannabis organizations should understand the fundamentals of an IRS audit. Adverse audit findings can cause harsh fines and possible criminal penalties for cannabis business owners. We find cannabis owners who regularly meet with a financial team of experts are more successful. They can stay abreast with current legislation and tax laws affecting the cannabis industry. Our financial experts at GreenGrowth are here to help your cannabis venture through any level of a tax audit. We employ several financial programs that can assist the company with its fiscal responsibilities including, tax planning and compliance, outsourced CFO support, audit preparation, tax controversy support, and much more.

For recommendations and assistance with an IRS audit, schedule a free consultation or contact us at 1-800-674-9050.