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The cannabis industry, although flourishing, faces unique challenges when it comes to tax compliance and financial management. With the Internal Revenue Service (IRS) paying close attention to cannabis companies, business owners must understand the red flags that can trigger an audit and how to avoid them.
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.
In this article, we will discuss the different types of tax audits, the most common warning signs, the consequences of an audit, and how to maintain compliance to ensure the financial health of your cannabis business.
Why Cannabis Companies are on the IRS Radar
Cannabis-based business audits are lucrative for the Internal Revenue Service. IRS auditors are more likely to see returns from cannabis audits than from mainstream industries and therefore prioritize the cannabis industry. This means the IRS actively seeks out growers, dispensaries, and other cannabis-based businesses as audit targets.
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 four types of audits and what to expect.
Four Types of IRS Tax Audits:
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.
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.
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.
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.
Common IRS Red Flags for Cannabis Businesses
Here are some of the most common warning signs that can trigger an IRS audit for cannabis companies:
Unreported or Underreported Income
One of the primary red flags for the IRS is unreported or underreported income. Companies must provide 1099’s to all vendors to whom they paid $600 or more during the tax year. 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.
Another common warning sign is excessive deductions. The IRS knows allocating expenses to Costs of Goods Sold (CoGS) is the only legal way for Cannabis businesses to deduct expenses. The IRS will often investigate if your return reports deductions significantly higher than the norm for business expenses in your industry. Be cautious when claiming deductions, and ensure you have clear documentation to support each deduction as a part of your business.
Failure to file the correct supporting documents, such as Form 8300
Form 8300 is mandatory for businesses receiving over $10,000 in cash or cash equivalents in single or related transactions. Cash equivalents include cashier’s checks, money orders, and traveler’s checks. This threshold applies to both buyers and sellers.
Cannabis businesses face unique challenges due to cash-based operations and limited financial services. Large cash transactions in the industry raise money laundering and tax evasion concerns. By filing Form 8300, cannabis businesses help the IRS track cash transactions, detect potential illegal activities, and ensure accurate income reporting for taxes. Non-compliance or structuring transactions to avoid reporting can lead to penalties and legal consequences.
Losses from Rental Property
Sustained losses from rental properties can draw scrutiny from the IRS, particularly if those losses seem disproportionate to your business revenue or expenses. Be prepared to provide documentation and explanations for any rental property losses associated with your cannabis business.
Home Office Deductions
Home office deductions are another area where cannabis business owners may face scrutiny. The IRS is particularly wary of taxpayers who claim home office deductions while also having a primary office location elsewhere. Ensure you understand the rules associated with home office deductions and maintain thorough records to support your claims.
Consequences of an IRS Audit for Cannabis Businesses
An IRS audit can have severe consequences for cannabis businesses, including:
Fines and Penalties
If the IRS determines that a cannabis business has underreported income, improperly claimed deductions, or failed to comply with tax laws, it can impose fines and penalties. These can range from a percentage of the underreported income to more severe financial penalties.
Loss of Licenses
In some cases, an IRS audit can result in the loss of licenses for cannabis businesses, effectively shutting down operations. This can be particularly devastating for businesses that have invested significant time and resources into building their brand and customer base.
In extreme cases, an IRS audit can result in criminal charges for cannabis business owners. These charges can include tax evasion, fraud, or other financial crimes, leading to possible jail time and irreparable damage to personal and professional reputations.
Tips for Avoiding IRS Audit Red Flags
Cannabis businesses should follow these best practices to minimize the risk of an IRS audit:
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.
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.
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.
Stay Informed About Tax Laws and Regulations
Stay up-to-date on tax laws and regulations affecting the cannabis industry. This includes federal and state tax laws and any changes that could impact your business. Regularly consult with tax professionals to ensure your business remains compliant.
Work with Cannabis-Specific Accounting and Tax Professionals
Working with experienced cannabis professional financial services can help your business stay compliant and navigate the complex tax landscape of the industry. These experts can ensure your tax returns are accurate and that you take advantage of all available deductions while avoiding red flags.
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.