Earlier this year the Treasury Inspector General published their 53-page report on how the IRS handles cash-based businesses and their findings for the cannabis industry.
There was some pretty juicy info in there including that nearly 60% of California cannabis businesses (if audited) would be out of compliance with 280E. Or that 26% of cannabis tax filers in Washington are either under-reporting income or not filing at all.
The Inspector General also noted that the IRS needs to step up their game in ‘finding’ these potentially non-compliant cannabis businesses using public information as well as leveraging information-sharing agreements they have with other agencies.
Click Here to Download Cannabis IG Report Here
In this video, we help you to better understand the report by discussing:
- What the IG Report Is
- High-Level Findings of the Report
- Recommendations From the Report to the IRS
- Deep Dive on Three Findings
- 3 Final Thoughts & Considerations
Now you may not know this or even expect this, but the IRS does have to answer to somebody. And very recently, an inspector general report came out detailing how the IRS treats cash based businesses, specifically marijuana and cannabis based businesses. So in this video, we’re going to detail some of the findings from that report, as well as recommendations from the inspector general to the IRS and what impacts that could have on the way you operate and do your tax filings for your cannabis based business. Now, if you need help with your cannabis business tax filings or accounting for your cannabis based business, that please reach out to us via our website at GreenGrowthCPAs.com or give us a call at (800) 674-9050. Let’s hop right into the presentation and learn a little bit more about this report. So today’s topic is going to be the inspector general report on the IRS and how they approach cash based and cannabis businesses in this presentation is brought to you by Green Growth CPAs.
So you may not know this, but there is an agency that overlooks the IRS and make sure that they’re doing their job correctly, and to find ways that they could maybe do their job better. So in this video, we’re gonna explore how they actually evaluated the IRS and how they approach cannabis based businesses and cash based businesses. But before we get started, I need to let you know that the information contained in this presentation is meant for guidance purposes only, and not as professional legal or tax advice and further, it does not give any personalized legal tax investment or any business advice in general. So with that out of the way, let’s review what we’re going to cover in this video. So first I’m going to help you to understand what the IG or inspector general report actually is. Then we’ll talk about some high level findings of the report.
Then we’ll cover some recommendations from the report to the IRS, from the inspector general. Then we’re going to go deep on three of the findings. First, we’ll talk about tax cases or cannabis tax cases that are not being worked and the implications for the IRS and what that could mean for you. Then we’ll talk about the recommendation and the finding that the inspector general told the IRS, they should be using public info to identify non filers and under-reporting of income. And lastly, we’ll explore the tax cuts and jobs act and section 471C and how that could impact your use in mitigation of 280 E. And from there, we’re going to explore any final thoughts and tips around the findings and what you can do for your cannabis business. So first let’s cover the report, and this is the treasury inspector general for tax administration report.
And this was published on March 30th, 2020, and it’s titled the growth of the marijuana industry warrants increased tax compliance efforts in additional guidance. So what is this report? Right? So our report was prepared by the inspector general for the us treasury department, which is the parent agency for the IRS or the internal revenue service. Now, while the inspector general is part of the agency itself, that office is for independently evaluating the performance of the treasury department and its component agencies such as the IRS. So in other words, the inspector general audited the auditors. Now the goal of this report is that the audit was initiated to evaluate the IRS is examination and education approach to certain cash based industries with an emphasis on the legal marijuana or cannabis operations. So let’s review for high level findings in the report, just very basic summary. And then you’ll get to understand how we’re going to go deeper and why we’re going to go deeper.
So first the inspector general reviews, statistical random samples of marijuana businesses in three States and determined that 59% of the tax filings for the year 2016, likely had two 80 adjustments, which is a lot and which when they projected over the population totaled over 48 and a half million dollars in unassessed taxes for the tax year of 2016 only that’s like $49 million in taxes. The IRS could have collected in just one tax year. Now they projected that out over five years and that’s almost $243 million in taxes that the IRS missed out on. Now, the inspector general also estimated the tax impact to comply with two 84, those sample businesses. Now, when projected out into the population, the inspector general estimated that a $95 million federal income tax impact to these taxpayers from the application of two 80 E on their tax return for 2016 or $475 million when forecasted out for five years.
Now, in addition, the inspector general selected a statistically random sample of 90 cannabis based businesses that filed state tax returns in the year 2016 in the state of Washington to determine whether these taxpayers were actually reporting all of their income in compliance with IRC 61. What that is is pretty much says, no matter if your income is legal or illegal, you still need to report it on your tax return. Now, the inspector general found that 26% of these returns have IRC 61 adjustments involving either under-reporting of income or non filing of their tax returns. Now, when they projected this over the population for just the state of Washington, they say that the IRS missed the opportunity to address three point $9 million of potential assessments just for the tax year of 2016 or over $19 million over five years. And that’s just one state out of the 33 plus States or however many it is now that have cannabis based businesses.
Now also the inspector general found that the IRS lacks guidance to taxpayers and tax professionals in the cannabis industry. Now having this guidance would improve awareness of tax filing requirements for tax payers in the industry, you know, those cannabis based businesses, and they want to put this guidance around IRC 280 E and 471 C, which we’ll talk about in this video. And that would reduce the burden of tracking inventory for certain small businesses. Now I’m not going to go too detailed into that. That could be a whole other video, but essentially the tax cuts and jobs act has done some things to kind of make it a little easier for cannabis based businesses. Potentially. Now, when you read 280e simply says this no deduction or credit shall be allowed for any amount or incurred during the taxable year in carrying on any trade or business, if such trade or business is trafficking a controlled substance.
Now the first sentence of 280E couldn’t be any more clear, but when you have new tax court cases and things along those lines, you find that you can actually deduct cost of goods sold or that there are reasonable methodologies to put other indirect costs into cost of goods sold depending on your vertical. So yes, we agree. There should be some more guidance on IRC 280E for cannabis based businesses. So now that you understand what the findings of this report are, let’s read some of the recommendations from the report by the inspector general. So first the inspector general recommended the IRS developed a comprehensive compliance approach for the cannabis industry. And it has four aspects. First is a methodology to identify businesses in the industry and track examination results, second develop and publicize guidance specific to the marijuana industry or the cannabis industry such as guidance on the application of IRC 471 C in conjunction with IRC 280E. Third, this is going to be an eye opener.
They want the IRS to leverage publicly available information at the state level and expand the use of existing federal and state agreements to identify non filers and underreported income in the cannabis industry right now that doesn’t get you shaken a little bit. You really need to start paying attention. Okay. They’re out there looking for information and being told by their boss to go find and use more publicly available information and agreements between federal and state agencies to identify cannabis based businesses. And the last part of this comprehensive compliance approach is that they want to increase the educational outreach towards unbanked taxpayers, making cash deposits regarding the unbanked relief policies available. Now I’m not going to touch on anything banking in this video, other than what I just said, but in the report, it talks about banking for cannabis based businesses and why it’s so complicated and hard to get an account.
Now, the IRS agreed with five of the six recommendations that the inspector general made. Now, the IRS didn’t agree with the recommendation to develop and provide guidance on IRC 471 C citing that they had other priorities. Wow. They don’t want to educate the industry. Uh, that seems obvious that they’re not going to do that because then that would actually give you some intelligence on, should you file this way or not? However, the IRS added to that once the 2019 in 2020 priority guidance plan is resolved. Another thing that they’re working on, they will be developing guidance to ensure the coordination between IRC 280E and 471 C actually considered doing that. So it’s in the works, but we’ll get to it when we get to it kind of thing. So now that you understand the findings and the recommendations from the report and what it is, I want to do a deep dive on three aspects of this.
So you can really understand the gravity of this report and what it’s actually saying in plain words. So the first finding I want to go over is that it was titled high risk marijuana business tax returns with millions of dollars in potential tax adjustments are not worked. So that’s what it was labeled in the report. Now the current IRS compliance approach for cannabis based businesses is primarily concentrated in the Western area. And on January 4th, in 2016, the Western area approved a compliance initiative project or CIP. And that’s how referred to it through this slide for the cannabis industry. Now part one of the CIP was limited to just 50 businesses in Colorado and was terminated the following year on June 30th, 2017, without any expansion into part two of that project. Now, according to the Western area management, the marijuana CIP was not continued to part two because of resource constraints, right?
Not enough agents or not enough money, but the 50 marijuana business examinations of the terminated Western area part one CIP are still in progress. Now the Western area has been involved in preparing internal guidance, materials, and conducting training for the revenue agents or the IRS agents for both CIP and non CIP examinations. So there’s been some training around this for the agents to understand what they’re looking for and how to approach it. Now on the screen, you can see here a chart, figure three and figure four. And this is from the report and what it has on there is CIP marijuana returns. So people from this actual project, non CIP, marijuana returns in dif returns. Now it talks and it shows through how many returns were closed, how many dollars per return were recovered, the dollars per hour, and then the no change in the returns now as reflected in figures three and four, those two charts there, the marijuana examination results for both CIP and non CIP, marijuana returns generate significantly higher dollar amounts in dollar returns per hour than normal dif examinations.
Also the no change rate for both CIP, marijuana and non CIP marijuana examinations is significantly lower than dif examinations. So what that means is that cannabis business examinations or marijuana based business examinations have some type of change almost more frequently than an ordinary business. Okay. Let me just explain something to you. You may be asking what is dif so dif stands for discriminate function, and it’s a mathematical technique used to classify income tax returns as to an examination potential pretty much. It’s how they find people to audit in the general population. Now, when you just look at a population of cannabis based businesses or marijuana businesses, that last column very important, let’s look at the top chart here. It says dif returns in the last column, no change rate, 19.3% or one in five, almost returns are not being changed. But if you look at the marijuana returns, CIP and non CIP for the CIP, one in 50 is not being changed.
You look at the non CIP one and a hundred is not being changed. So what that means is that if you’re examining cannabis based businesses, you’re surely more likely to find a change on their tax return that needs to be updated and more taxes can be found for that. Now the Western area management noted that the following two primary compliance issues for those marijuana or cannabis returns, number one, business expenses, incorrectly deducted based on IRC 280 E. We talk about this all the time. Now also number two is that there’s underreported income. So it’s very obvious to an auditor when they see art, your cannabis based business, there’s more likely than not going to be some way we can assess more taxes, penalties, or fines to your business and recover more. We see up here dollars per return in dollars per hour spent on that return.
Now you may be wondering, okay, well, how do they find these cannabis based businesses? Well, according to the IRS, they say that there’s no easy method to identify marijuana based businesses on the tax return filing information. Of course, unless your name is like four 20 bud bros, or I’m a big cannabis business, LLC. You’re probably not going to be found by your specific business name on your tax filing. Or if you don’t put the word 280E in there, you probably aren’t going to be found on your tax filing return information. So what the inspector general said that the IRS should explore alternatives, such as leveraging state information on marijuana based businesses, through existing information sharing agreements or available public information to develop an initiate, a national CIP or compliance initiative project. And they say that the objective of that national CIP should focus on creating a comprehensive compliance approach to identify noncompliant taxpayers in the industry, breaking it down, go find people that are not paying their taxes across the country, using public data or agreements that we have with the States and find some more money for the IRS.
Now I’m not making this up. What you see on the screen here is an excerpt from page 11 of this report, and I’ve highlighted some things in orange, so you can actually read through it. And they did this for the state of California for this report. So what you can see on the second line that I highlighted there, it says for California, the business licenses represent active retail and distributor licenses listed on its website. So essentially the IRS could go to the BCC site, find your entity name as well as your address, triangulate that find your tax return and then kick off an audit it’s that easy. And it’s being suggested by their boss, essentially, to do this. Now, what they also found out is that marijuana businesses in California, Oregon, and have a high rate of noncompliance with IRC two 80 E. Now that’s not mind blowing, not everybody has a reasonable methodology and how they approach 280e.
Now their review of three statistical random samples identified that 59% of businesses with a 2016 tax filing requirement likely had 280E adjustments. That’s 59%, almost 60% of businesses are doing it incorrectly. That’s huge. Now specifically per state, 78% of the returns in California, 50% of the returns in Oregon in 59% of the returns in Washington likely had 280E adjustments. That’s a lot, nearly 80% of the businesses in California are filing their taxes incorrectly. Now, when they projected out what they could have recovered in 2016 taxes, it came out to 48 and a half million dollars, almost $49 million that they could have collected in back taxes, projecting that out for five years, $242 million. So there’s a lot of money for the IRS to go and get out of these cannabis based businesses and the information to find these businesses is not very far, whether it’s public information or agreements that they already have with state and federal agencies.
Now, the second finding I want to do a little deeper dive on is the non filers and under reporting of income. So finding number two, the inspector general says that the IRS is not using available marijuana state tax return information to identify non filers and underreported income. So, as I said earlier, IRC 61 requires that gross income must be reported, whether it’s legal or illegal, where it comes from something that you’re doing legally or illegally, doesn’t matter, gotta file that and put that on your tax return. And so what we’re going to talk about in this slide builds on the previous one, using that publicly available information, because the state of Washington publicly posts on its website, a list of all the cannabis businesses and their sales. So the inspector general analyzed all that publicly available information from the state of Washington to identify potential underreported income in non filers, based on their analysis.
26% of returns in the state of Washington likely have IRC 61 adjustments. So as you can tell, one in four businesses are not reporting their full amount of income. That’s not a good thing. Now, the inspector general plan to use the state income tax and total sales information, things like gross receipts for California, Oregon, and Washington, but Washington is the only state that puts this information specifically the gross receipts out there publicly. So they couldn’t get the information for California or Oregon, but that doesn’t mean that they couldn’t leverage their existing relationships with the tax agencies in those States to get that information. So on the screen here, you can see the recommendation, the fifth, one of the report. I just want to read through it real quickly and help you to understand that you cannot hide as a cannabis based businesses. So recommendation number five, the commissioners should leverage publicly available state tax information and expand the use of federal and state agreements to identify non filers and underreported income of the marijuana industry, their bosses, telling them use the information that’s out there.
Go find more money in the management’s response. The IRS agreed with this recommendation, but disagree with the related outcomes of the measure. So in his response, the IRS noted that whether it pursues taxpayers in the marijuana industry depends on their priorities and available resources. The IRS stated that it will review the publicly available state tax information and federal state agreements to determine whether and how they can legally systematically, effectively and efficiently be used in compliance activities. So they said, Hey, all right, we’ll do it. And we’re going to review and find all that information and see if we can actually do this in a legal way. Well, I’m sure they’ll find a way to do it. And they are going to come in use that public information and those agreements to find if you are actually underreporting your income in the last finding I want to do a deep dive on here is the IRC 471 C loophole.
You may have seen blog posts or other people talking about this. And when you hear the word loophole, you should probably not do it. Okay. Tax law is one thing, right? There are talks laws that allow you to do certain things or tax court rulings that lay out more guidance. But when you see loophole, it probably means that you shouldn’t be dancing around that area, especially if you’re a cannabis based business. So finding number three, the tax cuts and jobs acts of 2018 provided the tax reform with 471 C, which may have created a loophole to mitigate 280E. So one of the positives of this report is that there’s an obscure tax law, federal tax law that got brought up, which is section 471 C. And this came from the 2017 Republican tax reform bill, better known as a tax cuts and jobs acts for 2018.
And what this tax reform did from section four 71 C, is that it could let marijuana companies with less than $25 million in gross receipts, completely escape 280E. Now, according to the report under this new provision, marijuana businesses could argue that they are entitled to using a method of accounting. That includes all expenses in cost of goods sold to potentially avoid the impact of 280 E. But the report also emphasize that the potential impact of 471 C for marijuana businesses will be based on how the IRS applies and administer is this new statute, as well as potentially how the courts interpret it. Right? So that means that some cannabis businesses are going to have to actually test the waters with a federal tax return using four 71 C backing all their business expenses into two and do their cost of goods sold and see how the IRS and likely a us tax court is going to respond.
And it’s going to take a year, two years, three, five, seven years for this to all shake out. So if you watched our video on the Richmond tax case, you have to have an accounting methodology that matches your style of business. So if you’re gonna be changing your accounting methodology, you need to get that approved by the IRS commissioner. So that’s one complication with this quote unquote loophole here. Also, when you start dancing around again with loopholes, you may be made an example of, for other people in the industry. So be very thoughtful on this. So now that you understand some of the impacts of this report and the evidence that came out and showed you really what is happening at the level of the IRS and inspector general in how they’re looking at, you know, recouping getting more quote unquote revenue for the U S government through cannabis based businesses.
And I just want to give you some final thoughts and tips. So first get your accounting in books cleaned up immediately. This means focusing on your financial systems, doing your own internal audits of your financials and of your tax returns at all levels of the government, for the city, the state and the federal government. And if you find something, then make the right move accordingly. If you find that you filed incorrectly, maybe file an amended tax return. And if you need help with these types of tasks that reach out to GreenGrowth CPAs, and we can walk you through that and make sure that you’re staying financially compliant because financial compliance can not be an afterthought. Ignorance is never an acceptable defense when it comes to tax audits, the, we didn’t know, or there’s not enough. Guidance is not going to work. There’s enough out there where you should know what you’re doing is probably not the right thing or it’s questionable.
And the IRS is not going to, again, listen to the, we didn’t know, it’s not a good excuse because cash crimes are the new drug crimes. He don’t care about the cannabis anymore. They care about where the money’s at, where the tax revenue is at and how much of that revenue are we collecting. And pretty much what you see in this report, the IRS has just been called out by their boss that they’re not doing enough to go and capture more revenue from these cannabis based businesses. And as you saw in one of the first charts, cannabis based businesses resulted in more dollars per hour for the IRS. So what that means is that if they go and audit these cannabis based businesses, they’re going to have a better ROI on the time spent per IRS agent. So just understand you’re not going to be able to play stupid for any longer.
The second final thought I want to leave you with is that expect a huge wave of audits in the coming years. Again, just as if your boss told you to step your game up, the IRS will surely be deploying more agents in more resources and even potentially contractors to conduct these audits. They know that there’s some money there. They’re going to go find it. They’re using contractors or been said to potentially be using contractors for cryptocurrency tax evasion. So it’s not far fetched to think they would use the same strategy for finding revenue from cannabis based businesses. And what this report shows is that there’s enough critical mass of income. And that there’s a high percentage of under-reporting non filing and two 80 adjustments that some fishing expeditions by the IRS with just a little bit of third party data could actually yield substantial revenue for the IRS.
So looking at the current state of, in the U S and around the world, but again, specifically in the U S it would almost be an abomination for the IRS to audit a typical ordinary business, a restaurant or this or that aside from if they’ve got a PPP loan or any SBA loans, but a vice like cannabis might have better public optics for the IRS to go audit that. I’m not saying that it’s the right thing to do, but it may be the choice of the IRS takes if they’re going to have to go and audit businesses anyways. And the last thing I want to leave you with is stick to court, tested tax strategies with four 71 C you may see a loophole, but as a tax firm, we see a snare. That’s going to grab you by the ankle and lift you upside down and shake all the money out of your business.
Now, the IRS doesn’t tend to look at all industries with a fine tooth comb when writing new tax reform, this specific reform opened up the door to some two 80 mitigation, but as you seen in many tax court cases that we’ve covered, it can turn out very, very bad for the cannabis businesses that try to circumvent two 80 E. Now the inspector general report does say that more guidance is needed around this tax code, but the IRS essentially said, we’ll get to it when we get to it. So don’t expect anything soon on four 71 C. And if you want to try to be a hero, you may try using four 71 C, but it’s not really that good of an idea to be a hero in these types of matters. Let someone else do it. And if you can, then you could potentially go back.
If you have the right accounting methodology for those tax years and file a potentially an amended return, don’t be a hero when it comes to taxes. So hopefully this video has helped you to better understand the inspector general report for the IRS on cannabis-based businesses and helped you to open your eyes to see, alright, there is information out there that can identify me, and the IRS will be ramping up audit efforts in the future. So if you need help with an internal financial audit or your cannabis business tax filings, please reach out to Green Growth CPAs via our website at GreenGrowthCPAs.com, or give us a call at (800) 674-9050. If you kick off an internal audit and you go and find things, that’s the best way, no. Before the IRS goes and puts their hands in your business and finds it before you do. So again, if you need help with, you know, looking at your financial systems, understanding your tax filing requirements, your methodologies, the way your accounts are set up in your chart of accounts and how expenses are being coded and things like that. And making sure that you’re in the best tax position possible, then please reach out to Green Growth CPAs via our website at GreenGrowthCPAs.com, or give us a call at (800) 674-9050. Have a great day. And we’ll talk to you soon.