What to Expect in a Tax Audit

Cannabis Knowledge & Insights

Tax audits are relatively common in the cannabis industry – here’s how to prepare for one at your business.

Make sure your sales, inventory, employee, and tax records are detailed and thorough.
Be prepared with historical financial records, receipts, tax returns, and anything else you can share.
It’s not likely you’ll win an appeal of the audit outcome, so it’s better to be prepared.

Speak to one of our experts if you’re facing an audit of your business.

Did you know that cannabis businesses are five times more likely to face an IRS business audit?

Federal regulations like the Cole Memorandum make it difficult to do business in the legal cannabis market, and because banks often won’t accept cannabis money, cannabis businesses deal in a lot of cash. That much cash makes cannabis operators prime targets for a business audit.

However, dealing with a lot of cash isn’t enough evidence for the IRS to audit your business. There are other common triggers that will often cause the federal tax regulators to scrutinize your cannabis company.

Some of the things that might draw the attention of an IRS audit include:

Loss or low profit margins that are not consistent with a successful business
Bank balances that increase or debt balances that decrease while profits remain flat
A lifestyle that doesn’t appear to be supported by your reported profit
Persistently low sales

If you’re facing a tax audit, we suggest you take it seriously.

The IRS has not shied away from handing down heavy penalties to operators that don’t comply with tax regulations. Here’s what you need to know about what the auditors will look for in your cannabis business.

How to Prepare for an Audit

Whether you’re facing a federal or state-level audit, how you prepare for the audit process can make a huge difference in your experience.

The first thing to do, if you haven’t been doing so all along, is to make sure your records are detailed and thorough. Keep and organize documentation related to sales, inventory management, purchases, taxes, hiring and employee agreements, environmental compliance, and more. Start with our guide to avoiding common bookkeeping mistakes and also check out everything you need to know about cannabis standard operating procedures.

There are also some steps you can take to lower your risk of being audited. Conducting periodic self-audits or working with a CPA firm with experience in the cannabis industry can help you spot any issues before the auditors do.

Depending on what state you are operating in, there are different requirements for how long records must be maintained. Your best bet: keep records archived in electronic format as well as the hard copy!

When you are notified that you are being audited, the cannabis or tax regulators should include a list of records you will be asked to provide. Typically, an auditor will ask for the following things:

Tax Return Data: likely you will need to submit previous years tax return information in addition to the current year, as the IRS will be looking for a point of comparison. You may also be asked for the returns of returns of other similar businesses.
Reliability of Taxpayer’s Information: if you have unexplained gaps in your records, the IRS will want to understand why your records are incomplete. They usually assume the worst, so be prepared to justify anything that’s missing and back up your receipts.
Minimum Income Probe: this tool is used to identify deposits that may be taxable income and/or sources of taxable income not otherwise disclosed by the taxpayer.
Your cash accounting method, which may include:

Inventory items,
The employee who handles these transactions
SOP for recording transactions and accounts
Cash deposit location and procedure
Cash handling procedure
Bank account information

Personal Financial Information

The state cannabis regulators are permitted to ask for a range of records and to inspect your physical location, so the list above is just an illustrative example of what you might be asked to provide. Unfortunately, cannabis regulatory authorities can pretty much ask you to turn over anything and everything, and you must comply. Focus on gathering the documents by the deadline they’ve set for you.

Failure to Comply with a Cannabis Audit

If you do not provide the documents requested, there are some strict sanctions that you may be facing.

Likewise, if you do anything to misrepresent your facts, you can get penalized. Never speculate or guess about something when responding to an auditor’s inquiry.

Once you are audited, you have the right to appeal if the results don’t go your way. Experts estimate that as few as 10% of taxpayers appeal their audits, but the odds of winning a normal audit case are high. Your audit result should have instructions for how to file an appeal, but it includes sending in the following information:

Your name, address and contact info
A statement that you want to appeal the IRS findings to the Office of Appeals
A copy of the letter you received that shows the proposed change(s)
The tax period(s) or year(s) involved
A list of each proposed item with which you disagree
The reason(s) you disagree with each item
The facts that support your position on each item
The law or authority, if any, that supports your position on each item.
The penalties-of-perjury statement as follows: “Under the penalties of perjury, I declare that the facts stated in this protest and any accompanying documents are true, correct, and complete to the best of my knowledge and belief.”
Your signature under the penalties of perjury statement

If you have any other questions about the audit process, get in touch with our experts. We’ve provided tax advice to dozens of companies in the cannabis industry and would be happy to help you sort through any issues you may have.