Victor and Associates

Cannabis accounting firms

Three Simple Steps Canna CEO’s Can Take to Avoid an IRS Audit

Three Simple Steps Canna CEO’s Can Take to Avoid an IRS Audit

Marijuana is by far the most controversial plant on earth. For more than half a century war has been waged on this plant, especially in the United States. Thousands have been imprisoned in the course of this war. In recent years, a certain degree of legality has been granted at the state level. However, marijuana continues to be a Schedule I drug and is still illegal at the federal level. Being illegal at the federal level does not preclude the state or the federal government from wanting their cut.

Because of this, the industry is closely monitored, heavily regulated, and taxed, and has a higher audit rate than other industries. In fact, most of the firms in that industry will be audited in the first four years of operation. Previous audits of marijuana companies have resulted in massive fines and even criminal charges (Harborside). While an audit may be unavoidable for cannabis companies, there are some steps that Canapreneurs can take to ensure that their business survives unscathed.

  1. IRC § 280e

The most stringent tax law impacting Cannabis is 26 U.S. Code Section 280e. 280e is a federal statute that was enacted in 1982 in response to a tax case in which a cocaine trafficker asserted his right to deduct ordinary and necessary expenses. IRC 280e states that companies that traffic Schedule I and II substances are prohibited from deduction and credit. Essentially, cannabis businesses are taxed on all revenues while being prohibited from deducting expenses incurred in generating those revenues to reduce taxable income.

Recent guidelines issued by the IRS have shown some relief for cannabis companies in the sense that IRC280e can be legally circumvented by the application of IRC §1.471. IRC §1.471 permits certain costs to be allocated to inventory and cost of the goods sold.

Cannabis entrepreneurs must exercise caution in the application of IRC471, as certain conditions must be met in order for IRC471 to be used. Accounting for costs and allocation per generally accepted accounting principles (GAAP) must be consistent. This means that cost must be allocated quarterly at the minimum, but preferably monthly. Companies that do not do this are most likely sitting on a time bomb of liability, as the IRS can refuse all deductions in an audit, which may result in under-reporting penalties and interest, And even criminal charges.

Here are some things you should do to (avoid/survive) an IIS audit:

  1. Read IRC §1.471 until you have a clear understanding of how it applies to your business
  2. Have a chart of accounts tailored to your specific business (manufacturing, edibles, cultivation, etc.)
  3. Have a document that tracks the stages of inventory, direct and indirect cost allocation, and yields per strain.
  4. Hire an Accountant who is trained in cannabis accounting
  5. Many Cannabis entrepreneurs are being advised to use IRC §263aDON’THarborside is an excellent lesson in the failure of the IRC 263a strategy.
  6. You can’t avoid 280! Another strategy under promotion is to create multiple complex entities to avoid 280th. As case after case has demonstrated the IRS is highly aware of this tactic and is consistently winning in court.

Form 8300

The IRS audits approximately 6% of Cannabis businesses juxtaposed to 1.5% of other businesses. The primary reasons for this high audit rate are IRC 280e and Form8300 Report of Cash Payment Over $10,000 Received in a Trade or Business.  Any trade or business operating in any of the 50 states, the District of  Columbia, or a U.S. Possession or territory (American Samoa, The Commonwealth of the Northern Mariana Islands, Guam, Puerto Rico, and the U.S. Virgin  Islands)  receiving more than $10,000 cash in a single transaction or related transactions must file form 8300 with the IRS.  Cannabis businesses are under  scrutiny for form 8300 due to heavy use of cash.

One of the primary issues with form 8300 is determining what is a related transaction. Many businesses are unaware that separate transactions between the same parties are considered related if they occur within 24 hours of each other (Tom purchases merchandise in cash for $6300 at 3:00 pm on Monday. The following day at 10:00 am Tom returns to the store and purchases an additional $5000 of merchandise and pays in cash). This is a related transaction since both transactions occurred within 24 hours and require Form 8300 to be filed.

The form must be filed within 15 days of the transaction and is filed electronically using FINCEN’s BSA-E filing system. Businesses are required to keep records of all forms submitted for up to five years and are required to provide a transaction statement to all parties involved by January 30th of the following year. Failure to file or filing an incomplete Form 8300 carries both civil and criminal penalties. Penalties vary between $270 and $25,000 per report, with a maximum of $3,339,000 per year, depending on the offense and the company.

To avoid being flagged for audit Cannabis entrepreneurs should:

  1. Implement a system that details how to handle the 8300 requirements. The system would need to specify who is responsible for completing the form and when. The best practice is for the form to be completed and submitted right after the transaction is completed.
  2. Ensure that the person assigned to the work has been trained on all requirements.
  3. Oversight- Forms must always be reviewed by another individual before submission. This minimizes errors and reduces audit risk
  4. Maintain Meticulous Records – Record keeping is important for each company, but is doubly important for cannabis companies, given the audit rate. Maintain all records associated with transactions requiring the Form 8300, including identification documents.
  5. Compliance – File Form 8300 for all transactions that meet the filing requirements and provide the required transaction report to affected persons within the prescribed time frames.

Meticulous Records

All companies must keep accurate records, but this is even more important to cannabis companies. With such scrutiny, strict regulations, and increased audit risks, it is incumbent upon Cannabis to retain irrefutable evidence of each transaction. Every transaction should be linked to a substantiation document so that you can confidently face state and federal audits.

The completeness and accuracy of your records are dependent on your accountant and the systems implemented. Systems should be implemented to track, detail, and document each transaction made by your company. In business, every transaction includes a source document such as contracts, bills, receipts, lease agreements, etc. All source documents should be added to the transaction when they are entered into your accounting system.

Source documents should be stored in the cloud so that they can be easily accessed from any location. These files will save you thousands of dollars in case of an audit. They provide a traceable system that an auditor can follow during an audit making the process far more efficient and hassle-free and easily show that your books are correct and deductions taken are legal.

If you are facing an audit, know that following the right processes and procedures is the best way to protect yourself. Even if you are not facing an audit, follow the steps above to ensure that you are fully prepared when your company gets audited.