CannaTax, Tax Audit Strategy 101

     Audit.  IRS. These words alone strike fear in Americans’ hearts. Together, IRS AND Audit are enough to induce chest pains and indigestion no Big Pharma product can touch.  Here’s the problem: You ARE going to be audited!  The Cannabis industry is in the crosshairs of the IRS.  In 2014, the IRS audited fewerthan 1% of all tax returns.  Small businesses with over $100,000 in revenue had an audit risk of 2%.  However, in 2014, about 8% of Cannabis Retailers were audited by the IRS.  For 2015, the statistics suggest a two-fold increase—to 16%. 
     If you assume you will be audited—and you should, having a tax professional (accountant or attorney) develop an audit strategy will be key to defending against the wolves banging on your door.  Recent US Tax Court cases have provided limited guidance on what can be considered the cost of goods sold (COGS).  With this direction, we can create an audit strategy for each particular business.  Although their federal tax rate can get as high as 75% (and Congress seems in no mood to address this), cannabis dispensaries and other industry components can implement strategies to lower their federal tax bill.
     As an industry subject to IRS 280E regulations, you have a few options to avoid IRS pitfalls. These include:  strictly adhering to 280E regulations, aggressively claiming expense-related deductions, or merging these two options, in some fashion.
     Cannabis businesses should be aware of the two different types of audits:  Paper Audit and Field Audit.  Each starts with a letter to either the individual or the business.  Be wary of scams!  The IRS will always communicate by mail and they do NOT—WILL NOT—phone or email your business!  Don’t fall victim to a scam phone call or spam email.
     A paper audit is generated by IRS computers when information the Agency has received does not match information on a tax return.  Due to the high volume of tax returns, this is basically a numbers game.  In most instances, regardless of the industry, reviewing returns for a paper audit is the first level of scrutiny when a tax return is filed. 
     A field audit is a more in-depth process that occurs after the IRS assigns a revenue agent.  The revenue agent will request a time to meet (in person) to review all documentation regarding income, expenses or deductions.  The IRSalso may use national and local industry standards to fit each industry into a “bubble” of how much revenue should be earned and how many expenses should be allowed.  This can be tricky in the cannabis industry. Taxpayers should also expect to prove the “reasonableness” of the income, expenses or deductions reported. The outcome of a field audit can be unpredictable for the average taxpayer, especially because revenue agents can get quite aggressive.
     The easiest way to immediately strengthen your audit strategy is to document everything.  The cannabis industry is a heavily cash-based industry that lacks access to normal banking systems.  Finding creative ways to document income and expenses is the smartest way to protect yourself and your business. Keep logs, ledgers and spreadsheets.  Make sure that documentation is time-stamped.  If all else fails, take pictures to document your business activity. Always keep notes on why the business incurred the expense and why it was critical to the business. 
     With no direct guidance from Congress, the cannabis industry is setting its own precedent and carving this path with help from tax court decisions.  At the end of the day, it all boils down to documentation and how prepared a business was at the time the return was audited.
     Don’t fight the IRS alone!  If you have questions about establishing your firm’s audit strategy contact a qualified tax firm like Tax Defense Partners today. Whatever you do, don’t wait for an IRS notice to start to develop an audit strategy.
     The founders of Tax Defense Partners have been in the Audit Representation, Tax Resolution and Tax Preparation business for almost 18 years. For more information, please visit us at or call us for a free consultation at 800-830-7777.  This column should be considered informational and not used as a substitute for tax, audit, accounting, investment, consulting or other professional advice. You should seek advice directly from a tax professional before making any decision or taking any action on accounting, tax, financial and consulting related matters and issues.