Published by NCIA’s Banking & Financial Services Committee (BFSC)

Contributors:

• Tapan Ramachandran, Otterz Inc. | hello@otterz.co
• Neil Rosenfield, Baker Tilly – neil.rosenfield@bakertilly.com
• Steven Gotsdiner, HBK, – sgotsdiner@hbkcpa.com
• Rochelle Dallons, Yield Bookkeeping Services – r.dallons@yieldbookkeeping.com
• Naomi Granger, National Association of Cannabis Accounting and Tax Professionals – naomi@nacatpros.org
• Curtis Winar, MGO CPA – cwinar@mgocpa.com
• Dorothy Kolb, Planet Earth Accounting & Advisory – dorothy@planetearthaccounting.com
• Pat Gately, Leyton – pgately@leyton.com

As the cannabis industry continues to expand, operators face unique challenges in tax compliance and financial management. Among the most daunting prospects for any business owner is an IRS audit, and for cannabis companies, the stakes are even higher. Proper preparation is key to ensuring your business is ready for this possibility.

The Increased Likelihood of an Audit

Cannabis companies are significantly more likely to be audited than those in other industries. A 2020 study by the Treasury Inspector General for Tax Administration found that cannabis businesses were 4.7 times more likely to be audited than non-cannabis businesses of similar size. This heightened scrutiny underscores the importance of being thoroughly prepared.

Building the Right Support Team

Assembling a team that understands the intricacies of the cannabis industry is essential. Key players include:

• Cannabis-Specific CPA: Expertise in 280E compliance, state-specific tax laws, and cost accounting methods tailored for cannabis businesses.
• Cannabis Tax Attorney: Specializes in cannabis tax law, provides regulatory guidance, and represents your business during audits.
• Compliance Officer: Ensures adherence to regulations, maintains proper documentation, and implements internal controls.
• Inventory Management Specialist: Oversees tracking systems, accurate inventory valuation, and optimization of Cost of Goods Sold (COGS).

Accurate Accounting and Documentation

Maintaining precise accounting records and documentation is critical. Essential records include sales receipts, vendor invoices, bank statements, payroll records, and inventory logs. Well-organized documentation supports your accounting entries and provides a solid foundation during an audit.

Standard Operating Procedures (SOPs)

Documented SOPs covering all areas of operation are vital, especially in a cash-heavy industry like cannabis. SOPs help mitigate risks such as misappropriation of funds, fraud, theft, and safety issues, ensuring consistency in your operations.

Consistent Employee Training

Regular training for employees is crucial due to the high turnover in the cannabis industry. Staff should be well-versed in handling cash, maintaining accurate records, and following SOPs to ensure compliance and security.

Internal Audits and Controls

Given the fluid nature of the cannabis industry, internal audits are essential. Regular self-audits help identify and correct potential issues before they escalate into major problems during an IRS audit.

Cost of Goods Sold (COGS) and IRC 471(c)

Accurate COGS calculations are vital for compliance with Section 280E, which disallows most business expense deductions except for COGS. Additionally, under IRC Section 471(c), small businesses may use a simplified inventory accounting method, potentially reducing tax burdens by including more costs in inventory rather than disallowed deductions. Ensure your business qualifies as a small business under IRS guidelines and maintain proper documentation to support the use of 471(c).

Managing Multiple Banking Relationships

If your cannabis business maintains multiple banking relationships, it’s essential to keep all records reconciled, including any intercompany and inter-bank transfers. Proper record-keeping and reconciliation are crucial for transparency and audit readiness.

State Audit Considerations

State audits can be particularly rigorous in the cannabis industry. Here are key considerations:

• Licensing and Compliance: Ensure you have all necessary licenses and permits, and can demonstrate adherence to state regulations, security protocols, and quality control standards.
• Financial Projections: Develop detailed financial projections, including revenue, expenses, and profitability. Use a cannabis-specific Chart of Accounts (COA) for accurate tracking.
• Operational Plans: Document all operational processes, from cultivation to distribution, and be prepared to present these during an audit.
• Risk Assessment and Contingency Planning: Identify and mitigate potential risks such as supply chain disruptions, regulatory changes, and security vulnerabilities.
• Security Measures: Most states require comprehensive security plans, covering aspects like surveillance, access controls, product storage, cash handling, and employee background checks.
• Document Management: Establish an organized system for storing essential documents, including licenses, compliance records, financial statements, and operational manuals.
• Policies and Procedures: Ensure that your policies and procedures are well-documented, covering safety, inventory reconciliation, and waste disposal.
• Professional Assistance: Hiring an accounting and tax professional with cannabis industry expertise can be invaluable for audit preparation and compliance.

Strengthening Your Approach to IRC 471(c) Compliance

IRC Section 471(c) offers cannabis businesses the opportunity to simplify their inventory accounting and potentially reduce their taxable income. However, successfully leveraging 471(c) requires careful planning and meticulous record-keeping. Here’s how to optimize your compliance strategy:

Key Requirements and Best Practices

1. Eligibility and Qualification:
   • Under 471(c), small businesses with gross receipts under $25 million (adjusted for inflation) can use simplified inventory accounting methods.
   • Ensure your cannabis business meets the IRS’s small business threshold, and keep records that prove your eligibility. This includes tracking and reporting your gross receipts accurately.
2. Accurate Categorization of COGS:
   • One of the main benefits of 471(c) is the ability to allocate more expenses to Cost of Goods Sold (COGS). This can include indirect costs that were previously non-deductible under 280E.
   • Carefully document and categorize every expense that contributes to inventory costs, ensuring you capture all eligible expenses without overstating them. This may include direct materials, labor, and even some overhead costs.
3. Detailed Documentation and Record-Keeping:
   • Maintaining thorough documentation is critical when applying 471(c). Every transaction, from purchasing raw materials to labor costs, should be meticulously recorded.
   • Keep records of how you allocate expenses to COGS under 471(c). This includes detailed explanations of the methods used for allocation, supported by invoices, receipts, and financial statements.
4. Regular Financial Reviews:
   • Conduct regular internal audits and financial reviews to ensure ongoing compliance with 471(c). This helps identify discrepancies early and allows for adjustments before filing tax returns.
   • Regularly reviewing your financials also helps ensure that your accounting methods align with both federal tax laws and state-specific regulations, reducing the risk of errors during an IRS audit.
5. Use of Specialized Software:
   • Employ accounting software specifically designed for the cannabis industry that supports 471(c) compliance. These tools help streamline the process of categorizing expenses, managing inventory, and generating accurate financial reports.
6. Professional Guidance:
   • Work with a tax professional who understands the intricacies of IRC 471(c) and the cannabis industry. They can provide tailored advice on optimizing your tax position and ensuring that your accounting practices align with the latest IRS guidelines.

By strategically implementing IRC 471(c) and maintaining strict adherence to its requirements, your cannabis business can benefit from reduced taxable income while remaining compliant with federal tax laws. Proper documentation, regular financial audits, and the use of industry-specific software are essential to maximizing the benefits of 471(c) and minimizing the risks during an IRS audit.

Conclusion

Preparing for an IRS audit as a cannabis operator requires a proactive approach and a knowledgeable team. By assembling the right professionals, maintaining accurate records, implementing strong internal controls, and staying informed about regulatory changes, you can navigate the complex world of cannabis taxation with confidence. Remember, the cost of proper preparation is always less than the potential consequences of being caught unprepared.

Investing in competent professional service providers may seem costly, but it can save you significantly in the long run. A 2022 survey by the National Cannabis Industry Association found that cannabis businesses working with industry-specific accountants and lawyers were 62% less likely to face major compliance issues during an audit.

For more detailed information, you can refer to the IRS guidelines for the cannabis industry and explore the Cannabis Industry Frequently Asked Questions. Additionally, these sources offer valuable insights on how to avoid an IRS cannabis tax audit.