Member Blog: Guidance for Navigating an IRS Cannabis Audit
By Bethany Moore
October 11, 2022

Member Blog: Guidance for Navigating an IRS Cannabis Audit

By Nolan Shutler, Director and State and Local Tax Practice Leader, MGO CPA 

Operators and investors have long suspected that the IRS targets cannabis businesses for tax audits. And after last year’s disclosures from the agency (requested and published by MJBizDaily) we now know the reason is relatively simple: the IRS gets back 2X or more per hour of audit examination when compared to mainstream industries.

Now, with the Inflation Reduction Act’s infusion of $80 billion in funding over the next 10 years to ramp up enforcement activities, the IRS’ focus on cannabis companies is likely to intensify.  Even if Federal legalization and/or descheduling of cannabis occurs, current and prior year’s returns will still be subject to IRC 280E, and the problems causing the high assessments aren’t going to go away overnight. Therefore, cannabis operators and investors are wise to level-up their tax compliance capabilities.

In this article, MGO CPA, lists out the stages of an IRS audit and provides key things to think about.

#1: Prepare for an audit BEFORE you hear from the IRS

There is a lot you can do before you get audited that will ease the process and help you arrive at a desirable conclusion. The good news is that “audit preparation” is really just implementing accounting and documentation best practices that will prove useful to the efficient administration of your business – even if you never get audited.

  • Retain financial documentation for at least 10 years 
    • Documents to save:
      • Financial statements
      • Point-of-sale transaction data
      • Invoices, receipts, and purchase orders
      • Credit card statements
      • Agreements
      • Cash logs
      • Payroll and contractor documentation
      • Rent payments, property tax bills, etc. 
  • Establish proper accounting methods
    • Your accounting and record-keeping procedures should align with Generally Accepted Accounting Principles (GAAP)
  • Maintain compliance with Federal tax law
    • The best way to stay off the IRS’ radar is to pay your taxes on time. Not paying taxes is the BIGGEST IRS red flag that can trigger an audit. 
  • Document Accounting Policies and Tax Positions
    • When you file taxes, you’ll be doing calculations around IRC 280E, cost-of-goods sold (COGS), and determining “separate trades or business.” Be sure to document the reasoning behind all these decisions as any cannabis business will need to address these positions under audit. 

#2: What to do when you get an audit notice

When you get the dreaded letter from the IRS the most important thing is not to panic! You’ll want to respond immediately and get your organization on track to meet the IRS’ requests. 

  • Understand your situation
    • There are several different types of audits of varying severity. You’ll want to dig into the details of the IRS letter to fully grasp what the IRS is asking. 
  • Call the professionals
    • It is important to reach out and get your cannabis accountant and/or legal representation involved as soon as possible. They should have previous experience working an IRS audit and will provide guidance to you and act as the primary point of contact. 
  • Prepare documentation
    • Now is when your hard work saving documentation pays off. Since it is all organized and available, it’ll be easy to meet the IRS’ demands. If you aren’t prepared, you’ll likely waste many hours digging up old receipts and other documents to justify the tax position in question. 

#3: Navigating the audit

Once the audit begins in earnest, be as responsive and collaborative as possible. Establishing rapport and demonstrating “good faith” intention are essential to securing an optimal conclusion to the audit. 

  • Let your qualified professional representation lead the way
    • Let your cannabis accountant or lawyer manage most IRS communications to limit accidental exposure.
  • Show the IRS you are serious
    • The IRS will want you to be collaborative. Anything else and you may be perceived as evasive. You want to provide as much of the requested documentation (as is practical) for the first meeting.
  • Don’t hide anything and bring up potential issues
    • If you know a mistake has been made, it is best to be upfront about it and work collaboratively with the IRS to address it.

#4: Strategize for a fair outcome

As the audit proceeds your cannabis accountant and/or lawyer will have a good idea about the likely outcome. Stay in regular communication and be collaborative to ensure “good faith” consideration. 

  • Choose a strategy
    • As the shape of your assessment comes into view, you’ll want to actively cooperate with the IRS to achieve an optimal result. 
  • Don’t “negotiate,” collaborate
    • Landing on an assessment is not a “negotiation” but there may be some flexibility if you’ve established a strong relationship with the auditor. They are also motivated to close the audit and move on. 

#5: Navigating Appeals and Tax Court

If the audit is completed and you feel the outcome is unmanageable or unfair, you may engage the appeals or tax court process. 

  • Navigating appeals
    • You have the right to appeal your auditor’s decision, but you want to make sure you have a very strong case built on a genuine dispute and/or valid legal argument.
  • U.S. Tax Court
    • In the final say, you may choose to take your case to US Tax Court. It is important to note that the cannabis industry does not have a strong history in tax court decisions.

Final thoughts on cannabis tax audits

In the end, both you and the IRS are seeking a quick end to the audit process. By being up-front and collaborative you can save yourself a lot of wasted time (read: fees, penalties, and interest) and heartache. Being adversarial or pursuing frivolous or unsubstantiated arguments will just make your path more difficult. 

As the cannabis industry evolves, and compliance functions become more sophisticated, hopefully, the IRS’ assessments and interest will wane. But in the meantime, remember that the IRS can still audit 2019 tax returns for another year (or longer, under certain circumstances). There may be significant risk tied up in an audit of those prior years (especially if you recently acquired the business). We highly recommend working with a dedicated cannabis accountant to proactively implement best practices retroactively and going-forward that will help you avoid getting audited in the first place. But in the unfortunate event of an audit, those same efforts will be helpful in securing an optimal outcome.

To see a more detailed, step-by-step approach to navigating an audit, download the MGO Cannabis IRS Audit Survival Guide.

Nolan Shutler, JD, is a director in MGO’s tax group focusing on tax controversy representation and general state and local tax (SALT) consulting. He also has experience in indirect tax,  tax planning, corporate tax compliance, and real estate transactions for public, private, and closely held businesses. Nolan has the ability to leverage tax and business management acumen to understand and forge paths to optimal outcomes.

MGO has a dedicated cannabis accounting, audit, tax, and business advisory practice built to help cannabis operations survive and thrive in a competitive marketplace.

We help cannabis organizations of all sizes — from multi-state operators to pre-revenue startups — in every vertical and every market, establish optimal accounting processes, manage tax and regulatory compliance, perform audits to raise capital or engage in M&A, and everything else an operator needs to succeed.


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