Although many – but not all – U.S. states and territories have legalized, or decriminalized, cannabis for medical and/or adult use, “marihuana” remains a Schedule I drug pursuant to the U.S. Controlled Substances Act and its regulations, and, therefore, illegal federally in the United States. Marijuana’s status under federal law has subjected the cannabis industry to increased scrutiny by the U.S. Internal Revenue Service (the “IRS”), as well as to additional financial challenges attributable, in large part, to application of 26 U.S. Code § 280E (“Section 280E”).
After filing a Freedom of Information Act (“FOIA”) request with the IRS, Marijuana Business Daily obtained “more than 200 pages of internal IRS documents … related to the enforcement of Section 280E … and the cannabis industry.” As Marijuana Business Daily recently reported:
The Internal Revenue Service has been scrutinizing the books and records of marijuana companies for more than a decade, ordering business owners to hand over tens of millions of dollars in unpaid taxes.
That fact isn’t necessarily news to many industry insiders, but what has largely been kept under wraps is the agency’s decision to undertake at least five sweeping, multiyear audit programs that targeted scores of cannabis businesses in at least four states across the West and in Detroit.
The documents obtained via the FOIA request and made publicly available by Marijuana Business Daily provide a rare look inside the operations and approaches of the IRS, at least when it comes to the cannabis industry. Among the documents obtained by the publication is an IRS “Participant Guide (Revised April 2015),” which provides an “Introduction to the Marijuana Industry” and covers subjects such as “Audit Techniques for Testing Gross Receipts” and “Audit Techniques for Testing Expenses.”
At bottom, as others have observed, this Participant Guide functions as a “playbook” of sorts for IRS agents when auditing cannabis businesses. As such, a careful review of that guide may give cannabis-related businesses a “leg up” in ensuring compliance with U.S. tax laws and successfully weathering an audit. As detailed below, there are certain “best practices” that those businesses should consider in order to minimize their federal tax exposure and the risk of being found to be in non-compliance with applicable federal law.
What Is Section 280E?
Generally, under Section 162(a) of the federal Internal Revenue Code, businesses may deduct any expense that is “ordinary and necessary” to carry on its trade or business. Such expenses may include anything from paying the office electric bill to the renumeration of salaries and wages to employees. These deductions to taxable income generally are not industry specific.
However, because of Section 280E, these deductions are not available to the cannabis industry. Section 280E provides: “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” Accordingly, by disallowing these types of deductions, a cannabis-related business must pay federal tax on an amount equal to its gross receipts less any “cost of goods sold.” The disparate tax treatment of Section 280E effectively creates phantom income to the taxpayer, which – depending upon the taxpayer – may lead to 100-percent of its top-line revenue being taxable.
The IRS’ “Playbook” on the Cannabis Industry
The recently uncovered IRS Participant Guide is a primer for IRS agents that (i) effectively establishes an adversarial relationship between the IRS and cannabis-related businesses and (ii) pointedly addresses how to weaponize Section 280E against the cannabis industry.
In that guide, for example, the IRS suggests that, because much of the industry relies on cash sales, various “indirect methods” should be used when auditing taxable gross receipts. Among other approaches, the Participant Guide, focusing on nuances of this specific industry, contemplates “calculating indoor grow yields based on utility bills” and even instructs agents to inspect ATMs within dispensaries as a way to indirectly ascertain gross receipts. It even provides that, if certain inconsistencies are identified between a prior year’s utility records and a business’s gross receipts, there is then a strong indication of underreporting of taxable income. The IRS also suggests that other specific pieces of data may be important in determining gross receipts, such as information from point-of-sale record-keepers, packaging usage data, inventory of equipment, and plant counts.
A careful review of the Participant Guide also reveals the emphasis placed on the “tour of business” and the initial interview with the taxpayer, as, from the IRS’ perspective, these can elicit the most useful information and may be the “only chance” for an agent to talk to the taxpayer directly. While attorneys are certainly permitted to be present during these tours, the guide suggests that, in practice, they often do not become involved until after the initial interview. Moreover, the Participant Guide specifically addresses the Fifth Amendment defense against self-incrimination available to cannabis-industry taxpayers. For instance, it notes that while these taxpayers may have a legitimate Fifth Amendment right, “this can be normally overcome because there are limitations to the Fifth Amendment.” To that end, the guide asserts that taxpayers cannot invoke the Fifth Amendment if the records are already required to be kept by a government regulator. Additionally, it notes that if the cannabis business is organized as something other than a sole proprietorship, it cannot claim the privilege even if managed and operated by a single individual.
The documents obtained by Marijuana Business Daily, including the IRS Participant Guide, may be found here.
Best Practices for the Cannabis Industry
In light of Section 280E — and, even more so, in light of the IRS’ focus on auditing the cannabis industry and the recently revealed documentation — businesses across (and adjacent to) the industry must be consistently attentive to ways to minimize their tax exposure, as well to minimize their risk of being deemed to be noncompliant with applicable federal law.
To best position and protect themselves in the event of an audit, or even more generally, these businesses should consider devising a “playbook” of their own, which can feature “best practices,” including, but not necessarily limited to, the following:
- Maintain all tax-related documentation for a seven-year period. While the statute of limitations for an audit is typically three to six years (depending upon the relevant tax-filing date), cannabis-related businesses, out of an abundance of caution, should consider retaining tax-related documents for a longer period given the industry’s legal status under federal law and the heightened scrutiny that it attracts from the IRS and others. Tax documentation may include, but is not necessarily limited to, tax returns, receipts, correspondence with tax authorities, and other financial records.
- Establish, if not already in place, proper methods of accounting in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”).
- Review business expenses to identify costs that may more appropriately qualify as “cost of goods sold” pursuant to 26 U.S. Code § 471. For example, for a cannabis retailer, “cost of goods sold” could include the purchase price of the cannabis, but not certain indirect costs, such as repairs and maintenance costs – those latter expenses would be subject to Section 280E disallowance. Accordingly, be prepared to demonstrate that the relevant expense does indeed qualify as “cost of goods sold” under applicable federal law. If you have any question or concern about how any such expense should be treated, consult with legal counsel or a certified public accountant knowledgeable about the cannabis industry and the unique tax and legal issues affecting it.”
- Carefully follow tax-court cases and other federal court rulings, U.S. Department of Treasury guidance, or IRS bulletins or other publications, involving or affecting the cannabis industry.
- Maintain honest and proper books and records. Furthermore, if a cannabis-related business has a separate trade or business that sells non-cannabis-related items (which, if a legal substance, should not be subject to Section 280E), maintain independent books and records, as well as segregated funds, for each trade or business.
- Retain and organize documentation regarding business owners’ personal living expenses and net worth, as the IRS has identified this information as an indirect factor that can be considered in determining business sales. Under the “Source and Application of Funds Method,” the IRS may attempt to establish unreported income through evidence of a consistent pattern where a taxpayer’s personal expenditures exceed his or her current income available funds. Further, the “Net Worth Method” allows the IRS to reconfigure income of the business as being the increase in a taxpayer’s net worth during a given taxable year further adjusted for Section 280E disallowance.
- Utilize IRS prepaid credit cards in the IRS2Go Mobile App to pay estimated taxes online if the business is subject to certain banking restrictions that make it difficult to pay taxes via a traditional checking account.
- Cooperate with IRS agents. A $5,000 penalty may be assessed for refusing agents entry into a place of business. That said, be sure to protect all legal rights, including the right to invoke the Fifth Amendment, if and as necessary and appropriate. Consult with experienced legal counsel as warranted.
- Contact an experienced tax attorney, preferably one with knowledge about the cannabis industry, and/or a qualified accountant if and when the business has been identified for audit.
- Be prepared for on-site tours of business and the initial interview. As mentioned, on-site tours and interviews with business owners and their employees are common methods employed by the IRS in audits across this industry. Therefore, it is important, in coordination with legal counsel and consistent with all applicable law, to adequately prepare employees to cooperate and be able to assist the IRS in its examination, such as by being able to retrieve cash register and ATM records and by describing internal control procedures. Involvement of attorneys in this process not only can help ensure full preparation but it can also, under certain circumstances at least, make discussions with those employees subject to the attorney-client privilege.
- In coordination with legal counsel, and consistent with all applicable law, provide guidance to employees to assist them in providing oral testimony that may be requested of them by the IRS during an audit.
Notably, relevant tax considerations (and best practices) may vary depending on the structure of a particular business. For instance, whether a cannabis-related business is a C corporation or a limited liability company (“LLC”) will impact not only where general legal liability follows, but also who ultimately owes the income tax that would normally be reduced by business expenses and who could be subject to an audit. In pass-through structures, such as an LLC, the owners are the ones responsible for paying the tax. Conversely, a C corporation is entirely responsible for its own tax debts. There are elections available to entities that wish to maintain a pass-through structure but not be ultimately responsible for its business’s tax liability.
Leech Tishman provides an integrated, multi-disciplinary approach to advising the cannabis industry. As such, attorneys in its Cannabis, Corporate, and Tax Practice Groups work together to help cannabis-related businesses navigate the ins-and-outs of Section 280 and other applicable federal tax law, as well as counsel any cannabis-related businesses faced with an audit. They also provide routine, day-to-day legal advice and assist with numerous legal issues that any business may encounter.
For assistance, or more information, please contact Alexander J. Gase, an Associate with Leech Tishman and a member of the Corporate and Tax Practice Groups or Michael H. Sampson, co-chair of the firm’s Cannabis Industry Group.
Alex is based in the Pittsburgh office and can be reached at 412.261.1600 or email@example.com. Mike is also based in the Pittsburgh office and can be reached at 412.261.1600 or firstname.lastname@example.org.
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Leech Tishman Fuscaldo & Lampl is a full-service law firm dedicated to assisting individuals, businesses, and institutions. Leech Tishman offers legal services in business restructuring & insolvency, corporate matters, employment & labor, estates & trusts, intellectual property, litigation & alternative dispute resolution, and real estate. In addition, the firm offers a wide range of legal services to clients in the aviation & aerospace, cannabis, construction, energy & natural resources, healthcare, and hospitality industries. Headquartered in Pittsburgh, PA, Leech Tishman also has offices in Chicago, Los Angeles, New York, Philadelphia, Sarasota and Wilmington, DE.