If you are a cannabis business owner, the mere mention of an IRS Audit gives you palpitations. 280e makes your business a target, and the fact that the IRS derives almost five times the revenue from a cannabis audit compared to any other industry makes it doubly concerning. So, what can you do to protect yourself from an IRS audit?
In this article, I’ll provide information on IRS red flags that will get your business audited, steps you should take to avoid these red flags, and how to prepare for an IRS audit. Before we tackle preventing an audit, you must first understand that all audits are not the same and do not carry the same penalties.
The IRS conducts three types of audits: correspondence, office, and field audits. A correspondence audit is the most common type of audit conducted by mail. The IRS will send you a letter asking for specific documents or information related to your tax return (Letter 5-66). Whatever you do, DO NOT ignore this letter! This type of audit can be quickly dealt with if you keep meticulous records and work with a qualified cannabis accounting and tax professional.
Another type of IRS audit is an office audit. As the name suggests, this is a face-to-face meeting held at an IRS office when the issues under investigation are too complex to be dealt with via correspondence.
Finally, there’s the field audit. You want to avoid a field audit at all costs. It is the most intimidating, intrusive, and intense audit. An IRS agent visits your business, examines all your financial records, AND interview you as well as all your employees. In this audit, you must provide documentation to substantiate all parts of your tax return. This audit can be a nightmare for even the most prepared cannabis business owner.
Being proactive and knowing what triggers will lead to an audit is the only defense you have against the power of Uncle Sam. I’ll take you through the steps to avoid the IRS triggers that will put your cannabis business in a vulnerable position. The more proactive you are in knowing what triggers exist for your industry and how to address them, the less likely you’ll find yourself falling victim to an IRS audit.
If you receive an IRS notice, do not panic. Whatever you do, DO NOT IGNORE IT! Because there are stringent penalties associated with ignoring IRS notices. DO NOT attempt to respond to the correspondence on your own. I recommend working with a cannabis tax and accounting expert to help you prepare for the audit.
Now that we’ve covered the different types of IRS audits, let’s look at the audit triggers.
- Not filing a tax return or paying taxes when due- If your cannabis business is starting and you had no income in the period, you should file a Zero return or mail a signed letter explaining that you had no income rather than not filing. You see, the IRS does not know that you had no income and will assume that this is a deliberate attempt to evade paying taxes.
- Underreporting Income-Your business may be operating on a cash basis, but there are still other ways the IRS can track your income. A perfect example is IRS form 1099. Companies must provide 1099’s to all vendors to whom $600 or more during the tax year. Even when you did not receive a form 1099 for income received, you should still report the income. The IRS categorizes underreporting income as filing a fraudulent return. When a tax return is fraudulent, there is no statute of limitations for how long the IRS can audit you.
- Taking excessive deductions or claiming false deductions- can trigger an IRS audit. The IRS knows that allocating expenses to COGS is the only legal way for Cannabis businesses to deduct expenses. They are also aware that some companies are packing as many costs as possible into COGS. Consequently, Cannabis businesses are scrutinized much more closely for these types of deduction abuse. IRS has tools to help them determine if your deduction allocations are reasonable. One such tool is the Industry Classification Benchmarking (ICB) program. The ICB program compares your business expense deductions to other businesses in your industry. If the deductions you claim are significantly higher than companies in your industry, the IRS will likely question their legitimacy.
- Commingling funds-Commingling is the term the IRS uses when referring to the mixing of personal and business funds or using the funds from one company to pay for the expenses of another company. Because the industry is highly unbanked and most companies operate in cash, it is easier to fall into that trap. It is simple for the IRS to verify which transactions are business or personal. When you commingle funds, you risk losing your license, your business, and your personal assets as well.
- Failure to file the correct supporting documents, such as Form 8300- Businesses must file Form 8300 whenever $10,000 or more is received in cash for one or more related transactions. Failure to file this form is considered money laundering and may result in imprisonment or a fine of up to $3,178,500. Related transactions are multiple purchases or sales of a similar nature within 24 hours.
- Consecutive losses. If you’ve lost money in three of the last five years, this could be looked at suspiciously by the IRS. Although the IRS considers this a red flag, there are many reasons businesses have losses for several years in a row. For example, if your business is a startup or growing, you will not likely turn a profit immediately. However, the IRS may classify your business as a hobby. If that happens, all deductions are disallowed, and you still must pay taxes on any income derived from the venture.
Knowing what triggers an audit is vitally important, but having a strategy to avoid or manage these triggers is even better.
The first thing you can do is make sure your books and records are complete, accurate, and well organized. Keep meticulous records. All transactions must tie out to a source document such as a receipt, invoice, checks, purchase orders, etc. Keep track of all transactions made through your business, including cash transactions. It will be much easier for you to gather the necessary information when requested by an IRS auditor and help you prevail in an audit.
Create a perpetual data room. A perpetual data room is a digital file cabinet to store all your important business documents, such as corporate formation documents, partnership agreements, invoices, receipts, bank statements, 1099’s, etc. Having all of your essential documents in one place will make it much easier for you to respond to any IRS audit quickly and accurately.
Lastly, make sure you thoroughly understand 280e and how these restrictions impact your cannabis business. Hire accounting and tax professionals who understand the restrictions caused by 280e, know what can and cannot be deducted, and how to correctly allocate these deductions to ensure that they are allowed by the IRS.
If you follow these tips, you can help ensure that your cannabis business does not fall victim to an IRS audit. If you find yourself on the wrong side of the IRS or you want to ensure that your business receives a no-change decision in case of an IRS audit, reach out to us at https://getvanda.com/.
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