Key Takeaways:
- Cannabis businesses face heightened scrutiny from state and local tax auditors due to the industry’s complex, multi-layered tax structure.
- Common audit triggers include discrepancies between point-of-sale data and filed returns, improper excise tax calculations, and failure to remit collected sales and excise taxes.
- Conducting a pre-audit review and maintaining clean, well-documented records can significantly reduce state and local tax audit risk and exposure for cannabis operators.
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Operating a cannabis business means navigating one of the most complex tax environments of any U.S. industry. Between federal restrictions, state-specific excise taxes, and a growing wave of local tax ordinances, the state and local tax (SALT) landscape for cannabis is anything but straightforward — and regulators are paying close attention.
If your cannabis business has not yet been audited, there is a good chance it will be. States that have legalized cannabis typically give operators about three years to get established before launching audit programs. Missouri, for example, began auditing all cannabis dispensaries in early 2025.
If you’re not prepared, an audit can freeze refunds, trigger costly assessments, and pull your attention away from running your business. Here is what you need to know about how cannabis businesses get flagged — and what you can do to stay ahead of it.
Common State and Local Tax Mistakes That Raise Red Flags
Several missteps consistently put cannabis operators at greater audit risk, many of which stem from the industry’s unusual tax structure rather than intentional noncompliance.
The most common issues auditors encounter include:
- Collecting sales or excise tax but not remitting it: This discrepancy is one of the first things auditors look for. Whether due to cash flow pressures or administrative gaps, failing to pass collected taxes on to the state or locality creates immediate exposure.
- Filing returns without paying the tax: Some cannabis businesses file their returns on time but do not pay the corresponding tax. While filing without paying is better than not filing at all — it limits the basis for any state-issued jeopardy assessment — it still invites scrutiny.
- Missing locality-specific cannabis taxes: Unlike most consumer industries, cannabis operators may owe not just state-level excise taxes but also separate local taxes layered on top. Some of those taxing jurisdictions are small municipalities that adopted cannabis taxes when state law permitted it. Missing even one obligation can create a significant gap.
- Errors in tax stacking for vertically integrated operations: For cannabis businesses that handle cultivation, manufacturing, and retail under one roof, excise taxes may apply at multiple points along the supply chain. In states like California, the order in which those taxes are calculated is legally prescribed, and errors in the stacking sequence can trigger assessments on audit.
What State and Local Tax Auditors Are Looking For
When a state or local tax auditor examines a cannabis business, the review typically covers several distinct areas. Understanding what they are looking for — and in what order — helps you anticipate where exposure might exist.
Sales and Excise Tax Returns
Auditors almost always start by comparing your point-of-sale (POS) system data to your filed sales and excise tax returns. If those numbers do not reconcile, auditors have grounds to dig deeper. Beyond that, many states require cannabis operators to maintain Marijuana Enforcement Tracking Reporting Compliance (Metrc) records tied to your cannabis license, and auditors will compare those reports against your filings as well. Discrepancies between Metrc data and reported figures can trigger significant additional scrutiny.
Auditors also closely review whether you have properly identified your taxable base. Cannabis businesses that use cashless ATM systems or card-adjacent payment processors have found that auditors increasingly consider those processing fees part of the taxable base. This is a newer area of focus that many operators do not anticipate. Understanding exactly what your state and local laws treat as taxable revenue is critical.
Income Tax Returns and the 280E Question
On the income tax side, auditors are increasingly focused on how cannabis companies handle the Section 280E deduction limitation. Recently, medical cannabis was rescheduled at the federal level, eliminating the 280E prohibition for medical cannabis businesses on their federal returns. Recreational cannabis businesses, however, remain prohibited from deducting ordinary and necessary business expenses — a restriction that could change significantly if federal rescheduling of recreational cannabis moves forward.
It’s also important to remember that these changes do not automatically affect state tax treatment. Many states (but not all) have decoupled from the 280E federal restriction, allowing the deduction on state income tax returns. Michigan, for example, decoupled only for adult-use cannabis, not medical, and created a specific audit task force to review whether businesses had properly applied that distinction. Knowing your state’s 280E decoupling position is not optional, it’s fundamental to filing your income tax returns correctly.
Auditors also examine Section 471(c) cost of goods sold (COGS) deductions. This provision allows certain small business taxpayers to take a broader COGS deduction, but many auditors are unfamiliar with it. Because federal taxable income is the starting point for most state income tax calculations, how you calculate COGS at the federal level flows directly into your state return — and can become a significant point of contention.
How to Prepare Before the Auditor Knocks
The most effective thing you can do is conduct a thorough pre-audit review before you ever receive an audit notice. Think of it as an internal dress rehearsal: identifying gaps and correcting them proactively is far less costly than managing the same issues under the pressure of an active audit.
Reconcile Your Records
A solid pre-audit review starts with reconciliation. That means comparing your POS data to your filed sales and excise tax returns, verifying that your state Metrc reports tie out to those same filings, and confirming that you have documentation to support any exemptions or deductions you claimed. You should also review whether you have properly self-assessed use tax on purchases where your suppliers did not collect sales tax from you — this is a common oversight that auditors regularly catch.
Review Your Invoices and Sales Receipts
Each invoice and sales receipt should clearly and separately identify every tax charged — state sales tax, state excise tax, and any applicable local taxes — along with how each was calculated. For vertically integrated operations, internal transfer invoices between related entities should reflect the same level of precision. If an auditor asks for copies of invoices and finds that taxes are not separately stated or that the calculation method is unclear, it creates additional ground for dispute.
Stay Current on Law Changes
State and local cannabis tax laws are not static. Michigan introduced a new wholesale transfer excise tax on adult-use cannabis at the start of 2025. Other states are actively expanding the scope of what is taxable, adjusting rates and creating new local tax opportunities. Meeting with a SALT professional at least once a quarter — not just at year-end — helps you stay aware of changes before they create compliance gaps. A monthly reconciliation process, supported by a consistent checklist, keeps your records audit-ready at all times.
Expect To Be Audited
Don’t view an audit as a “might happen”, view it as a “going to happen”. Building that expectation into how you operate, rather than reacting to it after the fact, puts you in a far stronger position — and keeps your energy where it belongs: running and growing your business.
How MGO Can Help
Our dedicated Cannabis team includes state and local tax professionals who bring deep industry knowledge to every engagement. We understand both the tax law and the operational realities of cannabis businesses, which means we can interpret audit requests accurately, advocate effectively on your behalf, and help you build the processes needed to help you stay compliant as the regulatory landscape evolves.
Reach out to our team today to assess your state and local tax exposure and make sure your cannabis business is ready for whatever comes next. A preaudit of your POS System and your backend compliance process is the starting point. MGO is here to mitigate your tax exposures and improve your tax protocols.