Key Takeaways:
- Prepare for a cannabis tax audit by retaining 10 years of thorough financial records, using GAAP-compliant accounting methods, and staying current on all federal tax obligations.
- Work with experienced cannabis accountants to document tax positions, accurately track COGS, and respond quickly to any IRS audit notice.
- If faced with unfavorable audit results, consider appealing through the IRS Independent Office of Appeals or, if necessary, pursuing Tax Court.
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As a cannabis business owner, you operate in one of the most heavily scrutinized industries in America. With Section 280E hanging over all plant-touching activities and limiting business deductions, you’re already carrying a heavy tax burden. So adding a potential audit to the mix, it’s understandable why tax compliance might keep you up at night.
But here’s the good news: with proper preparation, you can significantly reduce both your audit risk and potential negative outcomes — and with professional support you may even be able to negotiate a reduction or amendment. Let’s walk through a comprehensive strategy to help you prepare for and survive during an IRS examination.
Your Four-Step Cannabis Audit Preparation Plan
Taking proactive steps now can save you significant headaches (and money) later. Here’s how to get your cannabis business audit-ready:
1. Retain Proper Documentation (For At Least 10 Years)
The foundation of audit defense is comprehensive documentation. In the event of an audit, you’ll need to provide evidence of every transaction under IRS review. These documents must be organized so they can be quickly retrieved and linked to general ledger entries.
Essential documents to preserve:
- Financial statements (trial balance, profit and loss, balance sheet, chart of accounts, etc.)
- Point of sale transaction data
- Invoices, receipts, and purchase orders
- Credit card statements
- Agreements (intercompany, licensing, management, etc.)
- Cash logs (especially important!)
- Payroll documentation and independent contractor agreements
- Rent payments, property tax bills, utilities bills, and other overhead documentation
Since the IRS can leverage an extended statute of limitations when income tax is “substantially understated”, you should save most documents for 10 years and critical formation documents indefinitely.
2. Establish Proper Accounting Methods
Your accounting and record-keeping should align with generally accepted accounting principles (GAAP) guidelines, particularly for inventory accounting — the key to managing 280E exposure.
Critical accounting practices:
- Accrual method of accounting: As a business that uses inventory accounting and reports cost of goods sold (COGS) expenses, you’re generally required to use accrual accounting. This means assigning values to inventory items based on acquisition and development costs.
- Understanding COGS: Your COGS must reflect actual costs of goods sold — not merely renamed ordinary expense deductions. Identify each expense and correctly categorize it as direct or indirect. When allocating selling, general and administrative (SG&A) expenses, they should specifically tie to production costs (not just be a generic percentage of overhead).
- Straight-line depreciation: Recent IRS cases and guidance establish that only straight-line depreciation methods (used for book purposes) are allowable for inclusion in COGS. Bonus depreciation and modified accelerated cost recovery system (MACRS) are not authorized.
3. Stay in Compliance with Federal Tax Law
This may seem obvious, but it bears repeating: the best way to stay off the IRS radar is to pay your taxes. Not paying is the reddest flag of all.
With limited access to banking services and capital, some cannabis operators are tempted to treat delinquent tax payments as a financing tool. While it may seem attractive for cash flow, it dramatically increases your audit risk.
This applies doubly for federal employment taxes (withholding, FICA, etc.), where penalties and interest are severe. The IRS imposes the Trust Fund Recovery Penalty against “responsible persons” in their individual capacity, at 100% of the underlying tax liability.
Remember, cannabis companies are not eligible for bankruptcy protection. If your business is structured as a pass-through entity (LLC or S-corporation), tax debts become your personal liability.
4. Proactively Document Accounting Policies and Tax Positions
If there’s any confusion about accounting practices or you lack back-office support, hire an experienced cannabis accountant to:
- Perform a 280E/COGS study to identify appropriate tax treatment
- Determine whether your “separate trade or business” truly qualifies as separate
- Address outstanding tax balances with an installment agreement or “offer in compromise”
- Review document creation/retention policies
- Ensure inventory accounting procedures align with GAAP/International Financial Reporting Standards (IFRS) rules
Receiving an IRS Audit Notice: Your Action Plan
If you receive an audit notice, don’t panic. Follow these steps:
1. Understand the Situation
The IRS conducts several types of audits — from relatively simple correspondence audits to intensive field audits where they visit your facility. Note that the IRS will first contact you via traditional mail (never by phone or email).
2. Act Immediately
Initial IRS contact letters typically require a response within 10-30 days. Don’t procrastinate. Reach out to a cannabis-specialized accountant immediately and execute a power of attorney so that your representative can contact the IRS auditor within the required timeframe.
3. Work With Qualified Professionals
An experienced representative will know cannabis accounting inside and out, have experience navigating audits, and may even have connections at the IRS. They’ll help minimize risk and potentially negotiate a reasonable outcome.
4. Set the Right Tone
From the outset, build rapport and credibility with the IRS auditor. Organize document production, establish a reasonable timeline, and follow through on commitments.
5. Be Transparent About Known Issues
The IRS examiner is trained to identify errors and problems. If you know there’s a glaring error in your tax return or a gap in record-keeping, consider presenting it upfront. Reluctance may be perceived as fraudulent intent, whereas transparency might earn goodwill from the auditor.
Challenging Unfavorable Audit Results: Your Options
If your audit doesn’t result in a manageable outcome, you have options:
1. Appeal
The IRS Independent Office of Appeals offers a path to resolving disputes without litigation. To successfully navigate this process, you’ll need to clearly present your case, provide all supporting documentation, and demonstrate where the IRS assessment went wrong.
2. Tax Court
As a last resort, you can take your case to U.S. Tax Court. While there have been some successes (Harborside reduced their tax bill from $29 million to $11 million), note that every attempt to overturn 280E has failed in Tax Court. Consider whether potential savings justify the resources invested in litigation.
Beyond the IRS: State and Local Tax Risks
Don’t forget that maintaining compliance with state and local tax laws is equally important. State and local regulators issue your licenses and are directly connected to tax enforcement. Even a minor tax infraction at the local level could lead to license revocation.
Types of audits to keep in mind:
- State income tax
- State sales and use tax
- State excise tax
- Local business tax
Take Control of Your Cannabis Tax Strategy Today
Being “audit-ready” not only helps you navigate an IRS examination but also implements financial best practices that benefit your business in numerous ways — from regulatory compliance to preparing for potential acquisition or initial public offering (IPO).
The cannabis industry presents tremendous opportunities for entrepreneurs ready to forge new paths. But significant risks await the unprepared. By following these guidelines, you’ll be positioned not just to survive an audit, but to thrive in this challenging regulatory environment.
How MGO Can Help
Our dedicated cannabis accounting, audit, tax, and consulting practice help organizations of all sizes — from multi-state operators to pre-revenue startups — 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.
We also offer tax advocacy and resolution services — including pre-audit readiness, audit representation, and guidance on obtaining penalty abatements and negotiating installment agreements.
Reach out to our Cannabis team today to find out how we can help support your business.