Being audited is like being pulled over by the police: even though you’re sure you haven’t done anything wrong, you can’t be 100% sure they won’t find something amiss. We’ve previously written about the dangers of being audited. Now, let’s dig even deeper into financial matters and discuss five cannabis finance missteps that could raise red flags and trigger an IRS audit. 

Underreporting Income, Especially Cash Transactions

The IRS prioritizes audits in the cannabis industry because of the high risk of unreported cash transactions and requires all cash transactions over $10,000 to be reported using Form 8300.  Also known as Suspicious Activity Reports, or SARs, these won’t give you a respiratory ailment, but they can give you a heart attack if you aren’t filing these timely, and keeping an accurate and live log. 

Due to banking restrictions, cannabis businesses are often forced to operate primarily in cash. This reliance on cash makes cannabis businesses more likely to underreport income, as cash-only transactions are inherently harder to track and report — there is no digital paper trail. But if there’s no digital paper trail, how does the IRS even know a business has been underreporting its income? To paraphrase Ant-Man, “The IRS always finds out.”

As the law firm Hendershot Cowart P.C. points out, the IRS has multiple methods for determining if a cannabis business is underreporting income, including checking a vendor’s 1099 report against reported income. If a vendor reports income but you neglected to file a return, you might get flagged. 

The IRS also uses industry benchmarks, and if your deductions exceed the industry’s norms, you might get flagged. Additionally, auditors can — and frequently do — open up previous and subsequent periods for review, thus turning a one-year audit into a three-year audit. So, if another vendor, partner, or business associate is also being audited, guess what? You might also be audited.

Inaccurate or Incomplete Recordkeeping

Keep good records and stay organized, because failing to do so is a big red flag for the IRS and a substantial financial misstep. Stay on top of your recordkeeping; maintain meticulous sales, purchase, payroll, and expense records. All businesses are required to keep records for at least seven years. Incomplete or missing documentation can raise a red flag that may prompt an IRS audit. Haphazard payment trends — such as large changes in monthly sales or, conversely, reporting identical sales figures for several successive months — can also raise a red flag and are certainly financial missteps.

Pro-Tip: Maintaining an audit-ready “room,” be it a physical room with paper files, or a thumb drive that kept in secure storage – not a backup to the cloud – this audit-ready status will include the following items:

  • Corporate Federal and State Tax returns
  • Various state and local tax filings
  • Copies of your company formation documents.
  • Copies of your IRS EIN letter, state equivalent.
  • Backups of your QuickBooks software (weekly or more frequently)
  • Point of Sale software registers (weekly or more frequently)

Staying audit-ready can allow for rapid production and review of records, provide investors and regulators alike with peace of mind that your operation is maintained in good standing, and prevent from small problems, which lead to larger problems: like losing your cannabis license. 

Improper Deduction Claims Under Section 280E

IRC 280E prohibits businesses from deducting otherwise established business expenses from gross income associated with the “trafficking” of Schedule I or II substances. What you can deduct is referred to as the Cost of Goods Sold (COGS), and these deductions will apply more to cultivators than to retailers.

General and administrative expenses, research and development, and sales and marketing expenses are among those that are generally not allowed as deductible expenses. Having said that, you can’t go wrong with erring on the side of caution when it comes to what you deduct. You can try your luck, but the adage about “is the risk worth the reward” should ring in your ears whenever you question a deduction.

The implementation of IRC 471(c) in 2018, as part of the Tax Cuts and Jobs Act of 2017, this provision allows for the proportional reallocation of inventory-specific expenses to the cost of goods sold, with appropriate documentation, of course.  You should speak with your tax accountant if they’re familiar with implementing 471(c) to offset 280E restrictions.

Don’t risk an audit — and quite possibly a substantial fine — by making illicit deductions.

Filing Late or Inaccurate Tax Returns

Don’t be Cinderella and let your carriage turn back into a pumpkin. Turn in your taxes by the due date, because you risk more than just your ride turning back into a giant gourd; you can risk an audit, which can be expensive and exhausting. Also, make sure your information lines up when reporting to local, state, and federal authorities. If you report higher sales to the state than to the city, guess what?  Are your taxes compounded? Stacked?  Know the difference.  Establish the tax basis for every level of taxation, as part of a comprehensive SALT compliance and reporting schedule.  You might be throwing out a red flag for an audit if you don’t.

Payroll and Employment Tax Issues

Finally, make sure you handle your federal employment tax obligations. If you don’t withhold and remit payroll taxes or file employment tax returns, you are effectively creating a red flag that can be seen from space.  Proper financial planning from a good CFO helps effect proper trust account financial planning and analysis, making you keep funded and compliant.

Further, as the payroll company Paragon Payroll warns, payroll and tax records are usually the first documents regulators inspect during an audit, and any discrepancies can trigger deeper investigations.  Thus, keep your 941 and 940 returns on hand or in electronic format for your audit-ready “room.”  Keep your state employment tax returns in the same fashion.

Work smarter, not harder.

Conclusion

You wouldn’t drive your car at night if it had a taillight out, the license plates were missing, and there was a dog leash attached to one of the door handles. It’s just asking to be pulled over. Similarly, your cannabis business shouldn’t send out a bunch of red flags that are just begging the IRS to audit you. Don’t underreport your income; maintain robust recordkeeping; don’t make foolish deductions; file your returns on time; and adhere to all payroll and employment tax requirements. If you avoid these cannabis finance missteps, you’re much more likely to avoid being audited.