Dear Clients and Colleagues:
In recent months, there has been a significant increase in Internal Revenue Service audits of cannabis businesses in California and elsewhere. The reasoning is likely a combination of cannabis businesses being high-value targets given the nuances and challenges of IRS Regulation 280E, and the fact that the IRS is gaining bandwidth as the impact of COVID on staffing subsides. Thus, we have seen a number of clients receive audit notices for the 2019 tax year.
As a reminder, under IRS Regulation 280E, cannabis plant-touching business unlike other businesses are prohibited from taking ordinary business deductions because of the federal status of cannabis as a controlled substance. The full text of 26 US Code section 280E reads as follows:
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.
This will remain the case until there is federal legislation that either re-schedules cannabis or otherwise provides relief from this draconian tax rule. In the interim, IRS Reg. 280E allows cannabis businesses to “deduct” costs of goods sold, or “COGs”, which are technically not considered a deduction but rather an above the line reduction in gross profit. In any case, a cannabis business may reduce its taxable income by deducting COGs. This is much more helpful to producers (cultivators and manufacturers) then to retailers and distributors, since producers have a much greater ranger of COGs then retailers who can generally only deduct product acquisition costs.
We have defended a number of clients in 280E audits. We have also advised clients in how to mitigate the impact of 280E in the event of the audit by better identifying in their financials potential COGs. If you have received an IRS audit notice or wish to become more familiar with IRS Regulation 280E and its contours, please let us know.
Apart from tax return audits, the IRS has also ramped up its enforcement of Form 8300 requirements as to cannabis business. This generally requires reporting to the IRS the receipt of more than $10,000 in cash.
26 US Code section 60501 provides any business that receives a cash payment to file an information return with the IRS – Form 8300 – within 15 days of the day the payment is received. In addition, the business is required to send the person providing the cash with a “payee statement” under 26 USC section 6722 notifying them that the receipt of cash has been reported to the IRS. The failure to timely file both the information returns and the payee statements can result in the imposition of fines and penalties, and in egregious situations where there is an intentional disregard for the reporting requirements criminal charges could be filed.
While cannabis businesses are increasingly able to obtain bank accounts and conduct business through platforms that are linked to bank accounts, there are still many transactions that are conducted in cash, even for businesses with bank accounts. Accordingly, it is important to understand the contours of the Form 8300 requirements, which are not entirely obvious. For example, many businesses assume that they do not need to report the receipt of cash in amounts below $10,000, but that is not always the case. If a business sells more than $10,000 in product and receives payments in installments, those payments that aggregate more than $10,000 must be reported when related to a single transaction invoice. In addition, where multiple transactions are conducted between the same buyer and seller within a 24 hour period, they too need to be aggregated and reported.
What is less obvious and relevant to multi-state operators and other businesses that operate through different entities or use management companies is that the receipt of cash from a related entity to pay, for example, rent, is also considered a Form 8300 reportable event by the IRS. We have even seen the IRS take the position that where one entity transports cash to the bank for a related entity it is required to file the Form 8300.
We have defended clients in 8300 audits and can assist you if you receive an audit notice. In addition, we can assist you in creating protocols designed to comply with 8300 reporting requirements. In the event of such an audit, the IRS would take into consideration the existence of having such protocols in place and it would very likely lead to lesser fines and penalties.
Please let us know if you have questions or need assistance with these issues
Michael