More IRS Audits Are Coming. Here’s How to Handle Them.

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Image: Luis Louro / Shutterstock.com

It appears the Internal Revenue Service is keeping a close eye on the rapidly growing cannabis industry. The agency expects to audit more cannabis businesses this year than it has in the past.

The industry always has been a target for the IRS, which audits about one in five marijuana businesses each year. In September 2019, the agency announced plans to increase the number of cannabis audits. It followed up in March with a memo indicating the growth of the industry warrants increased “guidance.”

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IRS audits focus on ensuring businesses are adhering to a portion of the federal tax code known as Section 280E, an archaic rule that prevents legal canna-companies from taking standard business tax deductions because they are “trafficking a federally illegal substance.” The section hinders licensed businesses from investing in building improvements, pay raises, benefits, operational expansions, giving back to the community, and much more.

Knowing the IRS is increasing audits, operators should ask themselves where they stand if they become a target and what they can do now to track expenses more effectively. The goal is to reduce your tax burden in the eyes of the IRS, which is looking for every reason not to let that happen.

Even though 280E limits certain deductions, there are expenses cannabis companies can write off. Operators must be careful with what they claim and be prepared to justify their claims. If your major expenses are a result of selling or retailing a Schedule I substance like cannabis, according to the IRS, you cannot deduct those expenses. But expenses related to inventory, cultivation, or other parts of the business that don’t directly involve selling or retailing may be claimed as costs of goods sold, or COGS, which reduces your profit margin and therefore your tax burden on profits. Don’t randomly select a percentage of your business to claim as deductible under 280E. The IRS inevitably will require you to justify the decision.

So, what is deductible? Each business should consult with a cannabis accountant and lawyer to analyze the best approach. Licensees outside traditional retail may benefit from traditional deductions. For example, cannabis growers may claim deductions for raw materials and supplies such as seeds, soil, clones, and fertilizer; labor such as cleaning, trimming, and curing before the finished product is sold; and indirect production costs including repairs, maintenance, rent, utilities, grow supplies, and quality-control and inspection costs.

Knowing the IRS is increasing audits, operators should ask themselves where they stand if they become a target and what they can do now to track expenses more effectively.

The IRS has been skeptical about packaging and delivery labor and material expenses; the agency contends those are costs associated with selling the product because the expenses are part of preparing the product for sale. With proper documentation of labor expenses in the dispensary, some operators have been able to write off costs such as cleaning, checking IDs, selling merchandise, and producing products (if their state allows budtenders to roll joints to be sold later, for example).

Many vertically integrated cannabis companies employ staff members who start their shift in one part of the operation and end it in another. For instance, an employee may trim in the grow during the morning and budtend in the dispensary during the afternoon. The IRS sees those as completely different labor buckets, allowing you to minimize the impact of 280E on labor deductions.

Some businesses have made the mistake of trying to partner with a professional employer organization (PEO) or staffing firm to manage payroll-related taxes in an attempt to miscategorize labor hours as 100-percent exempt from 280E. If employees aren’t categorized correctly, the IRS could decide to audit not just your cannabis business, but also the outsourced company that manages your workforce processes, thus bringing more attention to your business.

If you do get audited, detailed record-keeping is the best way to make sure the process goes smoothly. Documenting every expense—whether it’s real estate, technology, people, or packaging—and ensuring they’re in the correct tax bucket is critical.

It’s time-consuming and expensive but vitally important to work through an audit with attorneys and certified public accountants who are well-versed in cannabis. If your books are in order—an accountant can help with that up front—the process will be less costly and time-consuming.

Evaluate the strategy you’ve implemented for tracking expenses that can be deducted versus those that can’t. Be ready to demonstrate why you’ve deducted certain expenses.

Audits are inconvenient for any business, but their rise in the cannabis industry could signal a move toward federal legalization of marijuana as regulators gain a greater understanding of how much tax revenue the industry generates. After all, the government ended Prohibition in 1933 in an effort to increase tax revenue during the Great Depression.


Keegan-Peterson-Wurk-mg-magazine-mgretailerKeegan Peterson, chief executive officer at Würk, founded the company in 2015 after recognizing cannabis businesses didn’t have access to the same scalable HR technology solutions mainstream companies have. Würk now serves hundreds of clients across thirty-three states, including some of the largest publicly traded cannabis corporations in the nation. Würk pays one in ten employees in the cannabis industry.

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