IRS audit. One of the most stressful phrases for a business. Finding those words in big red bold letters printed on an IRS envelope is never a happy discovery for business owners, particularly in the cannabis industry.
But how frequently are IRS audits occurring in the cannabis industry? More importantly, have they been increasing?
While IRS audits of cannabis businesses may make headlines, the IRS denies targeting the cannabis industry more than any other. Officially, the IRS takes a position that audit activities focus on taxpayers at high risk of non-compliance, and apparently, organizations in the cannabis industry fall within this category – warranting any IRS audit of a cannabis business and justifying a seemingly unbalanced focus on the industry.
Compliance Initiative Projects (CIPs) are the formal title for the IRS’s targeted audit programs of non-compliant taxpayer groups and industries. Typically used for discovering instances where taxpayers and businesses might have underpaid their federal taxes, recent activities in the cannabis industry paint an unsettling picture. Since 2010, the IRS has disclosed 5 CIPs targeting cannabis businesses, one of which (occurring in Colorado between 2016-2017) revealed over $43 million in unpaid federal taxes.
Read More: High profile cases like IRS vs. Harborside make public examples of businesses found in non-compliance.
This worries some cannabis industry leaders, who see the return on the IRS CIP investment as a troubling sign. Like any organization, the IRS must have an operational focus on the return of their investments at any given time. An audit ROI can be measured by dividing the total amount of unreported taxes discovered during the audit by the total number of auditor hours.
In the CIPs mentioned, the IRS auditors generated twice as much revenue in discovered unreported taxes as their average hourly revenue from any other industry. Some see this return as quantifying evidence of the financial incentives for the IRS to target the whole industry.
Considering the revenue precedent demonstrated by the CIPs launched since 2010, the incentive for IRS auditors to target cannabis businesses seems fairly obvious, but we should note that CIPs can only reveal taxes that operators should have already paid under the law.
So, are cannabis businesses more likely to try and misrepresent their financials? Or is it possible cannabis tax regulations are overly complex and lead to inadvertent underpayments?
IRS documents detailing the industry CIPs reveal troubling trends in the cannabis industry. Specifically, these documents reveal that, on average, only 3% of the cannabis businesses examined had no errors or adjustments on their tax returns – this stands in stark contrast to the 21% average found in other industry audits. If only 3% of examined cannabis businesses had no errors, it likewise means that 97% of businesses did.
On top of the seeming prevalence of inaccurate cannabis tax returns, IRS auditors also found that the average time needed to complete an audit on a cannabis business was 1/3 less than the time spent on businesses in other industries.
As more areas incorporate cannabis legalization, it stands to reason that IRS audits of cannabis businesses will increase in number. It remains unclear if the cannabis industry is being unfairly targeted, or why the average amount of unpaid taxes is so high. Again, the IRS’s official position targets “high-risk” businesses, but as long as the risk assessment for the cannabis industry remains high, cannabis business owners should expect CIPs and more industry audits to continue.
The best way to prepare for an IRS audit is to secure the services of a CPA that specializes in the cannabis industry. Not only will this help a business prepare for the disruption that an IRS audit might cause, but it can also prevent disastrous financial judgments that might be insurmountable when discovered. Cannabis CPAs should be experts in 280e compliance and 471 (which covers general inventory reporting requirements). Cannabis business owners should consult with marijuana accounting firms, working together to help reduce the amount of unpaid taxes in the industry overall and likely decreasing the ‘high-risk’ designation that the industry currently demonstrates.