Businesses that base operations around schedule I or II drugs are typically audited by the Internal Revenue Service (IRS) at a higher rate than a “normal” business. Being in the cannabis business it is likely you will receive some type of tax audit throughout the life of your business because of this unfortunate reality. If you follow us on Instagram you probably know we always tell our audience to be audit ready at all times. Want to know what “be audit ready” means? Redbud Advisors will walk you through it and teach you How to Avoid the 4 Tax Audits Cannabis Businesses Face.
The IRS has 4 types of tax audits, all very different in intensity.
Taxpayer Compliance Measurement Program (TCMP) Audit
As we have said before- The best offense is a good defense. Before an audit is issued the number one thing a business can do, especially a business in the cannabis industry, is be audit ready aka having a good defense.
A month-end checklist is a good example of a process to have in place to close out the month.
What Does it Mean to Be Audit Ready?
As a cannabis business owner, it is imperative to have impeccable record-keeping, remember the businesses in this industry are audited at a higher rate than others. If record-keeping is not a strength you possess it is time to hire the pros- this will save you time, money, and a migraine.
Redbud Advisors recommends cannabis businesses have daily, weekly, monthly, quarterly, and yearly processes in place to ensure all aspects of accounting and taxes are handled timely.
A month-end checklist is a good example of a process to have in place to close out the month. Below is an example month-end checklist Redbud Advisors has their clients complete by the 7th of every month.
Redbud Advisors Month-End Checklist
Credit Card statements
New contracts or leases
New debt or equity
All checks written
All payroll reports
All sales reports from POS
Inventory counts - monthly
State Compliance Reports
New Employee / Terminated Employee information (if applicable)
Physical count of cash on the last day of the month that reconciles with Cash Log
In addition to having processes in place, it is important to have supporting documentation for all of the business tax returns. If your business is being audited by the IRS the more information you can provide to back up any claims the better.
The specific vertical in the cannabis industry can warrant more intricate processes but a combination of all of the advice above is a step in the right direction. We encourage you to reach out to Redbud Advisors to discuss your specific needs to ensure all bases are covered.
Now that you are headed in the right direction to being audit-ready let's get to the 4 types of tax audits.
4 Types of Tax Audits Cannabis Businesses Face
Correspondence Audit- Most Common Tax Audit
The first audit a business will receive is a correspondence audit. This will be in the form of a letter mailed to your address on file with the IRS. This type of letter will generally be referred to as a 566 letter. If this is the letter the cannabis business owner receives more than likely the IRS is requesting documentation to support the cannabis business filings or the information in question.
Another letter associated with the correspondence audit a cannabis business may receive is the CP2000. This letter is sent when information on the tax return differs from what the IRS has on file for the business. This notice will recommend an adjustment to your account for overpayment/underpayment.
As a business owner, ignoring IRS communication in any form is not advised. If you need more information about how to handle IRS communication check out our blog 5 Tips from Cannabis Tax Experts: Navigating IRS Letter.
The correspondence audit is the most common type of tax audit, 3/4 of tax audits are correspondence audits.
A tax auditor is a trained professional, it is their job to find damaging information. Redbud Advisors recommends anyone summoned for an office audit bring a tax professional along to reduce the risk of damages and the auditor expanding the initial scope.
The Office Audit- Escalated Tax Audit
The next step in the escalation of tax audits is the office audit. When the IRS needs more in-depth information it isn’t ideal to send a letter. The IRS will summon business owners by mail to an office locally to conduct the audit. The office audit is a Q&A style audit.
An office audit is commonly about itemized deductions, business profits/losses, and rental income/expenses. These are common topics for an office audit but the audit is not limited to only these topics. A business owner should be prepared to answer a wide variety of questions about their cannabis business. It is important not to offer up information that is not asked by the auditor. A cannabis business owner giving too much information can do more harm than good.
A tax auditor is a trained professional, it is their job to find damaging information. Redbud Advisors recommends anyone summoned for an office audit bring a tax professional along to reduce the risk of damages and the auditor expanding the initial scope. With a Cannabis tax expert by your side, the audit will be fairly matched- professional v. professional.
As a cannabis business owner, a tax professional should be a priority given the nature of the industry and the hurdles to overcome with the IRS. If you receive a letter to come in for an office audit we recommend calling a cannabis tax professional and getting them up-to-speed. Redbud advisors are always up for a challenge.
This industry is audited at a higher rate than most, meaning as a cannabis business owner an audit could happen at any time.
Field Audit- Invasive Tax Audit
The field audit is an invasive tax audit. The auditors will come to your cannabis business or home. Field audits are carried out by IRS revenue agents who specialize in specific areas where other IRS representatives may not.
A field audit goes far beyond reviewing documents. The specialized agents may want to ask your employees questions, see financial statements, and even tour your facility. This type of audit is not limited to these circumstances and can go well beyond this scope.
The field audit time frame will vary based on the extent of the audit. As we advised previously it is essential to have a tax accountant present during these types of audits. It is even better to have both, a cannabis tax expert and tax attorney, present at the time the audit begins and until the audit ends.
Taxpayer Compliance Measurement Program (TCMP) Audit- Intensive Audit
The TCMP audit is performed by random selection. The taxpayers who are selected for this audit will need to show proof of every line item on their tax return. If you have ever been through this type of audit you understand why it is referred to as the audit from hell.
Essentially, the TCMP audit is a taxpayer providing documentation for every line item on their tax return showing they are not under-reporting income or over-reporting deductions. If any errors are discovered, the taxpayer risks additional taxes, interest, and penalties.
When a TCMP audit is performed the data collected is used to update the IRS’ discriminant function (DIF) system. A taxpayer's DIF score is what will trigger an audit. The higher your DIF score the higher chance of you or your business being selected for an audit. Being in the cannabis industry already stamps the “high risk” label all over your tax returns. The TCMP audit feels like an endless cycle. If you are ever selected for a TCMP audit having an accountant and tax lawyer present is the best way to potentially minimize additional taxes, fees, and penalties.
As a business owner in the cannabis industry, it should be clear by now to Keep. All. Documents. This industry is audited at a higher rate than most, meaning as a cannabis business owner an audit could happen at any time. Being a disciplined business owner and keeping detailed records is crucial to nip an audit in the bud.
If the IRS sends a letter notifying you of an audit on your business you should have a better understanding and more knowledge about what to expect with each type of audit. Remember to always respond to IRS communication, if requested, as soon as possible and never ignore it.
Redbud Advisors recommends having a cannabis tax expert, not just your average accountant, on your team to assist with keeping your business in compliance. A cannabis accountant is versed in the intricacies of this industry and is better specialized in how the tax codes and laws apply.