Why IRS Cannabis Audits Are Likely to Increase and How You Can Prepare

Why IRS Cannabis Audits Are Likely to Increase and How You Can Prepare

by Mike Goral
May 04, 2021

Insight into the IRS’s internal thought process toward cannabis company audits was recently uncovered through a Freedom of Information Act request initiated by MJBiz Daily. While the documents primarily discuss old audits conducted between 2012 and 2019, they do provide a unique look as to why the IRS may target the cannabis industry for future audits.

Cannabis Audits Are More Lucrative

It’s fairly common knowledge that the IRS has been conducting audits in the cannabis industry for several years. However, the documents revealed the significant financial incentives that the IRS benefits from by auditing cannabis companies compared to other industry groups. For instance, the report discloses that a 2012 cannabis audit generated an average of $945 per hour in a tax assessment versus $544 an hour from a non-cannabis business.

This disparity continued to deepen, despite expanded legalization. As several states, including California, changed their policies to permit adult cannabis use by 2019, the average hourly assessment rate increased to $2,752 from marijuana industry audits versus $1,065 from mainstream businesses. With the average hourly audit assessment rate almost tripling within the cannabis sector and when compared to non-cannabis industries over this period, the IRS’s financial motivations are apparent.

Additionally, the report showed only 3% of cannabis returns had no errors or adjustments, as opposed to 21% in other business areas. These documents also revealed that cannabis reviews took one-third the time of other industry groups. While an IRS representative denied that it targets marijuana businesses over other companies, given these figures, there are clear justifications for the agency dedicating more resources to reviews of cannabis companies.

The IRS found that marijuana returns in the “Western Area” resulted in the highest average per hour assessment in unpaid taxes — with IRC 280E being the main audit issue. As a result, government auditors can concentrate their efforts surrounding cost of goods sold (COGS) deductions rather than spending time on a wide variety of code sections that come into play in other industry groups.

Prepare Your Organization for Increased Scrutiny

Those that had expected the Biden administration to take a less aggressive approach toward cannabis companies will find the above information disappointing news. Based on the recent cannabis audit cases that have been made public, it’s clear that taking aggressive tax positions could be costly for taxpayers. If your organization has been taking this kind of approach, it may be time to rethink your strategy and get your financials aligned to stand up to more rigorous scrutiny by the IRS.

We’ve defended numerous cannabis clients successfully through the audit process and have seen that having good records and supporting documents to justify IRC Sec. 208E deductions is critical. You should also consider adding additional reserves from uncertain tax positions, as it is clear we can expect the IRS to continue targeting cannabis companies.

Reach out to our Cannabis experts if you have questions or want to learn more about preparing for an audit.

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