IRS Audits Explained
Anyone who files taxes likely bristles at the utterance of the word “audit.” While cannabis companies tend to attract more scrutiny than other businesses, it doesn’t have to be a horrorshow. If your books are clean, accurate, and up-to-date, you’ll breeze through an audit virtually unscathed.
By most estimates, only 1% of all taxpayers will be audited in a given year. Cannabis companies, on the other hand, are far more likely to be audited than companies of similar size in different industries. We can attribute this trend to a 2020 Treasury Dept. report recommending increased audits mainly based on non-compliance with Section 280E.
Nobody wants an audit. But knowing what to expect and how to prepare will make it easier to handle.
What is an IRS Audit?
If you are flagged for an IRS audit, your federal tax return will be reviewed to ensure it is correct and aligns with current tax laws.
During the audit, the auditor will verify expenses and income documents and substantiate all deductions, investments, and other items on your tax return. They aim to ensure that expenses are valid and match what you reported. Any discrepancies may need to be addressed before they can close the file.
Not all audits are conducted in person. Most can be handled through email or other correspondence.
Sometimes, you may be asked to attend an in-person meeting with an IRS agent, or a field agent may conduct the audit at your home or office. The latter scenario is more in-depth and usually happens when there are complex issues or when the feds want to look at an extensive volume of records. During in-person audits, the agent may also want to speak to your employees and partners.
What you can count on is that the IRS and the agent assigned to you will never ask for any documents or information they don’t specifically need, so it is best not to offer.
In the best of all possible worlds, your records will match your return, and no change will be required. If the audit finds a discrepancy, you’ll pay any taxes owed, and everyone can get back to business. If you disagree with the auditor’s summation, you can file an appeal.
Why Are Cannabis Businesses Audited More Often?
There are several reasons why cannabis companies are subject to more audits.
First, Section 280E restricts what can be deducted as a business expense. The IRS wants to ensure you’re following the rules and not deducting that can’t be directly attributable to COGS. If your deductions are excessive compared to the norm for your business model, it’s a massive red flag.
Plus, cannabis is a cash-intensive business. As such, cash transactions will be a focus. The auditor will want to know how you handle cash transactions, how much cash is kept on the premises at any given time, and how surplus cash is managed.
Cash transactions over $10,000 must be reported on Form 8300. Frequent large transactions raise concerns over potential money laundering or tax evasion. You don’t want that kind of attention as it may result in an indirect method audit, which can be far more invasive.
What is the Indirect Method?
The “indirect method” describes an audit strategy used when the IRS feels there is a strong case to support underreporting income but can’t prove their suspicion with more direct inquiries.
Essentially, if the method of accounting does not reflect income, the IRS is within its rights to investigate. Should they choose this route, they may need to establish a net worth for the business’s owners and how much, if any, has changed based on reported income and expenses. In this case, the auditor may broaden their investigation to include conversations with people not connected to the business.
While you might think the indirect method is a little invasive, the IRS has the legal right to do it. In their eyes, determining living expenses and cash inflow is one of the most critical aspects of this equation. If your lifestyle and bank account don’t reflect the business you do, an audit might be headed your way.
What Happens if I’m Audited?
The IRS will let you know about an audit by mail. They don’t use phone calls or other methods of communication.
They will tell you precisely what they want to see, and it’s your job to gather all supporting documentation within the time provided. Usually, you’ll have 30 days.
Pull together the requested documents and prepare to answer any questions the auditor might have about them. If you are undergoing a field audit, the agent may ask detailed questions about deposits, business activities, and cash transactions. The more organized your books are, the easier it is to pull it all together.
How to Mitigate Audit Impact
There’s not much you can do during an audit, but there’s plenty you can do beforehand. Here are a few ideas you can jump on immediately.
· Keep clean books. Your books should accurately reflect all income and expenses incurred. Books should also be reconciled to your business bank accounts to ensure your reporting matches facts.
· File returns on time and pay outstanding amounts promptly. Report all income and file on time. Even if you are claiming a loss, you still need to file. If you owe and can’t pay, there may be options like a payment plan or, in some cases, tax deferral. Filing late or failure to file are among the top audit red flags.
· Report all income and expenses. Use precise numbers pulled from invoices and other documents; don’t estimate or round up or down. Incomplete or inaccurate reporting could indicate to the IRS that your accounting methods are cause for concern.
Final Thoughts
Tax laws in the cannabis industry are in a state of flux. We all hope rescheduling will fix what’s broken, but that’s still a way off. Working with an experienced cannabis CPA ensures you have the guidance you need to keep the IRS at bay. Speak to us today about how we can help.