Marijuana dispensaries are five times more likely to face an IRS cash business audit. In 1970, lawmakers approved Section 280E of the Internal Revenue Code as a punitive measure in the “war on drugs” which was just starting at the time. Until December 2014, cannabis businesses often classified their marijuana as Cost of Goods Sold (COGS) to evade its extreme provisions. But then, the IRS drastically redefined COGS as it pertains to cannabis enterprises.

Under existing law, the business can add the cost of employee time to prep the product onto the actual cost. That loophole is no longer available, as far as the auditors are concerned. There has been some movement to repeal 280E. But given the vast amount of money that the government collects from these businesses, that’s probably not likely.

How Does the IRS Target Cash Businesses for Audit?

Cannabis businesses operate in a legal grey area, and that’s often strike one. However, the IRS obviously needs more than the type of business to increase cash business audit scrutiny. So, if there is further evidence that a cash-intensive business may have inaccurate records, that’s usually strike two. Such preliminary evidence includes:

• Perennial losses or low profit margins that are not consistent with a successful business or that the owner does not seem to correct,
• Bank balances that increase, or debt balances that decrease, as profits remain flat,
• A lifestyle that the reported business profits cannot sustain, or
• Persistently low sales.

In this game, two strikes and you’re out.

Cash Business Audit Methods

Once auditors target cash-based businesses, they first try to use the least invasive means. Typically, an auditor confronts a business-owner with the aforementioned audit badges and gives the owner the opportunity to present a defense. If the auditor doesn’t like the answers, more invasive means are available. The IRS also considers these methods to be very accurate, so they’re used quite often.

• Tax Return Data: The IRS usually compares previous years to the current year, the supporting schedules to the primary return form, and the returns of other similar businesses to the audited enterprise.
• Reliability of Taxpayer’s Information: Unexplained gaps often indicate that the records may be incomplete. Moreover, the IRS has very high standards in terms of records retention. If the taxpayer falls even a little bit short in this area, the Service usually assumes the worst.
• The Minimum Income Probe: As far as the IRS is concerned, these probes are almost absolutely conclusive, so this tool is probably the most common indirect cash business audit and income reconstruction platform. We’ll examine it in detail in a future post.
• LUQ Expenses or Deductions: The IRS also has a method for categorizing amounts that are large, unusual, or questionable. The method is fairly objective, but as the Service likes to point out, tax audits are a combination of art and science.

During this process, examiners commonly ask for cash register tapes or other such records, receipts and invoices, bank deposit records, and reconciliation worksheets. Auditors do not expect the owner to have the same recordkeeping system as everyone else, but they do expect a system to be present.

It’s very important for marijuana dispensaries to know about IRS cash business audit procedures and methods, because it’s usually only a matter of time before the examiners knock on their doors.