How Do Auditors Decide What’s Next?
After the background check, personal interview, document review, and other cash business audit steps, there is usually a significant discrepancy between the taxpayer’s declarations about business income and the auditor’s views on this subject. These discrepancies are especially common in marijuana dispensaries. These businesses, and their employees, are so new that the cash-handling procedures are often inconsistent, at best.
However, there is a significant difference between “inconsistent” and “inaccurate.” How does the auditor process all this information and decide whether or not to take the next step?
In the initial interview, the auditor made general queries about the business owner’s cash handling and other practices. Now that more data is available, this cash business audit step usually involves much more pointed questions. Some common ones include:
- Specific payees, dates, and amounts regarding suspect transactions,
- Independent verification, from a lender or other financial institution, of the payee, date, and amount,
- The money’s destination, and
- Other details, such as currency conversion.
The auditor will most likely be very insistent during this stage. For the most part, the records are there, and the auditor will do almost anything to get them. That includes an aggressive follow-up interview with the cash lender or person who made the cash purchase.
Some Specific Marijuana Dispensary Tactics
In this cash business audit step, the two numbers that usually matter most are 280E and 8300.
As discussed in a previous post, 280E is the regulatory section dealing with cost of goods sold (COGS) and controlled substances. When Michigan first allowed medical marijuana, COGS included both the materials and the effort that goes into preparing those materials for sale. But, the IRS very quietly changed the rules at the end of 2014, redefining COGS in this context as only the product and not the preparation time. The sudden change ensnared many Michigan marijuana dispensaries that had been operating under a different set of rules since 2008.
Form 8300 is the cash transaction report form. Marijuana wholesalers, in particular, often handle cash transactions that exceed $10,000. Auditors have a different slate of questions for marijuana 8300 audits, including things like “How many plants do you grow per year?” and “How many times did you harvest them during the examination period?” For now, the IRS insists that 8300 audits are strictly civil proceedings. But the Service already shares this information with the Financial Crimes Enforcement Network. A similar exchange with the Justice Department seems to be the next logical step.
Some Special Cash Business Audit Steps
A Net Operating Loss Deduction (NOLD) is a major red flag. If a marijuana dispensary, or any other cash business, loses money and the taxpayer makes ends meet at home, the extra money had to come from somewhere. If the taxpayer does not have a good explanation with documentation to back it up, the IRS will assume the worst.
Almost all cash business audits include an inadequate records notice. Form 978 and 979 both demand that recordkeeping practices improve. Failure to do so may be an independent audit trigger in subsequent years, as the IRS assumes that the taxpayer is either a scofflaw or has something to hide.
Some final points, which are common to all audits, involve cash hordes and badges of fraud. Investigators almost always conclude that cash hordes came from unreported cash transactions. Evidence of fraud involves both affirmative indications (e.g. poor records or substantial unexplained net worth increases) and affirmative acts (destroying records or hiding income).