“Preparation time is never wasted time.” Anonymous
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Part I – “The IRS Audit Process” is the first of a 3-Part Series on “Federal Tax Procedure- Audit, Dispute, Resolution for the Cannabis Industry for years 2021 and Onward.” Please subscribe to our newsletter to be notified of future publications in this series, live webinars, and other relevant tax topics for the cannabis industry written by cannabis accountants and tax professionals at www.420cpa.com.
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By Simon Menkes CPA, Rachel Wright CPA, and Abraham Finberg CPA of AB FinWright LLP (www.abfinwright.com) and 420CPA (www.420cpa.com)

Part I – The IRS Audit Process

The IRS Audit Process

So, what can a cannabis business owner expect in the coming months? Typically, the IRS begins by designing a proprietary algorithm to analyze all cannabis returns, producing a DIF Score (Discriminate Inventory Function) for each tax return – the higher the score, the higher the probability of errors on the tax return. Try as we might, we cannabis CPA’s have been unable to find out information about the algorithm. We’re as much in the dark as you are.

Once a business is chosen for examination they will either be scheduled for a correspondence audit (snail-mail), an office audit, in which the taxpayer will come to the closest IRS office, or a field audit, in which the auditor will visit the taxpayer. Usually, the field audits are the most comprehensive, since records of the cannabis business may now be available for review.

What Will the IRS Be Focusing On?

A standard business audit tends to revolve around the areas most prone to misstatement by taxpayers: travel and entertainment expenses, purchases of assets, loan payments and receipt of borrowed funds, balances of cash on hand. And especially with cannabis taxpayers: the business representation of gross profit (gross revenue – cost of goods sold) and the flow of cash within the business. The IRS auditor will follow the trail of money in and out of a cannabis business very closely, asking herself if all the sales that took place are represented in the financial statements and on the tax return. They’ll be looking closely at inventory purchases to see if they suggest that additional unrecorded sales might have taken place. They will also look at the tax positions taken on the tax returns with regards to 280E and 471(c), accountant disclosures, and forms 3115 for a change of accounting method.

Burden of Proof

Unlike a criminal trial, in which a defendant is innocent until proven guilty, historically, the IRS has placed the burden of proof on the taxpayer. However, nowadays the current code says as long as a client has reasonable records that bear out the numbers in their tax return, and if they’ve complied with IRS requests for documents, meetings, etc., then it is up to the IRS to disprove the taxpayer’s numbers. The burden of proof is stricter if an audit is contested in U.S. Tax Court.

Impact of COVID-19 on Audits

Everything we’ve stated above coincides with how the IRS has normally conducted audits of business taxpayers in the past. However, this has been under circumstances in which a pandemic is not ravaging the nation. COVID-19 has upended many businesses and other organizations, and this includes the IRS.

It is unclear exactly what impact the pandemic will have on IRS audits, other than the obvious, which is to make it quite likely that any audits will take place over Zoom during the near-future. To give you an idea of what is happening internally at the IRS, one of the authors of this article, Simon Menkes, had a recent conversation with an IRS official regarding a Levy Notice. When Simon pointed out that the client had mailed in the required proof a month before so that the levy was no longer necessary, the agent was very candid. She explained that their whole building had been emptied out when the pandemic began in March, and they’d only returned to their offices in August. The last to return were the mail handlers. The agent’s office typically receives 80,000 pieces of mail a day, and the mail had remained unopened for five months. That equated to 12,000,000 pieces of unopened correspondence. Needless to say, the IRS is struggling during this time as well as the rest of us, and this will probably end up slowing down the audit process significantly.

Whether COVID-19 delays the rollout of cannabis business audits altogether, and how the pandemic will affect these audits, remains to be seen. In terms of the pandemic, we are all in uncharted waters.

Our next article will discuss how cannabis taxpayers and their CPA and tax attorney representatives can expect to resolve any disputes that may arise out of an IRS audit.

Until then, stay safe and healthy, and thank your lucky stars you own a business in a protected industry.

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Please stay tuned for Part II of “Federal Tax Procedure- Audit, Dispute, Resolution for the Cannabis Industry for years 2021 and Onward” where we will discuss “Resolution Efforts.” We are licensed California CPA’s who serve clients throughout the state and in all legalized cannabis states in the US. Please feel free to reach out to our office at 420CPA in conjunction with ABFinWright LLP at (310) 237-3070.