Always keep your records as if you’ll be audited. The show’s guest today is Cannabis Lawyer Rachel Gillette, a staunch protector of Cannabis retail businesses against the IRS. Join in the conversation as Rachel discusses with Tony Frischknecht what safety measures you need to take to ensure you won’t get tangled up with the IRS. Make sure you keep all your receipts and have everything documented. Good record-keeping will always help you! Also, you need to understand the impact of 280 on a real-time basis to make educated decisions. Tune in to safeguard your business!
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How You Can Fight Back Against The IRS With Rachel Gillette
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This episode is a major milestone for the show. This is our 100th episode. It’s super exciting for me. It’s truly amazing because I’ve learned so much from our guests. For the readers, I want to thank everyone out there who has made this possible especially you guys. In honor of our 100th celebration, I have invited somebody that is extremely important for the industry and somebody that I feel you should reach out in times of trouble.
She is a leading cannabis-focused lawyer who helps clients nationwide proactively plan and implement strategies to capitalize on strategic business opportunities. At the vanguard of the retail marijuana industry, she leverages more than a decade of experience. She’s guiding clients to establish, expand and protect profitable businesses in a rapidly evolving legal regulatory and financial environment. From years of interacting with regulators and taxing authorities, she knows how state and local provisions will be applied and practice and what clients can anticipate at every step of the licensing process and beyond.
She vigorously protects clients’ interest in tax audits and deficiency assessments at the state and local level as well as IRC 280E adjustments. Clients value her ability to distill complex, often overwhelming information into a prioritized plan of action. As a strategic advisor, she helps clients prepare and get positioned to seize opportunities like starting operations in newly legalized states, scale businesses into multiple jurisdictions and launch new brands and products.
Her clients range from individual entrepreneurs and investors to startups to publicly traded companies with operations in one or multiple states in cannabis and cannabis adjacent businesses. Domestic and international entities exploring cannabis business opportunities turn to her for problematic industrial savvy counsel as they evaluate potential options.
She also serves as an expert witness on legal and regulatory issues involving hemp, marijuana, CBD and other cannabinoids. Before she joined Holland & Hart, she was a partner at Greenspoon Marder serving as Chair of the firm’s Cannabis Law Practice and as a member of the management committee. I’m super excited about this guest. Rachel, thank you so much for being our 100th episode. We’ve known each other for years. How did you arrive in the cannabis industry?
It’s a fun story. I will always say that I did everything backward in life. When I was supposed to be going to college, I was a ski bum and riding my mountain bike all over Durango and Telluride, Colorado. I live there. I had kids then I got married. I was a mom in my twenties and I decided to go back to school and get my undergrad degree and I went straight on to law school. I graduated from law school in my mid-30s. The timing of it was that I graduated during the Great Recession. I graduated in 2007. They were firing people from legal jobs and not hiring people at the time.
The only job that I could get when I moved back to Colorado and got licensed here was at a tax controversy practice. That’s where my background came in tax. I did that from about 2008 to 2010. I figured out in 2010 that the Colorado Department of Revenue was going to be the regulating entity of these new things, which were for-profit, medical marijuana businesses in the state of Colorado. We were the first in the nation as a state to have for-profit marijuana businesses at the time and that was the state stepping in and determining how to license these businesses that had popped up under the caregiver laws at the time. That was under House Bill 10-1284.
I’ve always been an advocate for the legalization of cannabis. I quit my job and told my mom that I was going to start my own practice. I called up my constitutional law professor and told her I was going to start my own practice representing medical marijuana businesses that were applying for licenses in Colorado. She said, “You are going to lose your law license.” I said, “It sounds good. Let’s do it.” Luckily, I had the experience of a couple of years of tax and business under my belt so I feel that was a little bit unique in the industry.
At the time, a lot of lawyers had been practicing criminal defense because people were still being prosecuted in Colorado. The federal government, at the time, didn’t know how to handle states that were passing these regulatory regimes as Colorado did back in 2010. There was a big holding of the breath to see how the federal government would react. That’s how I started in the cannabis space. I started working with licensees that were applying at the racetrack. It was at the racetrack and I was there on day one helping applicants apply for those licenses and it went from there.
You were involved in the application part at the beginning, more so. Is that correct?
Yes. At first, most of my practice consisted of helping people with their application process. You may remember this but, at the time, applications were boxes and boxes of stuff. They were asking for twelve months of credit card statements and all sorts of things that they don’t ask for now.
They wanted five years of bank statements. That was from each owner. In our circumstance, there were four of us at the time. My stack was about 12 inches tall. I can’t imagine the regulators went through all that information. I don’t know how they could.
If you were called, they didn’t start issuing licenses until two years later. They figured out that this was too much. It was an interesting time. What I have to say is that operators such as yourselves were brave at the time because there was still this uncertainty as to whether the federal government was going to bust into Colorado and start arresting people that were openly selling medical marijuana.
I remember at one point in 2011, the US Attorney sent letters to about 50 different businesses that were near schools telling them to shut down. It was an interesting time. Colorado, the regulators and the industry had their growing pains. We created a foundation for a lot of other states to follow what we learned. It’s been interesting to see how it’s all developed.Make sure you keep all your receipts and have everything documented. Good record-keeping will always help you. Click To Tweet
Coming to the point where we’re starting to see some success, some businesses are starting to flourish. We’ve got consolidation happening. One of the reasons I brought you on is taxes and cannabis. This has been a problem since the start of the entire industry and it is continuing. For the readers out there, it’s great that you’re going through this. You are making money and you’re finding your foothold. The issue is what do you have at the end of the day? This is the true meaning of, “Have I made it? What do I have in my bank account after I pay everybody off from the processing companies all the way to the IRS?” You’re like, “I’ve got something.” You’ve dealt with hundreds of individuals at this point. What can cannabis businesses expect when they are being audited?
Going back to those early days, we started seeing audits in Colorado back in 2008, 2009. The IRS was taking a close look in Colorado and because of my background, I started working with cannabis businesses that had audits back in 2010. It was funny because the IRS’ approach to an audit has changed. They were learning a lot or trying to figure it out. All of their training materials so I could see this evolution of their thinking of how they were approaching examinations because I have seen it in real-time.
Audits are going to be a regular occurrence in the cannabis industry. That won’t change anytime in the near future. It won’t change necessarily when we have federal legalization. Part of the main issue as to why tax authorities audit the cannabis industry is because it is cash-intensive. It’s considered a cash-intensive business. The IRS likes to audit all sorts of cash-intensive businesses and cannabis is no exception. Add the fact that it’s federally illegal and they want to make sure that people are complying with federal tax laws.
Back in the early days, it was much more difficult to represent and handle a cannabis audit because we had this albatross of federal enforcement hanging over all of these businesses. A lot of the companies at the time didn’t even keep records because they didn’t want to have that paper trail of the receipts or what they paid somebody for cannabis. That makes representing a company in an audit much more challenging because they didn’t have records at the time.
I’ll speak for those guys. What it comes down to is coming in from the shadows into the limelight. Having those thoughts of, “If I share myself and I share in this, they have evidence against me.” Working with my business partners, it was like, “We’re either in or out.” You had to decide. Many people did and many people didn’t.
I always say that you can’t straddle both worlds. You can’t be in the illicit market at the same time you’re in the legal market. You’ve got to be one or the other and you do have to be tax compliant as you’re well aware of in the cannabis industry. Businesses that learned over time, not only to feel more comfortable about the fact that if they remain in strict state compliance, they’re not necessarily going to be rated by the federal government. A few years ago, I started to see businesses take record-keeping seriously and making sure that they were keeping all of their receipts, etc. I could go through with you if it’s of interest to your readers what to expect when you get that inevitable letter from the IRS that you’ve been chosen for an audit.
Understanding getting the IRS letter and forms you’re going to get it in would be great because it’s going to come from different places. I haven’t heard of anybody scamming the cannabis industry with taxes but there are those people out there that are out scamming the IRS. How do you protect yourself? I’ll let you go into it. These are some of the things that, as a business owner, what do I need to be looking for?
First and foremost, we talked about record keeping. That is essential especially now, to make sure you keep all your receipts, you have everything documented and keep good up-to-date books and records. That’s important. If you are audited either by the IRS, the local jurisdiction or the state, that’s always going to be helpful. You want to keep good and organized records. That’s the first tip I can give cannabis businesses. For the most part, most people know that.
That’s a great point because, as entrepreneurs, we get caught up in trying to succeed and we forget about those details. I’m guilty of it myself. That’s 100% a great point.
If you get audited, it can save you so much money if you have good documentation. I like to look at things from a dollar perspective, “Is this going to save my client money at the end of the day?” Good record keeping does. Filing on time, paying on time and all of those things are going to save you lots and lots of money.
As a startup, do you need a CPA? Can you get by with a bookkeeper? When we’re talking about this, we’re saving a lot of dollars. We’re talking hundreds of thousands of dollars, even millions. This is extremely important. Would you recommend one or the other or do what you can? How do people go about that?
It’s having a good bookkeeper and a good CPA. You want to have a bookkeeper and a CPA that worked together and that you want to have a CPA that understands how to keep books for the cannabis business. Believe it or not, your chart of accounts is going to look a little different than any other business because you’re in cannabis. It’s because of that thing that we are all aware of, which is the Internal Revenue Code Section 280E, which has a tremendous burden on the industry. You have to be thinking about your books with 280E in mind. Your accountant needs to have some knowledge of 280E.
Setting up your chart of accounts from day one with 280E in mind, what is or isn’t a cost of goods sold? What is or isn’t disallowed under 280E is important. You need people that have the knowledge. It’s hard to go back and reorganize if you haven’t done it right from day one. Those are essential for your cannabis business. Having a fundamental knowledge as to what is or isn’t allowed expense is important too. You don’t have to know too much about the tax code to understand it.
To give you a basic overview for any business owner out there, the way the IRS looks at 280E is it’s going to be a disallowed expense unless you can put that expense and capitalize that expense into your cost of goods sold. Meaning you get your gross less your cost of goods sold and that’s your income. Certain expenses can be put into the cost of goods sold but you have to have an understanding of what those expenses are. For that, we have to turn to the Regulations and the Code Section 471. To be simplistic about it, if your expense has some direct or indirect nexus to production, that is a cost of goods sold. The cost of your product, less trade and other discounts plus acquisition costs is the cost of goods sold. That’s it. Everything else, probably not the cost of goods sold.
There’s a lot of debate as to what you can put into the cost of goods sold under Section 471 and that’s where, as a business owner, you want to rely on experts, accountants, lawyers, CPA or bookkeepers to help you with that. You have to have an understanding when you’re buying something or having an expense as to how much that is costing you. For example, marketing is a disallowed expense under 280E. It’s a selling cost. If you’re spending tons and tons of money on marketing, that’s going to cost you probably 35% more than the dollar you’re spending because you’re going to be taxed on that expense as if it’s income.
That’s a tough one for people to grasp. I don’t know how many times I’ve discussed it with people. They do not get that. If you spend $100,000, you’re going to be paying an extra $35,000 for that $100,000 at the end of the year.
People try to be creative about marketing. I don’t know that the IRS is right that certain marketing costs can’t go into the cost of goods sold but that’s a nuanced question. Generally, they will always disallow marketing. They’re going to disallow your bank fees, which I’ve gone back and forth with IRS revenue agents on this. Frankly, it’s in everybody’s best interest for cannabis businesses to have bank accounts and they need to keep records. Why isn’t that an indirect expense, at least as it relates to the grow but they typically are going to disallow banking fees?
Those banking fees are astronomical especially in the newer markets because they can charge a lot because nobody else is allowing it.
Thinking about things like, “How can I leverage social media and free marketing and these types of things?” You’re trying to be thoughtful about your things. Unfortunately, depending on the type of license you have, you can have a much more punitive tax treatment under 280E if you are a retailer, for example. If all you are as a store, the IRS is going to look at you or at least that the examination stage and we can talk about this as it goes up the chain in the IRS.
Typically, an examiner is going to allow what you paid for your product, they’re maybe going to allow transportation costs, they might allow some allocations for labor and those types of things if you can tie it to the acquisition, product procurement or production. That’s a tough argument. I want you to know that that’s a hit or miss with the IRS.
The IRS issued a Chief Counsel Memorandum, which I’m happy to send to you, on acquisition costs. They were restrictive as to what they consider an acquisition cost. Retailers are going to be treated much more punitively than a processor or a cultivator. A vertically integrated company might have a few expenses that are shared amongst the whole group of licensees so they may have a little bit of flexibility and expenses in putting things in the cost of goods sold.
That makes it tough. You’ve only got so many options on what you feel like when you want to start a business in the cannabis industry. To tell you the truth, the most expensive entry point is the production point. For the guys out there reading, I know it’s a lot of money to open a retail store but magnify that by ten if you want to open a production facility. A lot of people fall into that spot. If we want to go into social equity, those guys are going for retail because it’s going to be the easiest entry point.
Interestingly enough, where 280E hurts is when you’re able to scale the larger you go and the more money you make. It hurts the smaller businesses the most. If you are selling tens of millions of dollars of cannabis in your retail store, it’s not going to hurt you as much as if you sold $500,000 and you’re making a little bit of profit. It’s going to wipe out a lot of your profits. 280E affects those startup businesses, those new businesses and definitely on the retail side, but it hurts all over. Ironically, you’re going to get a much more punitive tax treatment if you’re selling grams of marijuana versus pounds of marijuana.
As a cultivator production, a lot of your expenses are indirectly or directly related to production so you can put those into the cost of goods sold legitimately and they will be allowed but it’s complicated and it’s nuanced. What I can say is there’s a lot of disagreement amongst tax professionals as to what you can and can’t put into the cost of goods sold and that remains. There even is disagreement amongst IRS examiners as to what they will allow and what they won’t allow.
It seems that falls back on to the situation that the IRS is still learning how to audit these companies so those arguments are coming up. I remember talking to our CPA when we started about how we should set up our systems and there was no direction from the IRS. You couldn’t get any information so you were left with a blank sheet of paper and you had to take the advice of your CPA that had never done this before either. At least it’s not that gray of an area anymore. At least we’re getting something. In dealing with these audits, one of the things that I’ve noticed is most people aren’t fighting them.
That’s unfortunate in my view only for one reason. First of all, the way an audit works is you’re going to get this letter and they’re going to ask you for a whole bunch of information. Sometimes they decide they want to go on a fishing expedition. When you get audited, you should understand that the IRS is entitled to certain information but they’re not entitled to some of the information they try to get. A lot of times, they’re doing an investigation so they’re trying to figure out if there are affiliated businesses, what’s the ownership, they may open up other audits.
Once they start with the business, a lot of times they open up the individuals for audit especially when they’re flow-through entities. They may open up affiliated businesses that may have common ownership. By the time you get that audit letter, they’ve already done an initial investigation into your company. They already know how your EIN is connected and what social security numbers are connected to that EIN. It’s not like they don’t know anything once they send you that letter.
If you have good books and records, there’s not too much to worry about except you want to understand how your CPA or your bookkeeper approach 280E. You want to know if you’ve been compliant and you want to know what to expect. It’s going to be a challenging time. Audits are never fun. Probably most of your readers have gone through an audit at some point. I will say the worst-case or the worst outcome you’re probably going to get is at the examination stage.You want to know if you've been compliant with the IRS, and you want to know what to expect. Click To Tweet
When you say worse, we’re talking penalty or assessment.
The penalty is the potential deficiency. I’ll explain why that is. First of all, from what I found is that examiners are being trained in real-time. The IRS has not hired a lot of people. They’re understaffed and they’re focusing on these cases. They do not have a lot of training that they’ve provided to IRS examiners. They’ve changed their approach to examinations over time. A lot of people don’t understand how cannabis businesses operate that are examiners. I’m not saying these aren’t smart people, it’s just they don’t understand the industry unnecessarily.
There can be inconsistent approaches at the examination level from auditor to auditor. Their primary job is to protect the government’s interest. If they think that something should have been disallowed in 280E or maybe it wasn’t allowed in the cost of goods sold or they’re not sure, they’re going to err on the side of the government. They’re going to say, “We’re going to protect the government’s interest and we’re not going to allow this expense.” It will become a deficiency.
They’re going to try to get as much as they can at the examination stage to protect the government’s interest because you have appeal rights. In an examination, once you’ve gone through the process, first of all, you can always communicate with the examiners’ manager. You can always say, “I don’t agree with this report,” or, “I don’t agree that you disallow that expense because it’s related to production.” You have opportunities to have a conversation with them. It isn’t like, “Here’s your report. You’re now screwed.” There is an opportunity to have a conversation.
Once you get your revenue agent’s report, you do get an opportunity for what’s called an Informal Appeal. That is the next step. They take the file out of the hands of the examiner. They give it to an independent person to look at the file to determine whether they had proper adjustments made. A lot of times, those appeals officers have a little bit of discretion as to hazards of litigation and they may take a different approach. Having somebody look at it independently, they may say, “You’re right, you provided documentation. I can see how this is related. I know that this is allowable under Section 471.” The other thing I would point out is that in the exam stage, examiners have a lot of pressure to close cases to move cases.
This is a big part. This is the question I want to talk about. I know Rachel personally from working with her and this is one of the things that was shocking to me because of the instance of them having deadlines. They’re sitting on their desk. I never knew this about them but I’ll let you explain because you’re more fluid with it. I felt there was laziness to it. It’s like, “Let’s get it on down the road.” It didn’t make sense.
What I find is that there can be a lot of errors at the examination stage, that may be a math error but it could also be that they didn’t look at some of the documentation you provided or they misunderstood the expense. There could be a ton of different reasons. We’ve found significant math errors that occurred at the examination stage that was pretty obvious and are easy to get adjusted.
These guys are hired by the government. They are IRS agents. Simple math should not be one of them that we have to follow up on. In my mind, that’s what I’m thinking.
I’ll give them a little bit of credit because I wouldn’t want their job but they have a hard job. They have a lot of cases open. They’re doing a lot of examinations at the same time and sometimes they’re pushed to close cases. We’ve had several circumstances where somebody’s gotten promoted in the middle of an exam. They’re then handing off your file to somebody else who picks it up and they don’t understand the background of the business. There can be a lot of situations.
I would say unless you’re facing a no-change audit or the adjustment isn’t significant at the examination stage, at the least, you should take your case, have it looked at by somebody who has experience in this area and take it to the next level and communicate with another independent party, which is appeals. At the very least, it makes sense for cannabis businesses to take that opportunity.
A lot of times, people say, “I’m going to agree because I’m done with the IRS. I don’t want to deal with this anymore. It’s too much pressure.” There can be reasons why you might want to get it behind you and I understand that. There’s this opportunity to appeal and it’s informal and it shouldn’t be too costly to at least have that conversation and to take another look at the case. That’s something people should take that opportunity. After you go through appeals, if you end up not settling, you then have the opportunity to go to Tax Court.
What a lot of people don’t understand and this may be a reason some people want to close these cases and put it behind them but these cases, as you may be aware of, take a long time even if you go through the appeals process. That’s mainly because the IRS is understaffed. COVID certainly did not help. Remember, until you get that bill and I don’t mean notice of deficiency, that assessment is not on your account meaning you don’t owe that money until you’ve exercised all your procedural and due process. Even if you’re representing yourself, pro se, it doesn’t make sense to me to take it to a third party because there could be some things that the examiner got wrong or maybe didn’t understand about your business so it’s worth looking at.
What I found in my experience is that 99% of the time, what I’m being paid is worth it because the reduction in tax is significant. I’m not trying to sell that but you do have to make that cost-benefit analysis. Is it worth paying an attorney or another CPA to take a lower look at this case or to assist me in this next stage? That’s always going to be a dollar analysis.
Does the IRS have unlimited resources to fight these?
As a general matter, if you’re taking a case to the Tax Court, they’re settling 98% of the time. They cannot litigate every single case. That’s why it could be beneficial to take it to the next level or at least have a conversation with somebody who might have a better understanding of the tax code, isn’t new, has handled other cannabis cases before. There can be a lot of reasons to do it. If your deficiency is something small, it may not make sense to take it to the next level because it could cost us some time and money at that point.
For most of us that have been involved in cannabis, it’s pretty significant no matter how you look at it because of the way 280E is focused. The other side of this, too, is it also depends on how aggressive you were with 280E. That changes everything too. How far did you push this to reduce your total tax liability? Some people push it more than others. It’s a matter of how do you offset that risk? Do you put that money aside just in case? Do you have these different programs that you’ve set aside? Still, not being federally legal, there’s a lot that’s up to interpretation. However, that’s to the benefit of the business owner because there is a lot of up to up to interpretation. That gives attorneys a lot of room to argue their points or why this should be a deduction.
I want to make one other point when it comes to emanation because this is important. One of the things people need to understand about these friendly examiners is that they’re trained investigators. They are trained to investigate and get information. I’d never put my clients in front of the IRS because they tend to overshare. No offense to my clients. That’s one of the things you have to think about because I know a lot of business owners might be inclined to be like, “My records are great. I’m going to represent myself.”
I’m not saying you shouldn’t do that. What I’m saying is that you have to understand that the IRS is looking for information. Sometimes they do go on fishing expeditions and I can tell that by the initial document requests that we get. You have to have an understanding of what they’re entitled to and what they’re not. You should be trying to keep the information related to the scope of the audit. A lot of times they ask for things that are completely outside the scope. That doesn’t necessarily mean you have to provide it. It’s something to think about.
It’s like when you see people get pulled over and the cops are like, “Can I search your car?” They’re like, “Go ahead.” You know they need a warrant. They can’t just search your car. They’re investigators. They’re going to ask for whatever they can to see what they can get away with. If they’re dealing with an attorney, at least a halfway decent one, the attorney’s going to be like, “We don’t owe you all this. We’re going to give you this because this is what you’re allowed by law.”
I don’t know about you but when you’re running a cannabis business, you don’t have time to learn all the different laws aside from what’s focused on you regulating the cannabis industry to keep the business going. At the same time, it’s like, “You don’t have time for that.” I’ve seen so many times where people skimped on finding the right attorney or getting the wrong CPA and they pay for it.
Penny-wise and pound-foolish, I see it all the time. It doesn’t equate to a lot of dollars too. The other thing people have to think about too is the payment of taxes because I see this as a chronic problem in the industry and it’s unfortunate. A lot of it has to do with 280E and the fact that a lot of business owners don’t understand how 280E impacts their business until their CPA prepares their tax returns and says, “Here’s how much you owe.” You have to plan 280E.
When I say keep good books and records, have a general understanding of 280E but also understand its impact on a real-time basis so you can plan because a lot of cannabis businesses are flow-through. What I see happen all the time is that business owners are saying, “I’m not making that much money because I know how much profit I have and I only have to pay this amount of tax.”
When they’re making their quarterly tax payments, they’re underpaying or maybe they’re not paying at all because they don’t think they’re going to be profitable that year. When their tax preparer prepares a return, the tax preparer says, “I know you don’t think you made a profit but there’s 280E and now you owe $150,000.” If you haven’t put that aside and you don’t have that check to write to the IRS, you’re looking at tens of thousands of dollars in penalties for failing to make estimated tax payments on time, for late payments. It could cost you so much more money if you don’t plan correctly. That tends to be a big problem in this industry.
I know you have to deal with local tax issues as well so stack that on top. What do you see that’s happening on the local side?
What we see on the local side is every local jurisdiction is doing audits. If they have excise tax, sales tax, use tax, business property tax, those audits are also occurring. I’ve seen this happen, the trifecta, where you’re being audited by your local jurisdiction, your state and the IRS. That does occur. There are ways that you can delay things but that does occur in this industry.
There’s not a drink strong enough for those days.
The state, as many cannabis businesses know, a lot of cannabis businesses now are going through their second sales, use and excise tax audits.
Why is that?
The look-back period is three years so they can look back three years. After three years have passed, they might be looking at you again. A lot of cannabis businesses are now being audited every 3 or 4 years. That’s not unusual at all. I’m handling a lot of state audits that are now the second go around. Understand that the same thing occurs in a state audit. State audits are interesting. A lot of times, they might apply what’s called an error method so they might audit you for three periods and see if you’re on point with your sales tax, use tax or excise tax. If you have an error in that 1, 2 or 3 of those months, they will average that error and take it through the entire audit period.
That may be completely inaccurate. Meaning you may have screwed up the three months that you gave them and you may not owe any tax on the other periods but because they take that error rate and apply it across three years, you end up with a big giant tax bill. I want people to understand that that is the state of Colorado’s method of auditing. Unfortunately, you may have to produce additional information but you don’t owe that tax that you get a bill for because they averaged an error and decided that you must have made it in all your months.
That’s crappy too because what you did for a quarter period means you screwed up 36 months. That’s ridiculous if you think about it. If you want to pull this out, how can that be possible? It’s been so long. I dealt with that with you. We talked about that. We went through that and it was like, “How could they do this?”
A lot of times, it’s an error in the way the POS calculates. They did 30 days instead of 31 days so you have an extra day in one month and not enough days in the other. It looks like there’s an error but there isn’t. Honestly, sometimes it can be easy to see but if you don’t recognize their methodology, you might be like, “They audited me. Now I owe $100,000. I’m going to pay it.” You may only owe $2,000 or you may not owe anything at all. It’s something that you want to take a look at or at least have an understanding of. At least look at your books and records and tie your POS to what you paid in sales tax or excise tax and make sure it’s correct. Look at all the months to see if it’s a gross error and a lot of times it is.
Colorado is a fairly mature state when it comes to cannabis. Are you finding that the experience of the IRS is growing from Colorado out to all these other states? What are you seeing out in the rest of the United States?
As an attorney with the IRS, I can represent people in all 50 states in front of the IRS. I am seeing audits in Maine, Massachusetts, Florida, California, the whole West Coast, Oregon, Washington. They’re everywhere. In fact, I brought with me the TIG Report, which is the Treasury Inspector General Report on the growth of the marijuana industry, warrants, increased tax compliance efforts and additional guidance. I found this thing to be quite handy for a few reasons. One is they said, “There’s a lot of money left on the table because nobody’s being compliant and there are too many filings so we’re going to audit the crap out of the industry.” That’s paraphrasing here but they’re like, “You should audit more.”
If you’re in cannabis, you’re going to get audited, is what she’s saying.Not every case should go to trial because sometimes, bad facts lead to very bad outcomes. Click To Tweet
You should expect it. It may not happen to everybody but you should plan for it. You should keep your records as if you’re going to be audited. There are two other things that are of importance. One is that this report acknowledges that the IRS has not provided appropriate guidance and needs to provide more guidance to the cannabis industry on how to comply with 280E. Also, probably how to comply with 471 if your cannabis business. I have used quotes from this report to have penalties abated in examinations that are not applied.
There are good arguments to be made, still. If you tried to comply with 280E, that’s another reason you may want to go to appeals because of the penalties. You may be able to get the penalties waived where they’re being applied in the examination because you try to comply or your CPA or accountant try to comply with 280E but there’s so much uncertainty. There’s so much disagreement amongst CPAs on how to even prepare a cannabis business tax return. If you made some effort and you make a good argument, you can usually get your penalties completely wiped out.
The word penalties are not going to be going away as if you said, “Screw 280E. I’m going to be a word of normal business. I’m going to take all my below-the-line expenses.” That’s where you’re going to have a difficult case in getting your penalties removed in an examination and those penalties can be significant. A lot of times, it’s a substantial understatement penalty so they can be big. At the very least, even if you’re representing yourself, if your examiner isn’t saying, “We’ll waive the penalties,” you should go to the next level. At least ask the appeals officer if they could evade the penalties because you may be able to get those removed. There’s some good information in this. We haven’t provided any guidance. Tax preparers aren’t consistent in how they prepared tax returns for cannabis businesses
You’ve been using it as ammunition pretty much for your cases.
I quote from it. The other thing that is interesting, which you may have heard of because there was a lot of talk about it, was this new section, IRC 471(c). There was a lot of buzz about it especially when this report came out. This was a change in the tax code that occurred with the Tax Cuts and JOBS Act. It was effective starting in 2018. 471(c) seems to say that a qualifying taxpayer can choose a method of accounting for inventory that conforms with their books and records. What this report acknowledged was this could potentially alleviate the impact of 280E, 471(c). If you say, “I’ll put all this stuff in the cost of goods sold.” It potentially could alleviate the impact of 280E. They acknowledged that in this report. There was a lot of buzz about it.
Especially if you’re starting a business, if you can start from there, if your CPA out there says, “This is how we’re starting it, from the start. I have the ammunition to back it up. Let’s do it this way.” Most people still don’t know about it.
They don’t but what you have to understand too is that since that report came out, the IRS drafted regulations surrounding 280E. What they said was you can’t use 471(c) to turn a non-recoverable cost, meaning something that’s not cost of good and make it into a recoverable cost.
They tried to close that loophole is what they’re trying to do.
It can’t be used to capitalize a cost, which is otherwise non-capitalizable and non-deductible but that’s not exactly true because the IRS has acknowledged and even given guidance on this. You can’t take below the line as a cannabis business, meaning in that expense section saying, “Here are my expenses.” You can put some of those in a cost of goods sold of under 471(c) if they’re related to production directly or indirectly. I don’t know if that’s the case.
There’s a lot of discussion and disagreement as to, “Is the IRS not right in their interpretation here or at least how they’re looking at the regs that it’s a timing provision and it’s not meant to be applied this way?” That’s some conversation people should have with their CPAs and their accountants. I wouldn’t call 471(c) a loophole. I don’t think that’s an accurate description of it but it’s interesting. People who are CPAs and tax attorneys that have much more knowledge than I do about inventory accounting can probably give some good guidance on that.
There’s a lot of room for being able to argue their point across to get some of these deductions whether or not the IRS came out with more instructions on 280E or not, is that correct?
Maybe we don’t want them to give more guidance, to be honest. We have to follow it. It’s keeping it gray and crossing our fingers. My hope is that if we do end up passing federal legalization, which is a conversation we should have, what does it look like? If Congress was to pass federal decriminalization or legalization tomorrow, how do they address all those people that are in the middle of their exams that are being impacted by 280E?
Is there a way we could be advocating as an industry that we tell the IRS, “Pencils down. No more enforcement. We’ve legalized cannabis that should have happened five years ago?” It’s something we should be having that discussion. 280E, in my view, has always been a subsidy for the black market. The IRS does not apply 280E to your street corner cannabis dealer or your illegal grower. They are only going after those that are legal, under state law and complying with the rules.
How messed up is that? This was started from the RICO Act from a case down in Florida and that’s where 280E came from. It was from the black market. That’s why they disallowed regular business deductions. It was a cocaine dealer. That’s where it originated.
He was able to take all his deductions because there was no prohibition against it. The Congress said, “This is unfair.” Listen to their reasoning, though, which is interesting. This is a quote that I’m paraphrasing, “There’s a public policy against drug dealing. Therefore, we need 280E.” Public Policy on cannabis has changed. There’s no doubt about it. In 1982, the reason that they passed 280E, which is a couple of sentences in the tax code, is no longer the case. It’s no longer a public policy that cannabis shouldn’t be legal or it’s no longer drug dealing. Why are we applying this archaic provision of the tax code to businesses that are trying to do everything right? I don’t understand it.
They’re basically turning a blind eye to the black market. They’re not applying it to what it was originally supposed to be applied to, which is illegal drug dealers. To me, that’s a subsidy. I’ve had this discussion with policymakers and everything like, “Maybe they don’t want to get rid of 280E because it makes them so much money.” The reality is it’s fictitious income. These businesses are spending money on marketing. They don’t have that dollar. It’s not real income to those businesses or to the individuals that own them.
More or less, that’s theft.
When you send them a bill for $1 million that they never made and they don’t have, you’re not even going to collect that money. You’re going to spend money trying to collect that money but it doesn’t exist. It never existed in the first place. I’m getting on my soapbox here but I’m passionate about this because it is fundamentally unfair. It is old. It’s outdated. It needs to go away. It was never meant to apply to a lawful business that’s operating in compliance with the law. We all know cannabis should not be a Schedule 1 controlled substance. We all know that.
The problem is there’s case law that’s backing up 280E at this point. Even if you go to the Harborside case, they’ve been kicking this can down the road.
Let me talk about the case law because the case was interesting. There are two things the case law does not do. First of all, we’ve beaten the dead horse on some of the same arguments when it comes to the case law that we actually have opinions on. The same arguments are being recycled. I don’t know how many times you can make the argument. If they said no, they said no. We shouldn’t be continuing to make those same arguments. We have to think a little bit differently.
The cases that we do have opinions on are issues that are not technical tax issues. They are, “I wasn’t trafficking drugs.” They’ve dealt with that in the CHAMP case. They’ve defined trafficking. They said it’s buying and selling. Why are we continuing to argue in a case that we’re not trafficking? They went to the Webster’s dictionary for that. It’s not rocket science. They said, “That’s the definition of trafficking. If you are buying and selling cannabis, it’s illegal. It’s Schedule One.
They have discussed the constitutionality and I’m not saying those arguments shouldn’t be raised because they should. There’s actually, in Northern California Small Business Assistance. That case has a dissenting opinion which discusses whether 280E is constitutional. It’s worth a read but that was a dissenting opinion. We didn’t win on that.
There are some definite constitutional issues. Things like, “I’m not a drug trafficker,” or, “You can’t say that I’m doing something illegal,” which is an argument that has been made which is funny. When you put your shingle out and you advertise that you sell cannabis, it’s pretty obvious that you’re selling cannabis.
The Harborside case didn’t even do this. This was raised in the Ninth Circuit case. What they have not gotten into is what is allowed under Section 471 as a cost of goods sold if you’re a reseller. What is allowed under Section 471 if you’re a producer? Those technical things, there hasn’t been an opinion on those, 471 in particular. That’s interesting because I do think that they’re saying things aren’t allowed under the regs when they are.
Taking a case to trial depends on the facts and circumstances. Not every case should go to trial because sometimes they’re bad facts, which leads to bad outcomes. Unfortunately, we’ve had that happen in a lot of the cannabis cases but we don’t have those nuanced tax-based arguments being made. They were made in the Harborside Ninth Circuit case but the holding, in that case, was basically, “You didn’t properly raise these issues in the underlying case so you can’t raise them now.” They didn’t even rule on those.
That’s something that a lot of people don’t understand is that whether or not you can put officer compensation into your cost of goods sold, if your officer is doing work for the grow, first of all, that is something that is in the regs and is allowable but you will have some examiner’s that say, “No. I’m not allowing officer compensation.” That’s unfortunate because I think it’s allowed. The regs speak to that and even the IRS training materials speak to that, which is interesting. The cases we have, I don’t think some of them should have been taken to trial, unfortunately, but they were and so we have some bad outcomes. That doesn’t mean that there are some good arguments to be made.
We’re dealing with an extremely stressful situation for the client. As you’re working with a client, what are some of the things you do to help relieve them from stress or help give them some safety? Something that they can be like, “I’ve got a good person on.” I’m sure you’ve dealt with all types of clients. You’ve got good ones and you have bad ones because this is a big part of it. The patience and the longevity of how long your client is willing to say, “Let’s keep fighting. Let’s keep going.” What are those conversations like when you’re talking with these people?
The anatomy of a case, as you know, I can be working with a client potentially for years because that’s how long some of these cases take to resolve. COVID hasn’t helped that situation at all. I do want to try to give comfort to my clients and my goal is to reduce your tax bill. That is always my goal. You don’t owe the amount of money that that examiner said you owed. I’m going to try to come up with all of those reasons why you do not owe this money.
I find that my goal is to try to be like, “This is not your problem. This is my problem. I’m going to communicate with the examiner. I’m definitely going to loop you in when you need to know some stuff. I may be coming back to you and asking you for information but you have to trust my judgment to some amount because my goal is to reduce your tax bill.” I’m doing that by almost like a drip of water that makes the stone go away. That’s how consistent sometimes I have to be. “I’m going to keep asking or hammering on this issue because I think I’m right but maybe I’ll approach it five different ways to get where I want to go.”You need to have people who have the knowledge. Click To Tweet
Sometimes, it’s interesting because the appeals officer will be like, “No. I don’t like any of those arguments.” I had a conversation like this where we had made this whole big argument as to why an abatement should be granted of the penalties that were assessed in this case. It was, “No, I don’t like that.” I then said, “How about this?” I made another argument and she’s like, “That’s your argument. Go ahead and put it in writing. I’ll accept it.”
You never know. Understand, they have to put a reason in their file as to why they allowed something that the examiner disallowed. Sometimes, you got to go at it from lots of different angles. You do have to have people that have knowledge. Having experience in this is important. The thing you have to understand, there’s also a difference between a CPA representing somebody in an exam and an attorney. Attorneys have privileges that CPAs don’t necessarily have. That may be important in certain cases but a lot of times, I work hand in hand with your CPA. I’m just giving you updates every so often to say where we’re at.
My goal is that it’s not going to be your daily problem. You’re not going to have to go home and be like, “My gosh,” every night. I’m saying, “I know this is taking a long time but we’re going to try to get this reduced significantly.” I love working with CPAs. Sometimes, they’re helpful in the examination stage, sometimes, I jump in when it’s time for the appeal. Sometimes, I’m there from day one. It just depends.
It also depends on your CPAs level of experience because CPAs are competent, in most cases, for handling audits of just about any business but cannabis businesses are unique. If they don’t have experience in handling a 280E matter, they don’t understand the nuances or they haven’t done it before, they may need some guidance. I do work with a lot of CPAs that are trying to assist their clients in tax preparation and in handling an audit. I’m happy to work with them because they have knowledge. They’re the numbers people. They do the math.
Conceptually, I’m coming up with the legal arguments and the tax code arguments, the things that I, by experience, know can potentially work. A lot of times, it’s a team effort. Sometimes CPAs, too, just hand over information because they think that’s their job. Maybe they’re not looking at it to say, “Is this related to the audit? Should we be providing this?” They are not looking at it from a legal perspective or a taxpayer rights perspective? They’re just like, “I’m a CPA. I got to hand over whatever the IRS tells me to.” There’s a role to play for CPAs certainly but a client should understand the difference is all I’m saying.
Have a good CPA, somebody that’s experienced in cannabis, for sure. I don’t know how many times I’ve said it. If your CPA hasn’t heard of 280E, you better get a new CPA. By now, how long it’s been discussed over the last decade or so and you got to have somebody in there that knows what they’re doing. The big thing coming from a client’s perspective is that the first six months to a year is brutal. We don’t know. Attorneys like yourself say, “We give updates. We make it our problem,” and then we show. All we look at is, “We’re going to $2 million or we’re going to owe $6 million.”
It’s so far outside of what you’ve made off of the business that it’s hard to comprehend that. It puts you in a bad place because it’s not only just extremely hard to work in this industry. When you think you’ve seen a little bit of light then all of a sudden, the government is there to slap you down and say, “We’re going to take everything and more.” It’s more so like a thug or a mobster would do is be like, “By the way, you made $100. We want $150.” You’re like, “Where am I going to come up with that? I just gave you everything I had.”
I’m fortunate that we met. You made the whole process so much better for me and my business partners. I really appreciate everything that you’ve done for us. I want people to know that there are people like you out there that are fighting for them. Some people don’t have anywhere to turn. They don’t know where to go. Knowing that there are awesome attorneys like you out there that are willing to take it on themselves is amazing.
I want to thank you for that. For the readers out there, a bunch of us have been through some audits for several years. I’m coming up between 5 and 6 years or so. You forget after the fourth, you’re like, “It’s just another year.” These things do take time. The worst part is the beginning. The first calculations that the examiner gives out are going to be the worst. If you feel that you don’t know where to turn, there are options out there like Rachel Gillette. These people do this day in and day out and they have tons of experience doing it.
Getting a regular attorney or a regular tax attorney is not the direction. They don’t understand everything that’s involved in this. This is why it’s so important. I don’t want to share facts because I have some business partners that are involved but we’re talking high six digits that we were able to save just by allowing the attorneys to do what they do best.
We spend some money on attorneys but at the end of the day, spending money for an attorney instead of paying the IRS, you weigh your options here. It just makes sense. It’s like, “Why would I pay them any more than I have to?” As you’re looking for options or if you’re looking for somebody to start you off right, I want to put Rachel’s name out there. She’s with Holland & Hart. She is actively doing this and I don’t think she’s going anywhere. She’s in it. She’s been doing this for a long time in cannabis solely.
She’s one of the few that is standing out. She’s not extremely in the face of the public because she’s so busy working. What it comes down to is she is busy working the system and fighting for people like you every day. Rachel, I want to thank you for being on the show with us. It’s been awesome. You’ve touched on a few things that I forgot about. I hope some of the readers were able to pick up some of that. I’m always here if you ever have any questions for me or you need some more information. Please reach out to me. I want you to reach out to Rachel if you’re stuck in a certain situation or you just want to know how to start. Rachel, what’s the best way people can reach you at Holland & Hart?
They can email me. That’s probably the best. My email is RKGillette@HollandHart.com. I’m going to give you my direct phone number too. I’m at my desk every day, a lot of times talking to the IRS. It’s (303) 295-8241.
You will also be able to go to my website at PlantProblem.com and we’ll have all of Rachel’s contact info there so you can find her there as well. I want to thank you guys for reading. I know this was a bit of a longer episode but at the end of the day, I can’t stress how important it is to understand what you’re getting into, the taxes of cannabis and the cannabis industry itself. Thank you so much for joining me. Rachel, awesome. Thanks for being on the show. I look forward to talking to you in the future. Have a wonderful day and I’ll catch you next time on Plant Problems.
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About Rachel K. Gillette
A leading cannabis-focused lawyer, Rachel helps clients nationwide proactively plan and implement strategies to capitalize on strategic business opportunities.
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