State legalization of both medicinal and recreational marijuana has created tension between states and the federal government. Marijuana remains an illegal substance under federal law and state-legalized marijuana businesses are encountering problems with federal banking regulations and aggressive IRS audits.
Are IRS Audits of Legalized Marijuana Businesses a Violation of Federalism?
Proponents of marijuana legalization argue that IRS audits are targeting the marijuana industry and are an abuse of power in violation of federalism principles. Federalism is the balance of power between federal and state governments. The Founding Fathers enumerated certain powers for the federal government in the Constitution, but also included the 10th Amendment to reserve unenumerated powers for the states. The theory was that states should govern themselves without interference from the federal government and the federal government should only regulate areas that states could not, such as foreign affairs and interstate commerce.
IRS audits targeting marijuana businesses could be an abuse of federal power because they interfere with an industry Colorado has legalized. Because of federal banking regulations, many banks refuse to work with marijuana businesses making it difficult for growers and retailers to open bank accounts. Since it is difficult for marijuana businesses to open accounts, most operate as cash businesses. Although the IRS has not admitted it is targeting the industry, cash-operated businesses are vulnerable to audits. Moreover, at least 30 marijuana companies in Colorado are currently being audited for the 2013 and 2014 tax years.
The Constitution grants the federal government broad powers to tax, but it is also a widely accepted principal that the federal government has the power to regulate banks under its enumerated power to regulate interstate commerce. Thus, marijuana businesses would have a hard time challenging these banking regulations and IRS practices.
Tax Compliance for Marijuana Businesses
Until the federal government amends banking regulations, marijuana businesses will continue to run a high risk of IRS audits. Thus, it is imperative that marijuana businesses comply with federal tax laws.
In general, profits from illegal activities are considered taxable income under federal tax law. The federal government taxes state-legalized marijuana, even though it is still an illegal substance under the Controlled Substances Act. It appears that the current IRS audits of Colorado marijuana businesses are related to compliance with section 280E of the Internal Revenue Code and Form 8300. Accordingly, marijuana businesses should have a basic understanding of section 280E and Form 8300.
Since marijuana is an illegal substance under federal law, business deductions are disallowed under section 280E. There is one exception to this rule. Marijuana businesses can deduct the cost of goods sold. For instance, a dispensary can deduct what it paid for marijuana products purchased from a grower. However, most business expenses, such as employee salaries, advertising costs, or rents, are not deductible.
Filing Form 8300 is also required for many marijuana businesses, since most deal with large amounts of cash. Form 8300 is a document that must be filed if the business has cash payments over $10,000.
What Should Marijuana Companies Do in Response to an Audit?
Marijuana businesses, and any business for that matter, can make the audit process less stressful by adhering to the following recommendations:
- Organize Business Records: Taxpayers subject to audits should review returns for the years subject to audit to ensure they have documentation for their claimed deductions i.e. credit cards statements and receipts.
- Hire a Tax Professional: Businesses are advised to hire a tax professional to ensure responses to IRS inquiries are timely and the appropriate documents are sent to the IRS.
- Understand the Law: Is it also important for taxpayers to know their rights during audits. For instance, taxpayers generally have 30 days to file an appeal if the taxpayer disagrees with the audit decision.
Assuming the business complied with federal tax laws, an audit is usually nothing more than a mere inconvenience. But, if the IRS discovers the taxpayer has not complied with tax laws, the taxpayer may be subject to fines for civil audits and prison time in the case of criminal audits. Since it appears that the marijuana industry is a target for audits, it is essential they comply with federal tax laws.