IRS Report After Cannabis State Audits Offers A Big Loophole

FAS CPA & Consultants

The IRS is keeping an eye on the cannabis industry, and yes, they plan to go for those entrepreneurs who are not compliant with their federal tax obligations. In the newest report by the Treasury Inspector General for Tax Administration (TIGTA),  the government alleges that the cannabis industry owes the government hundreds of millions of dollars in taxes. The outstanding charges are the result of the federal provision in Section 280E of the Internal Revenue Code, which prevents companies that traffic in illegal drugs from deducting standard business expenses.  Since marijuana remains an illicit drug in terms of federal law, marijuana enterprises face massive tax payments.


It is the view of Treasury, according to the report, that a federal program is required to determine the real noncompliance risk for the industry and to measure reporting accuracy in respect of the limitations set by Section 280E.


According to the report,  a major loophole might be available for the cannabis industry.  Hidden away in the TCJA of 2017, there might be a way for cannabis enterprises to escape the burdens of Section 280E.  The loophole will, however, only come to fruition after many years of litigation provides the required clarity to the parties involved.  What the potential loophole offers now, is hope – nothing more. The immediate future for the cannabis industry has a dark lining.  What is certain is the onslaught of IRS audits – a tsunami of reviews, most likely.  The legal fraternity’s message to the cannabis industry sounds pessimistic: “buckle up,” they say. “The only uncertainty is when it will start.”


The Report

The report is based on audits of cannabis enterprises in California, Oregon, and Washington State during 2016, and it concluded that noncompliance was rampant in respect of Section 280E.

⇒ Under Section 280E, 59% of submitted cannabis tax returns underpaid the federal government.

⇒ Estimated unpaid taxes lost to the government from cannabis enterprises in the states mentioned, exceeded $48.5 million.

⇒ This will result in a projected loss to the government of more than $242,6 million over a period of five years.

⇒ The IRS put in much effort to monitor the marijuana industry nationwide with programs like the so-called Compliance Initiative Projects (CIPs).

⇒ The objective of national CIP focusses on the establishment of a comprehensive compliance approach to identify noncompliance in the cannabis industry.

⇒ CIPs started in Colorado before spreading all over the country.

⇒ The IRS provided its agents with CIP training sessions (cannabis-related) in Seattle, Portland, Northern California, Nevada, Phoenix, and Detroit.

⇒ After TIGTA recommended that these training CIPs expand nationwide, the IRS agreed.

⇒ The IRS distributed a Participant Guide among its agents containing guidelines for auditing cannabis enterprises.

⇒ The IRS refused to make the Participant Guide public despite TIGTA recommendations of the same.


Keep in mind that the numbers above represent only three of the thirty-three states where marijuana is legally sold. 

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The Loophole

In terms of Section 471(c) of the TCJA of 2017, cannabis enterprises with annual revenue under $25 million, can escape 280E completely.


Accordingly, cannabis enterprises are entitled to deduct all expenses in the cost of goods sold and thereby avoid the impact of Section 280E.


The Bottom Line

It will all boil down to how the IRS applies this law, how the agency administers this statute, and how the courts interpret it.


For cannabis enterprises, this means litigation. Only if they test the water, will they see the reaction of the IRS. And this means going to court to see if the courts agree with them.


Most tax professionals will wait to see which way it all goes.  “We are looking at this on a case-by-case basis,” they say.


Criticizing The IRS

According to the cited report, the IRS should clarify the applications and parameters of Section 280E. The following recommendations were made to the IRS:

⇒ Release the Participant Guide for IRS Auditors to the public to improve compliance by cannabis enterprises

⇒ Publish guidelines specific to the cannabis industry online

⇒ Provide specific guidance for the cannabis industry in respect of 471(c) in conjunction with Section 280E. Make it public.

⇒ Use more state data about licensed cannabis enterprises to identify nonfliers and unreported income in the cannabis industry.

⇒ Reach out to the cannabis industry to increase awareness of available relief from tax penalties related to cash payments since cannabis enterprises have such limited banking options.

Check Our Tax Planning For U.S. Cannabis Investors

U.S. Tax Reporting Obligation For Foreign Cannabis Investors

Many foreigners have invested in the US Cannabis industry.  The market is growing, and firms from Canada and other international markets are showing a keen interest.  The downside is that a foreign investor in your cannabis enterprise means more tax reporting requirements, including Forms 5471 & 5472.  Failure to file these forms accurately and on-time will be perilous in terms of penalties. Most foreigners are oblivious to the specific filing requirements. Still, foreign investors in US Cannabis enterprises must file these forms before the July deadline to avoid high fees.


Form 5472

This is an information form for any business with owners, partners, or shareholders from a non-US country. Cannabis enterprises must also disclose all transactions with international partners, owners, and shareholders. C corps and LLCs with a minimum of 25-percent foreign ownership, shareholders, or partners have to submit it annually.


Late filings or non-filing is expensive. The penalty has just been increased from $10,000 to $25,000.  The IRS uses the information to enforce tax payments on transactions between the US and foreign participants.  Put differently, to stop foreign tax evasion and money laundering and prevent companies from taking advantage of tax exemptions for which they do not qualify.


Form 5471

This is also an information form for any foreign companies owned by US persons.  Citizens and residents (green card holders) who own a minimum of ten percent of a foreign corporation must file it, even if they are ex-pats or live outside the US. If you are an officer, director, or shareholder of a foreign corporation, you have to file Form 5471, irrespective of whether your enterprise is an LLC for tax purposes. In terms of US tax rules, any non-US entity is classified as a corporation by default if all the owners have limited liability.


Those who do not comply will face very tough penalties.  Penalties start at $10,000 for every tax year you failed to file, plus another $10,000 for every form if you take longer than 90-days to rectify your non-filing after receiving a notice of failure from the IRS.  AND a further $10,000 for every thirty days after that.


Reportable Transactions

Any exchange of money or property with a foreign shareholder. It includes payment for sales, rent, royalties, interest, and more, but it excludes dividend payments.


For a cannabis enterprise, the following transactions need to be reported:

⇒ Capital contributions to the cannabis venture made by foreign investors.

⇒ Exchange of commission, money, rental income, or sales.

⇒ Payment of expenses on behalf of a foreign entity.

⇒ Payments for the use of US property.

⇒ Payments related to acquisitions or dissolutions.

⇒ Sale or purchase of inventory.


Related Parties

Any direct or indirect foreign shareholder that owns 25% or more of the reporting corporation, among others. You can apply for a penalty abatement, but odds are it won’t be granted.  Begin by sending a letter to the IRS to explain your situation.  It will take up to eight months for the IRS to decide your case.  It is recommended that you instead file your forms timely, typically along with your annual tax return.  Of course, 2020 is an anomaly. You can, therefore, still file both forms before the deadline in July.


Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.

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