We usually write articles about concepts relating to financial management, especially with respect to tax management. Articles based on abstract financial concepts are important.
As a practicing CPA, on occasion one has to “get into the dirt” and “push the digits.”
We recently had the opportunity to assist a new client who is qualified as a “cannabis equity business” with the City of Oakland, California. We undertook an extensive due diligence process prior to offering our client an Engagement Letter in order to become familiar with the dirt in which these bushes grow.
A CPA should NEVER begin work for any client, especially a client operating in the cannabis industry, without conducting due diligence and having an Engagement Letter signed.
Our initial due diligence on the business entity, which we requested the client upload to a single Dropbox folder so we have everything in one place,[1] included:
- Review of the LLC Articles of Organization filed with the California Secretary of State.
- Review of the Information Statements filed with the California Secretary of State.
- Review of an executed copy of the Operating Agreement for the LLC.
- Review of an executed copy of Form 8832 “Check the Box” Entity Classification Election.
- Review of the Bureau of Cannabis Control [“BCC”] Cannabis – Delivery Dispensary form.
- Review of City of Oakland Business License and Cannabis License.
Once the due diligence was completed, we reviewed the policies and procedures for the operation of the business, including:
- Review of the Standard Operating Procedures [“SOPs”] for sales, marketing, merchandise control, delivery practices, and personnel.
- Review of internal accounting controls over the general ledger, and gross receipts. These procedures will vary substantially if the LLC’s access to commercial banking is limited.
- In an instance in which an operating entity has limited access to banking, extensive investigation is necessary to ascertain that cash is properly accounted for both in gross receipts and in the assets of the business.
California’s underground cannabis market is well known to all involved in the industry. We learned first-hand about some of these activities, especially prior to the deployment of METRC on a widespread basis[2]. The point that may not be obvious is that a Dispensary pays Cannabis Excise Tax [“CET”] on the cannabis and cannabis products it purchases from Distributors.
The record-keeping systems generally utilized in the industry do not provide a Dispensary with a summary of total CET paid to each Distributor. These deficiencies in record-keeping make the process of auditing Distributors far more problematic. These deficiencies also create a mechanism whereby underground operators can utilize arrangements with legitimate licenses to purchase cannabis and cannabis products on which CET purportedly has already been collected [and we presumably paid over to the California Dept. of Tax and Fee Administration [“CDTFA”] by the Distributor].
A California Dispensary has no direct reporting responsibility for CET at this time. We have queried multiple operators regarding the verification and archival of information relating to CET paid in connection with purchases. We have received a variety of responses.
Our next steps involved a review of gross receipts where we:
- Review bank statements for the entire year and one additional month on “both sides” with a view towards confirming that the deposits and other credits to the bank account tie to the General Ledger. Where the entity lacks bank accounts, we use the cash control ledger to verify cash in a similar fashion, keeping in mind the unique issues that cash poses.
- Compare the General Ledger totals for gross receipts with CDTFA quarterly filings for Sales Tax, and local jurisdiction [in this case Oakland] Gross Receipts Tax. Our focus is both on tying the total gross receipts in the quarterly filings to the General Ledger and on ascertaining that the taxes are properly calculated on individual delivery receipts, and on the quarterly filings.
Once we have completed our review steps above, we can provide the client with an Engagement Letter and accept a client[3].
Once we have accepted client pursuant to an executed Engagement Letter with a Cannabis Rider, we dig into the expense side of the entity.
- Our first step is to look at persons that provide services to the entity, whether as employees or independent contractors [which includes consideration of all that comes with AB 5], as well as all of the employment tax and EDD filings and reporting and withholding for contractors.
- We then focus on the allocation of payroll/contractor pay to functions within the business for management, accounting/finance, security, product management and delivery services. Many of the service invoices and expenses will track the activity of personnel for allocation of expenses to management, overhead, and IRC Sec. 280E non-deductible “trafficking expenses”.
- If officer’s pay needs to be allocated to various functions, we make sure we do it on “white paper” statements that are appended to Form 1125-E.
- We are going to leave the details of how the allocations described in the step above are done, as we have developed proprietary methods that we deploy under the Cannabacus brand and we and others have written extensively on the topic.
Once the expense allocations are completed, we are at the point that we start putting the information on the tax return [Form 1120 – Corporation Tax Return].
- We start by making sure that gross income per the general ledger and tax return always tie in.
- We use Form 1125-A as the place where we add “white paper” statements if there is anything we need to add to the calculation of Cost of Goods Sold {“COGS”].
- We deliberately group all of the IRC Sec. 280E trafficking expense items on a “white paper” statement which appears on Schedule M-1 – [“ Reconciliation of Income/Loss Per Books with Income Per Return”] with linking references on other schedules within the return where 280E components are broken out.
- It is our view that a thorough job of highlighting and linking all of the items the IRS will look for reduces the need forForms 8275 – Disclosure Statement and 8275-R Regulation Disclosure Statement as a consequence of disclosures within the body of the tax return.
- A very strong caution should be noted with respect to the bullets within this caption. The author has almost forty years of experience and “horse sense” about disclosure involving sensitive items related to cannabis. A newer practitioner would be wise to seek the guidance of a CPA with an MST or a tax attorney when facing disclosure decisions as the presentation in a return establishes the manner in which the return is likely to be audited.
- A final point is in order…all of those yes/no checkbox questions are there for good reason and answering one the wrong way can “set off bells” when the return is processed. Make sure you CAREFULLY READ AND ANSWER EVERY QUESTION.
- Make sure that where you are asked for an identifier such as a social security number, taxpayer identification number, Secretary of State Corporation number, etc., that you get it right. Accuracy in the simplest of items can save hours of time in the future.
- Once the Federal Return is done, the California Franchise Tax Return should be relatively straightforward with the exception of California allowing IRC Sec. 280E expenses for corporations.
[1] We note that our Dropbox Business is supplemented and hardened with a tool from Sookasa.com that makes it fully HIPAA compliant.
[2] We learned quite a bit about black market scams involving those with Delivery Only Dispensary licenses, and that will be the subject of a separate article.
[3] We note that our review up to this point has been to vet the client entity and its owners and to satisfy ourselves that there are no omissions of gross income. We note that the level of work required in these steps is such that we typically request a non-refundable retainer of $2,500-$3,500 when we undertake the due diligence steps.
