We are rapidly approaching the close of 2018 and the first birthday of a regulated medical and adult-use cannabis industry in California. The transformation from a lightly regulated medical cannabis industry to a highly regulated medical and adult-use commercial market1 has been plagued by fits and starts as the regulatory agencies struggle to create a workable structure 2. The highlights for us relating to this transition have included………………
- Concluding that cannabis cultivation in California constitutes agricultural activity [“farming”] for Federal and California income tax purposes.3
- Seeking to ease the difficulties of California’s cannabis industry regulators by raising questions and suggesting answers to financial and taxation issues created by the difficulty of imposing regulation on a very substantial and well-established underground industry as is demonstrated by actions taken throughout California to address the licensing backlog, including the legislative fix of “provisional licensing”.4
- Writing about painful transition to mandatory testing of cannabis products which are sold through the legal cannabis supply chain in California and the destruction of untested product as of last July 1.5
- Writing about the consequences of litigating in Tax Court without involving the expertise of a certified public accountant with cannabis industry experience.6 The article by Prof. Bryan Camp, Lesson From The Tax Court: Into The Weeds on COGS highlights the risks.
- Writing about the necessity of properly using a certified public accountant as an expert witness as well as the risks involved in the failure prepare and review the expert certified accountant’s work product, which can result in disqualification of the expert’s opinion with catastrophic consequences, as illustrated by a recent Tax Court case where Jim Marty, CPA of Bridge West CPA’s was disqualified under the Tax Court’s version of the Daubert Standard.7
We have undertaken a significant effort to educate our clients and prospective clients about requirements of the Internal Revenue Service8, California’s cannabis regulatory and tax agencies9 and the CPA’s role in the administrative processes relating to regulation and taxation.10
The preceding provides the foundational background and framework for the discussion that follows relating to the role and function of a CPA in assisting counsel for cannabis business who has undertaken litigation on behalf of a cannabis business. The primary focus of the discussion that follows relates to tax controversies, although the rules relating to privileges are generally applicable in any litigation context.
Forty years ago, in the landmark case of United States v. Kovel11,’ the Second Circuit extended the attorney-client privilege to include communications an attorney had with an accountant to assist the attorney in understanding the client’s financial information. In the Kovel case, the court analogized the accountant’s role to that of an interpreter. The law is well-established that if an attorney needs an interpreter to understand his client, the presence of the interpreter will not vitiate the attorney-client privilege. According to the Second Circuit, the tax laws can be as incomprehensible as a foreign language to many lawyers; “[h]ence the presence of an accountant… while the client is relating a complicated tax story to the lawyer, ought not to destroy the privilege …. “,
The attorney-client privilege, however, is valuable only to the extent the scope and limits are predictable and fully understood by all interested parties. A lack of a thorough understanding of the law as well as a lack of caution in the use of a privilege will render the privilege virtually worthless. No competent attorney would engage in confidential communications with a client or a representative of a client unless she was certain the attorney/client privilege would apply.
An investigative accountant can be clothed with an extension of the attorney/client privilege through the proper use of the Kovel case. However, great caution must be exercised by both the attorney and the accountant because both are potential targets of malpractice claims based on the disclosure of information that could have been maintained as confidential. A failure to engage a new and independent at the earliest possible time as well as a failure to carefully document the channel of communication may result in a disclosure of information that could have remained confidential and a malpractice action as a consequence. Information improperly or incautiously disclosed an accountant during an audit or in preparation for an audit may ultimately be required to be unnecessarily disclosed to others.
Uncertainties exist with respect to the preservation of the attorney/client privilege with respect to communications between and among a client, the client’s attorney, and the client’s accountant. Over the past four decades, courts have repeatedly narrowed the holding in Kovel. Of greater significance, few attorneys and even fewer accountants have a clear understanding of the scope and limits of the available protection for communications with accountants. The limited protection that remains is confusing to most because of a number of common misconceptions.
On October 27th the US District Court for the District of Minnesota issued an opinion in United States v. Adams, No. 0:17-cr-00064-DWF-KMM (D. Minn. Oct. 27, 2018) , addressing attorney-client privilege issues relevant to accountants working alongside tax attorneys. The court adopted a narrow, nuanced view of the waiver that applies when the taxpayer discloses an accountant’s work to the Internal Revenue Service (IRS) by filing an amended return.
In Adams, the taxpayer faced a seventeen-count superseding indictment in which the government alleged he spearheaded a scheme to defraud investors in two companies and to embezzle corporate funds for his personal benefit. In late 2017, the government added three counts of tax evasion to the indictment. The United States alleged that amended returns the taxpayer filed in late 2011 for his 2008, 2009 and 2010 tax years were willfully false under IRC § 7206(1).
- The Adams case demonstrates how far back the Department of Justice will go. In addition, there is not statute of limitations if the IRS can establish a taxpayer filed a fraudulent income tax return.
- Generally a corporation has no privilege. All communications among employees of corporations and between employees and owners of corporations are generally discoverable. Non-profit public benefit corporations which have been the workhorse entities to date for California’s cannabis industries are corporations for this purpose as are limited liability companies. Also, any reader of this article should be aware that two individuals and one overt criminal act constitutes a criminal conspiracy.
- Text messages are documents for the purpose of the discovery of documents. There is a record somewhere in the internet of the sender and recipient of every text communication ever sent.
- The crime/fraud exception to the attorney/client privilege and the narrow difference between advice sought and received relating to conduct already undertaken and advice sought and received that is used in furtherance of criminal activities mandate great caution with respect to representation in connection with a tax controversy. Individuals involved in California’s cannabis industry must never forget that all commercial cannabis activities are criminal activities in the eyes of the Department of Justice.
- The broad scope of the work product doctrine as to communications with an attorney relating to litigation, even closed litigation, make this privilege not infrequently to be as important as the attorney/client privilege. The strict limitation of the work product doctrine to communications and impression and the complete lack of the application of the work product doctrine to otherwise discoverable documents make an understanding of the scope and limitations of the doctrine of critical importance.
- Caution suggests an independent Kovel accountant should brought in immediately in connection with any federal or California tax audit of a California cannabis business except in an instance in which the attorney is knows beyond any reasonable doubt that the civil audit will not develop into a criminal investigation. This caution approach should be applied to Sales tax audits as well as CCT and CET tax audits.
California’s cannabis industry has long-focused on unfairness of IRC Section 280E to the cannabis industry. The vast majority of the tax cases involving cannabis have been income tax cases involving IRC Section 280E. Beginning in 2019 the focus of tax controversies in California will change for at least four reasons. First, income tax dollars at play in California’s cannabis industry are dwarfed by the CCT, CET and Sales tax dollars at play in the industry. Second, California’s tax collections are lagging behind projections. Third, CCT and CET were brought into California’s legal landscape with little if any thought with respect to tax administration. Fourth, California underwent a massive reorganization its administration of all taxes concurrently with its regulation of its medical and adult-use cannabis industry and CCT and CET are in a sense the over-looked stepchild in CDTFA.
2 We believe that it is critically important that the California Legislature and the entirety of the complex regulatory structure which they created never lose sight of Keeping Proposition 215’s Promise.
The agencies within the State of California with primary responsibility for oversight of the cannabis industry for regulatory compliance, which are the Bureau of Cannabis Control [“BCC”] for Retail [Dispensaries, Offsite Event and Distribution licensees, the California Department of Food and Agriculture’s [“CDFA”] CalCannabis Unit for Cultivation licensees, the California Department of Public Health’s [“CDPH”] Manufactured Cannabis Safety Bureau [“MCSB”] for Manufacturing, Extraction and Testing Laboratories and the California Department of Tax and Fee Administration [“CDTFA”], have issued a significant number of administrative pronouncements, regulations and Special Notices that expand upon the IRS’s requirements for financial records, recordkeeping, document formats, retention requirements and audit guidelines.
5 See Lessons June 30, 2018
10 See Regulation CPAs Accountants Tax Pros for an overview of the regulatory framework for accounting and tax professionals.
11 296 F.2d 918 (2nd Cir. 1961)