What every tax pro should know about cannabis compliance

The cannabis industry continues to expand rapidly, but its federal classification brings unique complications to your practice. If you're working with cannabis clients, understanding how to legally and accurately calculate cost of goods sold is critical. 

You need to know how to tailor your approach depending on whether your client is cultivating or selling cannabis.

Below, you’ll find a few of the top questions from a recent webinar on the topic and their corresponding answers. If you choose to attend the on-demand version of this webinar, you can access the full recording and the entire list of Q&As.  

Q: As an enrolled agent, what are my risks in preparing returns for cannabis clients?

A: Since cannabis is federally illegal, §280E always applies regardless of state law. (This code section disallows all deductions or credits related to trafficking in controlled substances under Schedule I or II of the Controlled Substances Act.) Your main concerns are carefully limiting deductions to cost of goods sold (COGS), avoiding aggressive expense treatment and being prepared for heightened IRS audit scrutiny when you sign a return.

Q: How many cannabis businesses are doing their taxes correctly?

A: Very few. In light of §280E, most cannabis business owners tend to over-deduct expenses or miss opportunities to maximize COGS, creating audit risk. Those closest to compliance usually work with tax consultants or firms specializing in cannabis law to track costs tightly and apply the rules conservatively.

Q: How common are IRS audits of cannabis businesses?

A: Exact numbers aren’t published, but audit rates are widely reported to be much higher than for other small businesses. The combination of §280E, heavy cash operations and inconsistent recordkeeping makes cannabis businesses a high-risk target.

Q: For cannabis businesses, why are sole proprietorships and S-corps less preferable entity choices than C-corps?

A: With Schedule C or S-corps, expenses disallowed by §280E flow straight through to the owner’s Form 1040, U.S. Individual Income Tax Return, as phantom income, increasing personal tax liability. In contrast, a C-corp applies the §280E disallowance at the entity level, which helps shield owners from personal tax implications and offers more flexibility in tax planning, along with a stronger audit defense.

To learn more about cannabis taxation, you can watch our on-demand webinar. NATP members can attend for free, depending on membership level! If you’re not an NATP member and want to learn more, join our completely free 30-day trial.