California: Cannabis Client Due Diligence and Corporate Tax Return Preparation

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We normally create articles about ideas relating to monetary management, specifically with respect to tax management. Articles primarily based on abstract monetary ideas are vital.

As a practicing CPA, on occasion a single has to “get into the dirt” and “push the digits.”

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We lately had the chance to help a new client who is certified as a “cannabis equity business” with the City of Oakland, California. We undertook an comprehensive due diligence procedure prior to providing our client an Engagement Letter in order to turn into familiar with the dirt in which these bushes develop.

A CPA should really In no way commence perform for any client, specifically a client operating in the cannabis market, with out conducting due diligence and getting an Engagement Letter signed.

Our initial due diligence on the enterprise entity, which we requested the client upload to a single Dropbox folder so we have every little thing in a single location,[1] incorporated:

  • Assessment of the LLC Articles of Organization filed with the California Secretary of State.
  • Assessment of the Information and facts Statements filed with the California Secretary of State.
  • Assessment of an executed copy of the Operating Agreement for the LLC.
  • Assessment of an executed copy of Kind 8832 “Check the Box” Entity Classification Election.
  • Assessment of the Bureau of Cannabis Manage [“BCC”] Cannabis – Delivery Dispensary type.
  • Assessment of City of Oakland Enterprise License and Cannabis License.

After the due diligence was completed, we reviewed the policies and procedures for the operation of the enterprise, like:

  • Assessment of the Normal Operating Procedures [“SOPs”] for sales, promoting, merchandise handle, delivery practices, and personnel.
  • Assessment of internal accounting controls more than the common ledger, and gross receipts. These procedures will differ substantially if the LLC’s access to industrial banking is restricted.
  • In an instance in which an operating entity has restricted access to banking, comprehensive investigation is required to ascertain that money is appropriately accounted for each in gross receipts and in the assets of the enterprise.

California’s underground cannabis industry is nicely identified to all involved in the market. We discovered initially-hand about some of these activities, specifically prior to the deployment of METRC on a widespread basis[2]. The point that may well not be apparent is that a Dispensary pays Cannabis Excise Tax [“CET”] on the cannabis and cannabis solutions it purchases from Distributors.

The record-maintaining systems typically utilized in the market do not supply a Dispensary with a summary of total CET paid to each and every Distributor. These deficiencies in record-maintaining make the procedure of auditing Distributors far far more problematic. These deficiencies also make a mechanism whereby underground operators can make use of arrangements with reputable licenses to buy cannabis and cannabis solutions on which CET purportedly has currently 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 duty for CET at this time. We have queried several operators relating to the verification and archival of info relating to CET paid in connection with purchases. We have received a range of responses.

Our subsequent measures involved a critique of gross receipts exactly where we:

  • Assessment bank statements for the whole year and a single added month on “both sides” with a view towards confirming that the deposits and other credits to the bank account tie to the Common Ledger. Exactly where the entity lacks bank accounts, we use the money handle ledger to confirm money in a comparable style, maintaining in thoughts the one of a kind difficulties that money poses.
  • Examine the Common Ledger totals for gross receipts with CDTFA quarterly filings for Sales Tax, and neighborhood jurisdiction [in this case Oakland] Gross Receipts Tax. Our concentrate is each on tying the total gross receipts in the quarterly filings to the Common Ledger and on ascertaining that the taxes are appropriately calculated on person delivery receipts, and on the quarterly filings.

After we have completed our critique measures above, we can supply the client with an Engagement Letter and accept a client[3].

After we have accepted client pursuant to an executed Engagement Letter with a Cannabis Rider, we dig into the expense side of the entity.

  • Our initially step is to appear at persons that supply solutions to the entity, whether or not as personnel or independent contractors [which includes consideration of all that comes with AB 5], as nicely as all of the employment tax and EDD filings and reporting and withholding for contractors.
  • We then concentrate on the allocation of payroll/contractor spend to functions inside the enterprise for management, accounting/finance, safety, item management and delivery solutions. A lot of of the service invoices and costs will track the activity of personnel for allocation of costs to management, overhead, and IRC Sec. 280E non-deductible “trafficking expenses”.
  • If officer’s spend requires to be allocated to several functions, we make confident we do it on “white paper” statements that are appended to Kind 1125-E.
  • We are going to leave the particulars of how the allocations described in the step above are carried out, as we have created proprietary procedures that we deploy below the Cannabacus brand and we and other people have written extensively on the subject.

After the expense allocations are completed, we are at the point that we start off placing the info on the tax return [Form 1120 – Corporation Tax Return].

  • We start off by producing confident that gross earnings per the common ledger and tax return often tie in.
  • We use Kind 1125-A as the location exactly where we add “white paper” statements if there is something we want to add to the calculation of Expense of Goods Sold {“COGS”].
  • We deliberately group all of the IRC Sec. 280E trafficking expense products on a “white paper” statement which seems on Schedule M-1 – [“ Reconciliation of Income/Loss Per Books with Income Per Return”] with linking references on other schedules inside the return exactly where 280E elements are broken out.
  • It is our view that a thorough job of highlighting and linking all of the products the IRS will appear for reduces the want forForms 8275 – Disclosure Statement and 8275-R Regulation Disclosure Statement as a consequence of disclosures inside the physique of the tax return.
  • A really powerful caution should really be noted with respect to the bullets inside this caption. The author has just about forty years of encounter and “horse sense” about disclosure involving sensitive products connected to cannabis. A newer practitioner would be smart to seek the guidance of a CPA with an MST or a tax lawyer when facing disclosure choices as the presentation in a return establishes the manner in which the return is most likely to be audited.
  • A final point is in order…all of these yes/no checkbox inquiries are there for superior explanation and answering a single the incorrect way can “set off bells” when the return is processed. Make confident you Meticulously Study AND ANSWER Just about every Query.
  • Make confident that exactly where you are asked for an identifier such as a social safety quantity, taxpayer identification quantity, Secretary of State Corporation quantity, and so forth., that you get it correct. Accuracy in the simplest of products can save hours of time in the future.
  • After the Federal Return is carried out, the California Franchise Tax Return should really be somewhat simple with the exception of California permitting IRC Sec. 280E costs for corporations.

[1] We note that our Dropbox Enterprise is supplemented and hardened with a tool from that tends to make it totally HIPAA compliant.

[2] We discovered pretty a bit about black industry scams involving these with Delivery Only Dispensary licenses, and that will be the topic of a separate report.

[3] We note that our critique 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 earnings. We note that the level of perform essential in these measures is such that we usually request a non-refundable retainer of $two,500-$three,500 when we undertake the due diligence measures.

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