California: Cannabis Client Due Diligence and Corporate Tax Return Preparation

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We typically create articles about ideas relating to monetary management, specially with respect to tax management. Articles primarily based on abstract monetary ideas are critical.

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 approach prior to providing our client an Engagement Letter in order to turn out to be familiar with the dirt in which these bushes develop.

A CPA should really In no way commence function for any client, specially a client operating in the cannabis market, devoid of conducting due diligence and obtaining 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 all the things in a single location,[1] integrated:

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

As soon as the due diligence was completed, we reviewed the policies and procedures for the operation of the enterprise, such as:

  • Evaluation of the Normal Operating Procedures [“SOPs”] for sales, promoting, merchandise manage, delivery practices, and personnel.
  • Evaluation of internal accounting controls more than the basic 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 essential to ascertain that money is correctly accounted for each in gross receipts and in the assets of the enterprise.

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

The record-maintaining systems frequently utilized in the market do not offer a Dispensary with a summary of total CET paid to every single Distributor. These deficiencies in record-maintaining make the approach of auditing Distributors far far more problematic. These deficiencies also build a mechanism whereby underground operators can make use of arrangements with reputable licenses to acquire cannabis and cannabis items 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 a number of operators concerning the verification and archival of information and facts relating to CET paid in connection with purchases. We have received a range of responses.

Our subsequent actions involved a overview of gross receipts exactly where we:

  • Evaluation bank statements for the complete year and a single extra 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 manage ledger to confirm money in a comparable style, maintaining in thoughts the one of a kind difficulties that money poses.
  • Evaluate 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 correctly calculated on person delivery receipts, and on the quarterly filings.

As soon as we have completed our overview actions above, we can offer the client with an Engagement Letter and accept a client[3].

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

  • Our very first step is to appear at persons that offer solutions to the entity, no matter if as workers 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. Numerous 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 desires to be allocated to numerous functions, we make positive we do it on “white paper” statements that are appended to Kind 1125-E.
  • We are going to leave the facts of how the allocations described in the step above are accomplished, as we have created proprietary techniques that we deploy below the Cannabacus brand and we and other people have written extensively on the subject.

As soon as the expense allocations are completed, we are at the point that we begin placing the information and facts on the tax return [Form 1120 – Corporation Tax Return].

  • We begin by producing positive that gross revenue per the basic 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 quite powerful caution should really be noted with respect to the bullets inside this caption. The author has virtually forty years of knowledge and “horse sense” about disclosure involving sensitive products associated to cannabis. A newer practitioner would be sensible 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 probably to be audited.
  • A final point is in order…all of these yes/no checkbox queries are there for excellent explanation and answering a single the incorrect way can “set off bells” when the return is processed. Make positive you Very carefully Study AND ANSWER Each and every Query.
  • Make positive 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 on., that you get it ideal. Accuracy in the simplest of products can save hours of time in the future.
  • As soon as the Federal Return is accomplished, the California Franchise Tax Return should really be reasonably simple with the exception of California permitting IRC Sec. 280E costs for corporations.

[1] We note that our Dropbox Business enterprise is supplemented and hardened with a tool from Sookasa.com that tends to make it completely HIPAA compliant.

[2] We discovered fairly 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 overview 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 revenue. We note that the level of function expected in these actions is such that we normally request a non-refundable retainer of $two,500-$three,500 when we undertake the due diligence actions.

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